Credit Default Swaps on Municipal Bonds: A Double-Edged Sword?
Credit Default Swaps on Municipal Bonds: A Double-Edged Sword?
Ming-Jie Wang 0 1
0 Ming-Jie Wang, Credit Default Swaps on Municipal Bonds: A Double-Edged Sword? , 35 Yale J. on Reg. (2018). Available at: https://digitalcommons.law.yale.edu/yjreg/vol35/iss1/6
1 Thi s Article si brought to you for free and open access by Yale Law School Legal Scholarship Repository. It has been accepted for inclusion inaYle Journal on Regulation by an authorized editor of Yale Law School Legal Scholarship Repository. For more information , please contact
The municipal bond market has traditionallybeen viewed as a relatively
safe market, where credit risk wasn't a primary concern. The spate offiscal
crises that state and local governments have experienced in recent years,
however, has changed this narrative. With credit risk increasingly on the
forefront of investors and bond issuers' minds, credit default swaps ("CDSs")
loom large as a financial derivative that can directly mitigate or hedge
municipal credit risk. A nascent market for municipal credit default swaps
(muni CDSs) does exist. The market, however, is thinly traded, and, for a
number of reasons, a robustmuni CDS market has not yet developed.
This Note explores whether a more robust muni CDS market should be
developed and considers the available optionsfor doing so. While a number of
policies could make the muni CDS market safer and more robust, policymakers
must grapple with costs and benefits that come with more widespread use of
muni CDSs. Besides tracingthe reasonsfor the historicallack of a robust muni
CDS market, this Note makes a number of additionalcontributions. It provides
an overview of the mechanics and state of the extant muni CDS market.
Additionally, it argues that the current distressed conditions within the
municipal bond market may be tempering some of the constraints that have
historically limited the muni CDS market. It also suggests a number of
proposals that would help make the muni CDS market more robust, while also
discussing at length the costs and benefits of these proposals.
Although the municipal bond market has traditionally been viewed as a
relatively safe market where credit risk was not a primary concern,' recent
history suggests that market participants may have to pay more attention to a
municipality's ability to make its payments in full and on time. State and local
governments have experienced a spate of fiscal crises in recent years, some of
which have even ended in defaults and bankruptcies. 2 As credit risk becomes
more of a concern for market participants, credit default swaps (CDSs) could
be a financial instrument that mitigates or hedges the credit risk of these
municipal bonds. CDSs are financial derivatives that function as insurance
against credit events of the underlying securities (i.e. municipal bonds). Thus,
the owner of a CDS can directly hedge the credit risk associated with owning
1. The risk is that the borrower (in this case the issuer of the bond) will not be able to
make payments in full. See, e.g., Sugato Chakravarty & Asani Sarkar, Liquidity in U.S. Fixed Income
Markets: A Comparison of the Bid-Ask Spread in Corporate, Government and MunicipalBond Markets
2 (FRB New York, Staff Report No. 73, 1999), http://papers.ssrn.com/sol3/papers.cfm?abstractid
2. See John Patrick Hunt, ConstitutionalizedConsent: Preemption of State Tax Limits
in Municipal Bankruptcy, 34 YALE J. ON REG. 391 (2017); Richard Ravitch & Paul Volcker, Final
Report, ST. BUDGET CRisis TASK FORCE (2014), http://www.pgpf.org/sites/default/files
/state budget crisis taskforcefinalreport_01142014.pdf[http://perma.cc/C587-T9DK].
the underlying bond. 3 Indeed, CDSs are widely used in corporate, sovereign,
and other credit markets.4
A nascent market for municipal credit default swaps (muni CDSs) exists;
however, these CDS instruments are thinly traded, with notional amounts that
are small compared with the cash municipal bond market and with other CDS
markets. 5 To date, a robust muni CDS market has not yet developed for a
number of reasons. First, given the low historical rate of municipal defaults,
investors have not traditionally demanded protection against credit events.
Second, municipal bonds are largely concentrated in the hands of investors who
invest in these securities for their tax advantages and hold them to maturity.
Another hurdle to more widespread use of muni CDSs is the fact that muni
CDSs do not receive the same tax benefits as the underlying cash instruments.
This Note will evaluate the normative arguments for developing a robust
muni CDS market and consider the options available for doing so. While a
number of policies could make the muni CDS market safer and more robust,
policymakers must also grapple with the complex set of costs and benefits
associated with the more widespread use of muni CDSs.6 Although this Note
does not make a definitive recommendation, it does aim to tee up these
questions and provide policymakers with a framework for considering the
trade-offs of a more robust muni CDS market.
This Note is the first academic article to provide a unified historical and
market-based explanation for the lack of credit default swaps or other
credithedge instruments in the municipal bond market. While there is no shortage of
scholarly commentary on the municipal bond market7 or state and local
government budget crises, no article to date has focused specifically on the
credit risk posed by municipal bonds and the potential means of mitigating such
In addition to tracing the reasons for the historical lack of a robust muni
CDS market, this Note makes a number of novel contributions. It provides an
overview of the mechanics, size, and state of the extant muni CDS market. It
also argues that the current distressed conditions within the municipal bond
market may be removing (or at least mitigating) some of the constraints that
have historically limited the muni CDS market. It suggests a number of
proposals that would help make the muni CDS market more robust (i.e., safer,
more liquid, and more price-transparent9), while also discussing at length the
costs and benefits of these proposals. Thus, a significant part of this Note's
contribution is to inform policymakers (primarily at the federal level) who are
deliberating the normative issue of supporting a more robust muni CDS market.
Given the lack of academic treatment of this subject, Parts II and III rely
heavily on industry reports and news articles. Part IV, which suggests reforms
that can create a more robust market and evaluates the costs and benefits of
these reforms, draws on relevant theoretical and empirical work in economics.
The rest of this Note proceeds as follows: Part I provides a brief overview
of the mechanics of the muni CDS market. Part II explains the historical lack of
credit risk instruments in the municipal bond market by looking at demand and
supply dynamics while introducing the concept of informationally insensitive
debt. Part III argues that the emergence of credit risk as an increasingly
important risk factor counteracts some of the constraints identified in Part II and
explains why CDSs are superior to alternative sources of credit hedging. Part IV
considers a series of proposals that would create a more robust muni CDS
market and weighs the pros and cons of muni CDSs becoming more widely
used. Lastly, this Note concludes by situating muni CDSs in the current
economic and policymaking environment.
I. Understanding the Muni CDS Market
A. Muni CDS Market Mechanics
This section lays out the mechanics of the muni CDS market as it
currently exists. It touches on CDS economics, credit events, settlement,
standardization and clearing, and arbitrage, all critical factors underlying the
9. Price transparency refers to the ability of market participants to discern the value of
securities (or other items) being traded in a market. A more liquid market, with more trades and
opportunities for market participants to gather data on the value of securities, is generally more
transparent and will have lower costs associated with each transaction. See, e.g., Amy Edwards,
Lawrence Harris & Michael Piwowar, CorporateBond Market Transaction Costs and Transparency, 62
J. FIN. 1421, 1421-22 (2007); Lawrence Harris & Michael Piwowar, Secondary Trading Costs in the
MunicipalBondMarket, 61 J. FIN. 1361, 1362 (2006).
1. CDS Economics
CDSs are essentially a form of insurance. The protection buyer pays the
protection seller a periodical premium (similar to an insurance premium) in
return for protection against a credit event of the underlying debt instrument's
issuer. If no credit event occurs over the duration of the CDS contract, only the
premiums are exchanged between buyer and seller. If a credit event transpires,
however, the protection seller compensates the protection buyer for the loss on
the underlying bond (the protection seller pays the protection buyer the par
value of the bond in exchange for a delivered bond).' 0 The protection buyer
typically has the option to deliver a bond with a maximum maturity of thirty
years. Economically, this is equivalent to the protection seller paying an
amount equal to the contract notional value minus the value of "deliverable"
debt obligations issued by the reference entity (the municipality). This amount
is also known as the "recovery value."'12
2. Credit Events
As mentioned above, a CDS contract is settled upon the occurrence of a
credit event. For muni CDSs, there are two types of credit event triggers: (
failure to pay and (
) restructurings. Failure to pay is straightforward: It is "a
failure to pay under an Obligation of the Reference Entity in accordance with
the terms of the Obligation at the time of the failure."'1 3 A restructuring refers to
"a modification of the terms of an Obligation of the Reference Entity so as to
delay or reduce the Reference Entity's payment obligation."14
Traditionally, the default form of settlement in the muni CDS market has
been physical settlement. In a physically settled transaction, upon the
occurrence of a credit event, "[the] protection buyer delivers to the [protection
seller] a par amount of Deliverable Obligations of the reference entity equal to
the notional amount in return for a cash payment equal to the notional
amount. "'1 As noted above, the protection buyer has the option of delivering
10. This proposition assumes physical settlement. If the transaction was cash settled,
no bond would be physically delivered. See infra note 17 for further discussion on cash compared to
11. See SiVAN MAHADEVAN ET AL., CREDIT DERIVATIVES INSIGHTS: HANDBOOK OF
CREDIT DERIVATIVES AND STRUCTURED CREDIT STRATEGIES 148 (2011).
12. INT'L MONETARY FUND, GLOBAL FINANCIAL STABILITY REPORT 57 (2013).
13. Lary Stromfeld, Credit Default Swaps for Municipal Reference Entities,
CADWALADER, WICKERSHAM & TAFT LLP 10 (May 2008), http://www.sourcemediaconferences.com
15. Id. at 5.
any bond with a maximum maturity of thirty years and receiving par from the
Cash settlement is an alternative form of settlement that does not require
the physical exchange of the underlying securities.' 7 With the latest
International Swaps and Derivatives Association (ISDA) muni CDS protocol,
cash settlement is now the market norm.' 8 In a cash settlement process, the
payment from the protection seller to the protection buyer after a credit event is
equivalent to the par value of the reference obligation (the municipal bond),
minus the recovery rate. This value will equal the "market price" of the bonds at
a set time after the credit event occurs. This market price is typically
determined by soliciting quotes for the underlying bond from bond dealers in an
4. Standardization & Clearing
Standardization of derivatives helps increase transactional efficiency
instead of renegotiating terms for every new derivative contract, standardization
allows parties to agree to a set of rules and norms that apply to all contracts.
Central clearing of derivatives, on the other hand, is aimed at reducing
counterparty risk within the derivatives market. By forcing transactions to go
through a central clearing house, central clearing allows for positions to be
netted out across counterparties, reducing the risk that a large counterparty's
inability to unwind its positions properly would have substantial negative
externalities for the rest of the market. After the financial crisis, standardization
and central clearing were implemented for many derivatives, in part as a
response to the havoc that Lehman Brothers's failure wrought upon the
standardization or central clearing. Indeed, to the extent this market exists,
Mahadevan, supranote 11.
17. Note that cash settlement and physical settlement are economically equivalent. To
see this, note that in a cash settlement process, the protection seller pays the protection buyer (notional) *
(1-RR), where RR is the recovery rate. So if RR is lower, the seller has to pay more, which makes sense.
In a physical settlement process, the protection seller pays to protection buyer cash equal to notional
amount, in exchange for a par amount of deliverable bonds (market value = recovery value, or 1-RR).
18. ISDA is a trade association composed of broker-dealers and other market
participants that provides internal market rules and protocols that market participants sign on to for
purposes of standardization and transactional efficiency. In short, it helps the industry resolve collective
action problems. See 2012 ISDA U.S. Municipal Reference Entity CDS Protocol, INT'L SWAPS &
DERIVATIVES ASS'N (2012), http://www.isda.org/2012MuniCDSProt/docs/2012%/`201SDA%/`20U.S.
%20Municipal%20Reference%2OEntity%20Protocol.pdf [http://perma.cc/4UEF-D9P7] [hereinafter
19. Stromfeld, supra note 13, at 4.
20. Kimberly Summe, An Evaluation of the U.S. Regulatory Response to Systemic Risk
and FailurePosedby Derivatives, 4 HARV. Bus. L. REV. ONLINE 76, 76 (2014),
trades are conducted on a bilateral, over-the-counter basis. Nonetheless, there
have been efforts to introduce a degree of standardization within the market. In
particular, ISDA introduced a muni CDS protocol in 2012.21 This protocol
specifies, among other things, mandatory cash settlement, rolling "look-backs"
for credit events and succession events, standardized fixed-rate and three-month
initial calculation periods, a recovery rate assumption of seventy-five percent
for pricing purposes, an automatic trigger for a "Restructuring Credit Event,"
and new or revised templates for different types of muni CDSs.22 Although
market participants are not legally obligated to sign on to these protocols, they
are incentivized to do so, especially if the largest market participants have
already done so. 23
B. The HistoricalLack of CreditRisk Instruments
Although the basic legal, operational, and economic structures exist for
creating a robust market for hedging municipal credit risk, such a market does
not exist. The historic lack of such a market can be explained through a
combination of demand-side constraints, supply-side constraints, and the
informational insensitivity of the municipal bond market.
1. Demand-Side Constraints
A number of demand-side market dynamics contribute to the public
perception that municipal bonds are not credit-risk instruments. Municipal
bonds have traditionally been held by private "retail" investors and not by
hedge funds, which might be more likely to put on credit risk hedges. 24 The
concentration of municipal bond demand in the private investor space is largely
a function of these bonds' tax-exempt status, which attracts wealthy
individuals. 25 These investors also demand municipal bonds for their ability to
deliver safe, attractive yields, especially in low interest-rate environments. 26
Although there has been some recent rotation out of the household sector27 into
mutual funds and exchange-traded funds (ETFs), hedge funds are estimated to
comprise only five percent of the municipal bond market.28 The upshot is that
municipal bond investors tend to hold these bonds to maturity, and these
securities are not traded very frequently in the secondary market.29 This also
means that municipal bonds are less likely to be bought and sold for speculative
purposes, which contributes to a lack of demand for credit-risk hedges. These
factors, coupled with the historically low rate of defaults in the municipal bond
market, mean that municipal bonds are typically thought of as tax and interest
rate products-and not credit products requiring credit risk hedges.
2. Supply-Side Constraints
A number of factors have prevented the muni CDS market from
flourishing on the supply side. For example, municipal bond issuers-who have
influence over the broker-dealers who underwrite their bond issuances and who
are also the likeliest suppliers of muni CDSs-are opposed to muni CDSs
because they don't want to create the impression that their bonds are not safe.30
Indeed, "The proliferation of the derivatives is angering treasurers around the
country, who say the derivatives are sending a negative message and possibly
driving up their costs of borrowing at a time when they need all the help they
can get." 3 1 The fact that the municipal bond market is a relatively closed,
insular market32 with a limited set of actors makes it even more likely that
broker-dealers would be wary of angering these customers.
SEC. & EXCH. COMM'N, supranote 26.
'buy-and-hold' market because many investors hold municipal securities until maturity. Indeed,
following the initial distribution period, municipal securities trade infrequently.").
Another reason why the muni CDS market has not flourished is the
differential tax treatment of municipal bonds and muni CDSs. Muni CDS cash
flows are not subject to the tax exemption of the underlying bonds, meaning
that an investor wishing to replicate the cash flows of a municipal bond using a
muni CDS and a treasury bond of similar maturity would be hard-pressed to do
so.33 In other words, muni CDSs that perfectly hedge the underlying bonds
simply do not exist.
3. Information Insensitivity
The notion of informational insensitivity provides a theoretical
explanation for why municipal bonds have not traditionally been as responsive
to credit risk.34 Information insensitivity refers to the notion that for certain
"safe" securities (usually debt), the owner of the contract does not have an
incentive to produce information about the entity that issued the contract.35
Information insensitivity gives investors the peace of mind not to have to
constantly monitor the assets backing these debt securities. 36 Because these
informationally insensitive securities have the same value for a wide range of
the issuer's assets, the payout has a hockey-stick-like shape, where the kink
represents the point at which markets begin to worry about the issuer defaulting
(the debt then becomes informationally sensitive).
Fabozzi eds., 2008).
See THE HANDBOOK OF MUNICIPAL BONDS 655 (Sylvan G. Feldstein & Frank J.
As John Cochrane explains:
In Gorton and Metrick's vision, short-term debt is normally an "information-insensitive"
security. When the bank is far from default, the value of its debt, especially short-term
debt, is essentially the same for a wide range of values for the bank's assets. Debt holders
therefore don't need to investigate the company's finances. In turn, this feature means that
the short-term debt of companies and banks far from bankruptcy is highly liquid. If I offer
to sell you such debt, you don't have to worry that I know something you don't know,
because nobody can really have much information about the value of such debt. As a
result, bid-ask spreads, which derive from asymmetric information, are tiny.
John H. Cochrane, Toward a Run-Free Financial System, in ACROSS THE GREAT DIVIDE: NEW
PERSPECTIVES ON THE FINANCIAL CRISIS 197, 206 (Martin Neil Bally & John B. Taylor eds., 2014).
Of course, many of the properties of the "truly" informationally insensitive
debt described above do not apply to municipal bonds. Municipal bonds are
typically not short-term debt, their bid-ask spreads are not vanishingly small,
and as we have seen, they are not "safe" money-like debt instruments. The
analogy, however, is instructive. Municipal debt may not be completely
informationally insensitive, but it is at least not very informationally sensitive.
As discussed above, investors typically hold municipal bonds to maturity
without necessarily paying attention to the issuer's (i.e., the municipality's)
underlying assets or other liabilities. Monoline insurance companies that insure
these bonds contribute to their informational insensitivity by wrapping their
own credit ratings around municipal bond issuances, these companies reduce
the incentives for investors to produce information about the underlying
creditworthiness of the issuer.38 Thus, municipal bonds are not particularly
informationally sensitive until the market suspects that the issuer may be in
danger of defaulting, pushing the bonds' payoff towards the kink in the above
III. Emerging Credit Risk in the Muni Market
The recent spate of municipal defaults may ease some of the hurdles to
forming a robust muni CDS market. Operating from this presumption, this Part
first argues that the incidence of local government fiscal crises, some of which
have resulted in significant haircuts on the par value of municipal bonds
through bankruptcy or other forms of debt restructuring, means that credit risk
will likely play an increasingly important role in evaluating municipal bonds
going forward. It then goes on to explain that, although investors are not
without means of hedging the interest rate and duration risk on municipal
bonds, instruments that directly hedge credit risk are few and far between,
especially given the significant challenges to short selling municipal bonds.
A. CreditRisk as an EmergingRisk Factor
The number of municipal defaults has increased substantially in recent
years. Since November 2011, San Bernardino, CA, Stockton, CA, Jefferson
County, AL, and Detroit, MI have filed four of the five largest municipal
bankruptcies of all time, as measured by total obligations.39 In Detroit, the
largest U.S. city ever to file for bankruptcy, bondholders took significant
haircuts. For example, unlimited tax general obligation bondholders recovered
only seventy-three cents on the dollar whereas limited tax general obligation
bondholders recovered a mere forty-two cents on the dollar.40 In fact, holders of
the city's lease bonds fared even worse, with only a twelve-percent recovery
rate.4' In contrast, Detroit's pension holders experienced relatively minor
haircuts. 42 Puerto Rico experienced a severe fiscal crisis and, with no legal
ability to access bankruptcy, ended up defaulting on its general obligations
bonds, resulting in a thirty percent recovery rate for bondholders.43 Cities like
Chicago and Dallas have also been experiencing difficulties, with bankruptcy
potentially on the horizon.44
A confluence of factors produced these fiscal difficulties, which in turn
eroded municipalities' ability to pay back their debt obligations. First, states and
39. Robert Slavin, Why So Many Big Municipal Bankruptcies?, FIN. PLANNING (Jan.
15, 2015, 5:15 PM), http://www.financial-planning.com/news/why-so-many-big-municipal-bankruptcies
[http://perma.cc/H6JM-V57V]; see also Hunt, supranote 2, at 392-93 (noting the underlying causes of
40. Tommy Chan, BPG Fixed Income: Detroit One Year Later, States Bolstering
Bondholder Protections, ZIEGLER CAP. MGMT.: MKT. INSIGHT & RES. (2016),
42. See Eighth Amended Plan for the Adjustment of Debts of the City of Detroit, In re
City of Detroit, No. 13-53846 (E.D. Mich. Oct. 22, 2014), ECF No. 8045; Anne VanderMey, Detroit
PensionersApprove Bankruptcy Haircutin Landslide, FORTUNE (July 23, 2014), http://fortune.com/2014
43. See, e.g., Heather Gillers & Nick Timiraos, Puerto Rico Defaults on
ConstitutionallyGuaranteedDebt, WALL ST. J. (July 1, 2016, 6:42 PM), http://www.wsj.com/articles
Daniel Bases, Puerto Rico's Defaulted Debt at Record Low as Recovery Rate, Legal Battle Weigh,
REUTERS (Mar. 20, 2017, 3:23 PM),
44. See, e.g., Ted Dabrowski & John Klinger, Chicago's Total Debt More Than
Triples to Over $24b in 2015, ILL. POL'Y (July 11, 2016),
http://www.illinoispolicy.org/chicagos-totaldebt-more-than-triples-to-over-24b-in-2015 [http://perma.cc/Z2RQ-LWCF]; Mary Williams Walsh,
Dallas Stares Down a Texas-Size Threat of Bankruptcy, N.Y. TIMES (Nov. 20, 2016),
localities are still recovering from revenue lost because of the 2008 recession.45
Second, reductions in federal spending have made state and local finances less
even and predictable.46 Third, municipalities' long-term pension, retirement,
and healthcare expenditures continue to outpace revenue growth.4 7 Fourth, a
lack of infrastructure investment over time means that states have to borrow
more just to keep up with capital deterioration. 48 Lastly, "[t]he near-total
absence of serious consultation between federal and state fiscal policymakers
has often obscured the long-term impact of expenditure cuts and revenue
Given the fiscal challenges facing state and local governments, credit risk
will likely become a more important factor in the municipal bond market going
forward. Under this scenario, what are the implications for the notion of
municipal bonds as informationally insensitive debt? The fact that the full faith
and credit pledge to general obligation debt holders was insufficient to prevent
such debt holders from taking significant haircuts (in Detroit, for
example)coupled with the increasing legal protections afforded pensioners and other
post-employment beneficiaries-suggests that investors holding municipal debt
have a greater likelihood of not being paid back in full. In other words,
municipal bonds may be becoming more informationally sensitive. Another
factor that points in this direction is that fewer municipal bond issuances
nowadays have a monoline insurance wrapping (i.e., an insurance company that
insures the bonds) that allows the bonds to mirror the high credit ratings of the
insurer. 0 One way for investors to cope with the increased information
sensitivity and credit risk of municipal bonds is to turn to the muni CDS market.
B. Alternative Sources ofHedging
In theory, there are a number of alternatives to using CDSs to hedge the
credit risk of municipal bonds. But these alternatives have a number of
drawbacks that render the muni CDS a superior credit hedge. One possible
alternative is short selling the municipal bonds themselves, which would allow
investors to directly profit from a decline in the price of a municipal bond.5
Unfortunately, a short side of the municipal bond market has not developed
because of a number of legal and technical difficulties. First, since investors
tend to hold municipal bonds to maturity, most bonds cannot be borrowed,
which is a necessary step in the short selling process.52 Additionally, "short
positioning municipal securities is rare because the Internal Revenue Service
will not allow both a borrower and lender of a municipal security to claim a tax
exemption," and "[i]n effect, the lender of a municipal security would be
trading tax exempt interest for taxable interest."53
To see the practical implications of this limitation, note that the holder of a
short bond position must pay to the lender amounts equal to the interest that a
holder of the bond being shorted would receive during this time period. Thus,
for a corporate bond, if the holder of the bond would have received one dollar
in interest, the holder of the short position pays the lender that same dollar in
interest. For municipal bonds, however, if a holder of the bond would have
received one dollar in tax-exempt interest, this might be equivalent to say $1.30
in pre-tax interest. Since the borrower (short seller) cannot claim a tax
exemption on this interest payment, they must pay to the lender $1.30 instead of
$1 in interest, making this a very expensive and often inefficient position to
The IRS also imposes additional reporting requirements on the parties
participating in short selling municipal securities, which may discourage such
activity ex ante.5 Indeed, FINRA has found that "most municipal short
positions are inadvertent and may result from branch or trading errors, duplicate
transactions, the sale of a security in the process of a partial redemption or a
partial call, or a delay in delivery of the securities from a counterparty." 56 Thus,
the most obvious means of hedging municipal bonds-short selling-is
effectively not an option for investors.
Even if a short-selling market existed for municipal bonds, credit default
swaps would be a superior instrument for hedging credit risk. As the IMF notes
in the sovereign bond and sovereign CDS (SCDS) space, SCDS are more
efficient than short sales as a means of hedging credit risk because short selling
51. Much like short selling in the stock market, short selling a bond requires one to
borrow a bond, sell it today, and buy it back at a later point in time (hopefully at a lower price). See, e.g.,
Paul Asquith et al., The Marketfor Borrowing CorporateBonds, 107 J. FIN. ECON. 155 (2013).
52. John Carney, How to Profitfrom a Muni Bond Crisis, CNBC (Feb. 10, 2011, 1:45
PM), http://www.cnbc.com/id/41513958 [http://perma.cc/LBE3-NMLS].
53. Proposed Amendments to Rule lOb-10 and Proposed Rulemaking, 59 Fed. Reg.
12767, 12769 n.24 (Mar. 17, 1994) (codified at 17 C.F.R. pt. 240 (2017)) (citing I.R.C. ? 6045(d)
54. In other words, the fact that payment-in-lieu-of-interest here is not tax-exempt
substantially increases the carrying cost of borrowing municipal bonds.
55. See Municipal Securities Trading: Guidance Related to Firm Short Positions and
Fails-to-Receive in Municipal Securities, FINRA 5 n.1 (2015), http://www.finra.org/sites/default/files
/notice doc file ref/Notice Regulatory_ 15-27.pdf[http://perma.cc/4PVS-AUM8].
56. Id. at 4.
necessitates a sufficiently deep market for borrowing the underlying bonds.
Additionally, during times of stress, short selling demand can overwhelm
supply of the underlying bonds, and such loans may be recalled at any point. 58
To the extent investors hedge their municipal bond risk, they traditionally
rely on Treasuries or Treasury futures to hedge interest rate risk.59 Another
possible alternative to using muni CDSs is shorting a muni ETF.60 However,
shorting ETFs may be logistically challenging doing so requires finding
someone to lend the ETFs and, since these ETFs are comprised of a large
number of municipal bonds, shorting the ETFs themselves will not necessarily
be a great hedge for the credit risk of any particular municipal bond. Another
possibility might be to hedge municipal bonds using municipal bond futures.
However, for a number of reasons, a deep market in municipal bond futures
does not exist.61 Even if a deep futures market existed, futures would have both
interest rate and credit risk embedded within them. To put on a pure credit risk
hedge, investors would have to add an interest rate swap, which would be costly
and significantly more complicated than just using a muni CDS.
IV. Unsheathing the Sword: Creating a Robust Muni CDS Market
Part IV considers the implications of creating a deeper market for muni
CDSs. It first analyzes potential reforms to the muni CDS market that would
make the market deeper, more liquid, and more robust, before discussing the
opportunities and benefits that would arise from having a more robust muni
CDS market. Finally, it analyzes the drawbacks and costs associated with such
A number of options are available for creating a deeper and safer muni
CDS market. 62 For example, muni CDSs could be given the same tax benefits
as the underlying bonds, muni CDS contracts could be centrally cleared, a ban
on naked trading of muni CDS contracts could be instituted, investors could be
required to disclose net long muni CDS positions, and temporary restrictions on
muni CDS trading could be implemented in times of market stress. Taken
together, these reforms may not be necessary or even sufficient for creating a
fully functional muni CDS market, but they would likely improve upon today's
virtually non-existent one.
1. Tax Equivalence with Muni Bonds
As previously suggested, a significant constraint on the growth of the
muni CDS market is differential tax treatment received by muni CDSs and the
underlying bonds. One way to cure this difference would be to change the tax
code to treat the cash flows equally. This option is likely politically infeasible,
as it would, of course, require legislation from Congress. The tax exemption on
municipal bonds is justified by a policy desire to incentivize local infrastructure
development. 63 Although a robust muni CDS market could lower borrowing
costs and help spur infrastructure development, extending tax-exempt status to
muni CDSs via legislation is probably a non-starter. Even if such a change
could be codified in legislation, policymakers would have to consider the
opportunity cost of forgone tax revenue. Although muni CDSs are only one
percent of the cash market now, if symmetrical tax treatment allows the market
to grow to the same relative size as the corporate and sovereign CDS markets
(fifty percent of the approximately four trillion dollars cash market), the federal
government could be giving up a substantial source of tax revenue.
2. Central Clearing
The remaining reforms would not require legislation and could in theory
be implemented by the SEC. For example, the SEC could make a
determination, pursuant to ? 723(a) of Title VII of the Dodd-Frank Act, that
muni CDSs should be centrally cleared and not traded on a bilateral,
over-thecounter basis. 64 There are several key benefits to moving to a centrally cleared
system, including a reduction of counterparty risk, netting of positions across
counterparties, and sharing of extreme losses. 65 The additional safeguards that
central clearing would provide to mitigate downside scenarios in the muni CDS
expense of liquidity, one could also argue that a safe market is a necessary first step to establishing a
market (the default of a large market participant, for example) could potentially
help improve liquidity in the market itself In the sovereign CDS context, there
are concerns about the exposure of central clearinghouses to wrong-way risks.66
However, these relate to the posting of margin (or collateral) in the same
currencies as the underlying bonds are denominated in, which is not an issue in
the muni CDS market.
3. Banning "Naked" Muni CDS Trading
Another regulation that the SEC could impose to improve the muni CDS
market is to ban naked muni CDS trading to discourage speculative behavior.67
One worry might be that investors would participate in a more robust muni
CDS market to speculate on municipalities experiencing fiscal distress. This
could be achieved through "naked" CDS trading, which is going long (i.e.,
buying a contract) on the CDS without owning the underlying bond-in effect,
buying insurance on your neighbor's house in the hope that it catches on fire.
Banning naked CDS trading would mean that investors who want to purchase
muni CDS contracts must have an offsetting position in the underlying
municipal bond. The European Union, for example, has banned naked
sovereign CDS trading for these and other reasons. 68 In particular, market
participants can, with some limited market-making exceptions, buy protection
on European sovereign debt only if they hold the underlying bonds or if they
have exposures that are "meaningfully correlated" with the underlying bonds. 69
A regulator considering a ban on naked CDS trading as a means of
promoting market stability must also evaluate the costs of such a ban. In
particular, a ban on naked muni CDS trading could further detract from muni
CDS market liquidity to the point where muni CDSs cease to properly function
as hedges and indicators of implied credit risk.70 In general, bans on short
selling in other markets have been associated with reduced market liquidity,
reduced price discovery, and increased price volatility.7 Ultimately, banning
66. Id. at 74. "Wrong-way risks" in the sovereign CDS context refers to "the fact that
the posted initial margin and the default fund contribution would be in dollars or euros or in government
securities denominated in those currencies. Such securities are the same as those underlying most of the
SCDS contracts. So distress of a sovereign would create a vicious cycle (a realization of the wrong-way
risk) by impairing the value of the collateral while at the same time increasing the risk in the SCDS
contract, which would require more such collateral to be posted." Id.
67. For example, SEC Regulation SHO deals with short selling bans with respect to
equities. See Definition of "Short Sale" and Marking Requirements, 17 C.F.R. ? 242.200 (2017).
68. "The prohibition is based on the view that, in extreme market conditions, such
short selling could push sovereign bond prices into a downward spiral, which would lead to disorderly
markets and systemic risks, and hence sharply raise the issuance costs of the underlying sovereigns."
INT'L MONETARY FUND, supra note 12, at 57. There is also concern that negative price spirals for
sovereign debt and settlement failures could result from uncovered (naked) short selling and CDS
protection buying. Id. at 72.
70. Id. at 57.
71. Id. at 71.
naked CDS trading is a fairly blunt instrument. The same purpose could be
achieved by other reforms such as mandating better disclosure, central clearing,
or posting appropriate collateral.
4. Mandating Disclosure of Muni CDS Positions
Indeed, mandating the disclosure of net long muni CDS positions (net
short exposure to municipal bonds) is another regulation that the SEC could
impose to discourage speculative behavior. 72 Doing so would increase market
transparency and likely discourage investors from taking long muni CDS
positions (for fear that their competitors would know what positions they are
taking). As with banning naked CDS trading, the regulatory trade-off is
between reducing the negative externalities of muni CDSs and discouraging
5. Market "Circuit Breakers"
Regulators could also institute temporary restrictions on muni CDS
trading when large price movements occur. The idea here is that CDSs may
exacerbate a market-wide sell-off of a particular municipality's debt (perhaps
due to actual or rumored likelihood of default). To avoid the negative
consequences of such a sell-off which could range from substantially higher
borrowing costs for the municipality to actually being forced to default if it is
unable to roll over its debt-regulators could institute "circuit breakers" that
kick in to halt trading after a substantial decrease in price. In the stock market,
for example, the SEC in 2010 adopted a "revised uptick" or "circuit breaker"
rule that restricted the short sale of a stock whose price had fallen by more than
ten percent compared to its prior day closing price.73 Although the SEC has not
implemented such a rule with respect to the CDS market, the SEC has the
authority to implement market-wide circuit breakers.74 Another model that
regulators could look towards is the circuit breaker rule in Europe, which
applies to all financial instruments, including sovereign CDSs. The circuit
breaker is triggered at the discretion of a regulatory body in the case of a
significant price fall from the previous day's close (ten percent for liquid shares
and a threshold to be determined for other instruments). The circuit breaker
implements a temporary short selling prohibition for the remainder of the day
and the following trading day, which can be extended for up to two more
trading days in case of a further significant price fall.
B. Opportunitiesof a Robust Muni CDS Market
Should a robust muni CDS market exist, a number of opportunities and
benefits could be realized. First, investors would have a means of directly (and
relatively cheaply) hedging the emerging credit risk within the municipal bond
market. 76 Second, a greater demand for muni CDSs would inevitably lead to
greater supply and liquidity in the market, which would result in more price
discovery and transparency. For example, CDSs that trade in liquid markets and
are priced properly tend to provide better information about the default
probabilities of the underlying bonds. This in turn would allow the market to
give municipalities a clearer signal of perceptions of actual or anticipated fiscal
distress. One possible outcome is a bifurcated market, with substantial liquidity
in certain single names that are experiencing distress but not in others. Indeed,
this is the case for the sovereign CDS market.
Another potential benefit of enhanced liquidity in the muni CDS market is
the possibility that increased availability of muni CDSs would make investors
more willing to lend to municipalities or to lend at lower rates. Indeed, the
emergence of the muni CDS market during the 2008 financial crisis had exactly
that effect on municipal bond yields. 79 Another potential second-order effect is
a more liquid secondary market for municipal bonds. Being able to buy CDS
protection on the underlying bonds may make investors more likely to purchase
municipal bonds on the secondary market.80 And, if investors cannot engage in
naked muni CDS trades, demand for the underlying bonds might also increase.
If, however, the vast majority of municipal bond investors remain retail,
holdto-maturity types, these second-order liquidity effects may be muted because
they are unlikely to sell the bonds after purchase.
Another potential benefit of a robust muni CDS market is that it could act
as a substitute for the decline in the monoline insurance market for municipal
bonds. As mentioned in Part III, monoline insurers such as Municipal Bond
Insurance Association, Guaranty Municipal Co., and American Municipal Bond
Assurance provide an insurance "wrapping" for municipal bond issuances that
allows the bond to take on the insurer's credit rating.8' During the financial
crisis, however, many monoline insurers experienced financial difficulties.82 In
2008, nearly half of all newly issued municipal bonds carried monoline
insurance, compared with less than seven percent by 2015. 83 Thus, muni CDSs
could act as an alternative means for investors to insure against municipal bond
defaults and also as a hedge against the potential future failure of monoline
insurers that continue to insure municipal bonds.
A more robust muni CDS market with greater price transparency and price
discovery could also enable state and federal policymakers to incorporate muni
CDS spreads into their oversight and risk monitoring of distressed
municipalities. For a number of reasons, CDS spreads should provide a more
accurate measure of potential risk of default than bond yields. First, bond yields
are a function of many other factors besides credit risk, including the risk-free
rate, maturity date, and call provisions. Additionally, if municipal bonds are
somewhat informationally insensitive,84 muni CDS spreads could be more
sensitive to relevant information, especially if hedge funds (also known as the
"smart money") actively participate in the muni CDS market. Ultimately,
deriving default probabilities (from a purely mathematical perspective) from
CDS spreads is easier than using bond yields because CDSs are less complex
than the underlying bonds.
However, there may be reason to doubt that even a robust muni CDS
market could act as an accurate leading indicator of a municipality's fiscal
distress. Certainly, the market as it currently exists is not capable of sending
accurate signals. As Matthew Holian and Marc Joffe note, "the applicability of
CDS implied default probabilities to the municipal market is greatly limited,
however, by the fact that CDS trades against a relatively small number of
municipal issuers, and trading volume is low even for those issuers for which
CDSs are available."" CDS markets in general may not be a good leading
indicator of an impending crisis. For example, in the lead-up to the financial
crisis, indexes of CDSs on mortgage-backed securities (in particular, the ABX
index) traded at normal levels until the crisis hit. 86 The same phenomenon
(convergence of spreads and then a sudden divergence or blowing out) occurred
in the sovereign CDS market before the Eurozone sovereign debt crisis.8 7
C. Drawbacksof a Robust Muni CDS Market
Although the creation of a robust muni CDS market could have many
benefits, it also presents a number of potential challenges. For example, there is
a risk that speculating hedge funds will constitute the majority of buyers in the
muni CDS market. This risk would be mitigated, but not eliminated, by a
regulation that bans naked muni CDS trading.88 Nonetheless, there is evidence
that CDS markets attract speculative traders, and the muni CDS market is
probably not immune from this phenomenon.89
Additionally, a more robust muni CDS market could potentially transmit
negative market sentiment and raise borrowing costs for municipalities at a
faster rate. In the worst case scenario, this could even result in defaults taking
place earlier than they would have otherwise, as lenders are driven away by
perceptions that a municipality's finances are shaky. 90 There is evidence of this
mechanism playing out during the 2008 financial crisis:
In the case of New Jersey, someone bought five years' worth of default
protection on the state's debt in mid-July, on a day when the price edged to
$41,000, from $40,000, for $10 million worth of bonds. (Traders do not have to
own the bonds to buy the related swaps.) The price then floated up gently until
mid-September, when suddenly Lehman Brothers declared bankruptcy, Merrill
Lynch was sold and A.I.G. had to be bailed out by the Federal Reserve, all in the
space of a few days.
Instantly, investors everywhere were risk averse, and the price of a five-year
swap on New Jersey's debt jumped to $84,000 for $10 million in bonds. For the
buyer in mid-July, that is a jump in value of more than 100 percent in just two
months. 9 1
It is important to note that this occurred in a very thinly traded market
where just one transaction could move market prices. Nonetheless, a more
liquid muni CDS market creates another means through which negative market
sentiment-or in the worst-case scenario, a full-on panic-could adversely
Another potential concern is that even in a market that is generally liquid,
the market for individual single-name CDSs may be quite small, which could
allow a single bad actor (a hedge fund, for example) to force a municipality into
default. This concern would be somewhat mitigated by regulations, specifically
the ban on naked muni CDS trading, mandated disclosure of net long muni
CDS positions, and automatic circuit breakers for significant drops in price.92
These proposals could work in tandem to discourage excessive speculation and
provide a backstop to severe price drops. Compared with the corporate bond
and corporate CDS markets, muni CDSs may be less likely to cause a default of
the issuer entity. In contrast to a corporation, which typically issues both stock
and debt, a municipality does not issue any stock. Thus, even if a hedge fund
had a very negative view of a city's finances that it chose to express through
long muni CDS positions, it could not couple this view with a short stock
position and directly drive the municipality into bankruptcy.93 It might, in
theory, be able to raise the municipality's borrowing costs so much that the
municipality could not roll over its debt.
Another concern that policymakers should consider is the possibility that
broader use of muni CDSs could increase the risk of contagion between
municipalities. In financial crises, correlations among financial instruments tend
to increase towards one hundred percent, and muni CDSs or the MCDX index
could be a means of amplifying negative shocks across the municipal bond
sector.94 In other words, market participants might infer broader weakness
within the municipal bond sector from stress in any particular municipality, and
muni CDSs could be a means of transmitting this information contagion across
municipalities. In the sovereign context, an IMF study did not uncover much
empirical evidence of contagion but did note that "SCDSs tend to adjust more
rapidly to new information during periods of stress, though not typically at
other times."9 5 The IMF also found that residual volatility in a given European
country's CDS spreads could be explained by volatility in other Euro-area CDS
92. See supraSection IVA.
94. See, e.g., Leonidas Sandoval & Italo De Paula Franca, Correlationof Financial
Markets in Times of Crisis, 391 PHYSICA A: STAT. MECHANICS & ITS APPLICATIONS 187 (2012)
(investigating the phenomenon of correlated volatility across markets).
95. INT'L MONETARY FUND, supranote 12, at 58.
spreads.96 However, this phenomenon could be explained by the
interconnectedness of Euro-area economies and in particular, their banking
sectors. Unlike in the European or sovereign context, economic and financial
linkages among distressed municipalities might not be quite as high, which
limits spillover effects and contagion risks.
A new risk that would be created by a more robust muni CDS market is
the deterioration of the creditworthiness of a large muni CDS protection seller.
During the financial crisis, for example, AIG's role as a seller of CDS
protection contributed to its financial distress, which also led to distress in the
broader financial system.97 This form of counterparty credit risk could be
mitigated, however, by reforms such as central clearing of muni CDSs and
requiring counterparties to post appropriate collateral.
Relatedly, CDSs played a substantial role during the financial crisis (partly
through AIG) and may still be viewed, perhaps correctly, as financial "weapons
of mass destruction." 98 Should we really be encouraging more use of these
potentially dangerous financial instruments? In particular, should we be worried
that the risks associated with letting hedge funds use muni CDSs as tools of
speculation would be greater than their possible benefits? There is reason to
believe that hedge funds' participation in the muni CDS market could have
some offsetting benefits. As Michael Corkery and Matt Wirz observed, hedge
funds are a source of liquidity as individual investors get more skittish. In
return, they often want higher interest rates and more financial information
from municipal officials than such officials are accustomed to providing. And
hedge funds are not shy about pushing for improved disclosure and financial
With a more robust muni CDS market, hedge funds would also be more
likely to invest in the underlying bonds. In the sovereign context, however,
CDS trading is concentrated among broker-dealers, non-dealer banks, and
security firms, with hedge funds playing a relatively small role.' 00
Another cause for worry is the potential conflicts of interest that could
arise with broker-dealers underwriting municipal bonds while also writing
CDSs on the same instruments.' 0 ' There is some evidence that this may have
97. Henry Sender, AIG Saga Shows Dangers of Credit Default Swaps, FIN. TIMES
(Mar. 6, 2009), http://www.ft.com/content/aa741ba8-0a7e-1lde-95ed-0000779fd2ac [http://perma.cc
98. John Chapman, CDS: Modern Day Weapons of Mass Destruction, FIN. TIMES
(Sept. 11, 2011), http://www.ft.com/content/1c81fdf8-d4b9-11e0-a7ac-00144feab49a [http://perma.cc
taken place at Goldman Sachs. In particular, ProPublica reported that, in 2008,
Goldman sold CDS protection on California debt to clients at the same time that
it collected underwriting fees on the bonds, noting that "[t]he company may
have hoped to parlay the swaps market into more activity in municipal bond
trading, which is traditionally light because muni investors tend to hold the
bonds to maturity."'1 02 While investment banks are not necessarily prohibited
from acting as both underwriters and market makers in financial securities with
opposite cash flows, such a strategy at best gives the appearance of a conflict of
interest and at worst recalls the questionable Abacus deal Goldman facilitated
during the financial crisis. 103
As state and local governments experience higher levels of fiscal distress
in the years to come, credit risk will become an increasingly important
component of the municipal bond market. Muni CDSs provide a means of
directly hedging against this credit risk. Although muni CDSs currently exist as
a financial instrument, the market for them is essentially non-existent. This
Note considered a number of potential reforms that could create a more liquid
and robust muni CDS market, while also weighing the costs and benefits of
such an outcome. Ultimately, more theoretical and empirical research is needed
to help quantify these costs and benefits and provide policymakers with more
precise regulatory recommendations. In addition, policymakers should consider
the extent to which, in a worst-case scenario, the municipal bond and CDS
markets could be a source of systemic risk during a financial crisis. As the 2008
financial crisis showed, financial innovation without appropriate regulation can
have dire consequences, both for the financial system and the economy at large.
potential conflicts of interest that arise in the broker-dealer and the effect of recent SEC regulations on
1. CDS Economics ......................... ..... ... 305
2. Credit Events ................................... 305
3. Settlement ........................................... 305
4. Standardization & Clearing ................... ...... 306 B. The HistoricalLack of CreditRisk Instruments............ ... 307
1. Demand-Side Constraints ................... ....... 307
2. Supply-Side Constraints ................... ..... ... 308
3. Information Insensitivity ................... ....... 309 III. Emerging Credit Risk in the Muni Market .............. ........ 310 A. CreditRisk as an Emergent Risk Factor............ ....... 311 B. AlternativeSources ofHedging ................... ...... 312 IV. Unsheathing the Sword: Creating a Robust Muni CDS Market. ...... 314 A. PotentialReforms. ................................... 314
1. Tax Equivalence with Muni Bonds ................... 315
2. Central Clearing ......................... ..... ... 315
3. Banning "Naked" Muni CDS Trading ............ ..... 316
4. Mandating Disclosure of Muni CDS Positions ...... ..... 317
5. Market "Circuit Breakers" .................. ....... 317 B. Opportunitiesof a Robust Muni CDS Market...... ......... 318 C. Drawbacks ofa Robust Muni CDS Market........... ...... 320 Conclusion ................................................ 323
3. Patrick Augustin et al., CreditDefault Swaps: Past, Present, and Future, 8 ANN. REV. FIN. ECON . 175 , 177 ( 2016 ).
5. Cate Long , There Is No Municipal CDS Market, REUTERS (Jan. 12 , 2012 ), http://blogs.reuters.com/muniland/2012/01/12/there-is -no-municipal-cds-market-treasurer-lockyer [http://perma .cc/QSX3-F6AF].
6. See infra Part IV.
7. See, e.g., William J. Casey & Owen T. Smith , A New Look at MunicipalBondsDisclosureResponsibilities in the MunicipalBond Market, 50 ST . JOHN'S L. REV . 639 ( 1976 ); Charlotte W. Rhodes, Living in a Material World: Defining "Materiality"in the MunicipalBond Market and Rule 15c2- 12 , 72 WASH. & LEE L. REV . 1989 ( 2015 ); Steven L. Schwarcz , A MinimalistApproach to State "Bankruptcy," 59 UCLA L . REV. 322 ( 2011 ).
8. See, e.g., Dorothy A. Brown, FiscalDistress and Politics: The Bankruptcy Filing of Bridgeportas a Case Study in ReclaimingLocal Sovereignty, 11 BANKR . DEV. J. 625 ( 1995 ) ; M. Heath Frost, Comment, States as Chapter9 Bankruptcy Gatekeepers:Federalism, Specific Authorization and ProtectionofMunicipalEconomic Health, 84 MISS. L.J. 817 , 832 - 34 ( 2015 ); David Gamage, Preventing State Budget Crises: Managingthe Fiscal VolatilityProblem , 98 CALIF. L. REV. 749 ( 2010 ); Hunt, supra note 2; Melissa B. Jacoby , Federalism Form and Function in the Detroit Bankruptcy, 33 YALE J . ON REG . 55 ( 2016 ) ; David A. Skeel Jr ., States ofBankruptcy, 79 U. CHI. L. REV . 677 , 689 - 718 ( 2012 ).
21. See ISDA Protocol,supranote 18 .
22. Stromfeld et al., ISDA March 2012 Supplement and Protocol: Updating Muni CDS , Cadwalader Wickersham & Taft LLP ( 2012 ), http://www.lexology.com/library/detail.aspx?g = 2affc945 -32b4 - 425f - b7de-ebab3fc3b65a [http://perma.cc/UDP6-WJSZ].
23. In effect, these ISDA protocols function as standardized contracts that help with market coordination and transactional efficiency. If the dominant market players have signed on, smaller players will likely have to adopt the protocol in order to participate in the market .
24. Hedge funds are generally more sophisticated investors, have higher appetites for risk, and are more likely to use more sophisticated means of hedging (or alternatively, speculating on) a specific type of risk.
25. Nicole Bullock & Aline van Duyn, California Treasurer Joins Debate on CDS, FIN . TIMES (Mar. 31 , 2010 ), http://www.ft. com/content/887139c2-3dl4-1 ldf-b8lb-00l44feabdcO?mhq5j = e6 [http://perma.cc/GX6C-XBTG].
26. See SEC. & EXCH. COMM'N, REPORT ON THE MUNICIPAL SECURITIES MARKET , at v ( 2012 ), http://www.sec.gov/news/studies/2012/munireport073112.pdf [http://perma.cc/53UH-C6ZM] ("Individuals, or 'retail' investors, directly or indirectly hold more than 75% of the outstanding principal amount of municipal securities. The municipal securities market traditionally has been described as a
27. The "household sector" includes non-profit organizations, domestic hedge funds, private equity funds, and personal trusts. See FinancialAccounts of the United States, FED . RES., https://www.federalreserve.gov/releases/zl/current/html/blOl.htm [http://perma.cc/L9L3-UJ3U].
28. Natalie Cohen & Roy Eappen, Who Holds MunicipalBonds, MUN . SEC. RES. (July 27 , 2015 ), http://www.institutionalinvestor.com/images/519/94682/Holders of MunicipalBonds 072715.pdf [http://perma.cc/FB8M-N4SD]. The authors assume that hedge funds represent ~$200 billion of municipal bond holds . Id. at 2 . $ 200 billion divided by the 2015Q1 total amount of $3.694 trillion equals approximately five percent .
30. See , e.g., Nathaniel Popper , Credit Default Swap Deals Unnerve California, L.A. TIMES (Aug. 19, 2010 ), http://articles.latimes.com/2010/aug/19/business/la-fi-california-swaps20100819 [http://perma.cc/5PFH-VZLH].
31. See lanthe Jeanne Dugan, States Bristle as Investors Make Wagers on Defaults, WALL ST . J. (Apr. 27 , 2010 , 12 :01 AM), https://www.wsj.com/articles /SB10001424052748704464704575208592421153342 [http://perma.cc/44XX-4J6F].
32. The market is closed on the demand side since demand is limited to investors who can benefit from the tax exemption. The market is closed on the supply side since it is limited to issuers who qualify for the tax exemption in the first place . George Friedlander , US MunicipalStrategy Special Focus, CITI RES. MUNS. 3 ( 2014 ), http://cdn.bondbuyer.com/media/pdfs/BBrandeisl4-Friedlanderpaper.pdf [http://perma.cc/4KLR-7RZE].
34. See generally Arthur W.S. Duff & David Zaring , New Paradigms and Familiar Tools in the New Derivatives Regulation, 81 GEO . WASH. L. REV. 677 , 704 ( 2013 ) ("'Information insensitivity' means the securities are immune from information asymmetry or adverse selection when traded, and no trader has an incentive to create private information about the security.").
35. Tri Vi Dang et al., Ignorance , Debt and FinancialCrises (Yale Univ. & Mass. Inst. Tech., Working Paper , 2012 ), http://www.columbia.edu/-td2332/Paper Ignorance.pdf [http://perma.cc/QYH6-Z5YW].
37. Dang et al., supra note 34, at 22 fig.8.
38. See , e.g., Viral V. Acharya et al., On the Financial Regulation of Insurance Companies (N .Y.U. Stern Sch. Bus., White Paper , 2009 ), http://w4.stern.nyu.edu/salomon/docs /whitepaper.pdf [http://perma.cc/NRT8-XF7H].
45. See , e.g., Oliff et al, States Continue to Feel Recession's Impact, CTR . ON BUDGET & POL'Y PRIORITIES 1 ( 2012 ), https://www.cbpp.org/sites/default/files/atoms/files/2-8-08sfp.pdf [http://perma.cc/5XZJ-WZ7E].
46. Iris J. Lay & Michael Leachman , At Risk: Federal Grants to State and Local Governments, CTR . ON BUDGET & POL'Y PRIORITIES ( 2017 ), http://www.cbpp.org/research/state-budgetand -tax/at-risk-federal-grants-to-state-and-local-governments [http://perma .cc/Z86G-ZG4S].
47. William G. Gale & Aaron Krupkin , Financing State and Local Pension Obligations:Issues and Options, BROOKINGS 7-8 ( 2016 ), http://www.brookings.edu/wp-content/uploads /2016/07/PB-Pension -shortfalls-and-SL-budgets .pdf [http://perma.cc/6D48-MVPC].
48. Elizabeth McNichol , It's Time for States to Invest in Infrastructure, CTR . ON BUDGET & POL'Y PRIORITIES ( 2017 ), http://www.cbpp.org/research/state -budget-and-tax/its-time-forstates-to-invest-in-infrastructure [http://perma .cc/9Q8H-QTQ7].
49. Ravitch & Volcker, supra note 2, at 3.
50. Paul Sullivan, Municipal Bond Defaults Shake Up a Once-Sedate Market , N.Y. TIMES (Apr. 22, 2016 ), http://www.nytimes.com/ 2016 /04/23/your-money/ municipal-bond-defaultsshake-up-a-once-sedate-market .html [http://perma.cc/AYX3-SYA4] .
57. INT'L MONETARY FUND , supranote 12 , at 75.
58. Id .
59. THE HANDBOOK OF MUNICIPAL BONDS , supranote 33 , at 350-51.
60. An ETF , or "exchange-traded fund," invests in a wide variety of instruments (usually with a broader theme or focus) and are traded on exchanges, just like the shares of a company . See, e.g., William A . Birdthistle, The Fortunes and Foibles of Exchange-Traded Funds: A Positive Market Response to the Problems of Mutual Funds, 33 DEL . J. CORP . L. 69 ( 2008 ) (explaining the mechanics of ETFs) . The largest municipal bond ETF is the iShares S&P National Municipal Bond Fund . See Carney, supranote 52 .
61. The lack of a deep market in municipal bond futures can be attributed to the existence of well-established hedges (in particular, Treasuries and Treasury futures), a failure to embrace electronic trading, and market segmentation . See Patrick J. Cusatis, An Analysis of the FailedMunicipal Bond and Note FuturesContracts , 28 J. FUTURES MARK . 656 ( 2008 ).
62. Safety here refers to reducing the negative externalities that could emerge from more widespread use of muni CDSs. These might include speculative behavior that raises the borrowing costs of municipalities, contagion effects, or even price spirals that result in a municipality defaulting on its debt payments. Although some of the reforms directed towards market safety may come at the
63. Scott Greenberg , Reexamining the Tax Exemption ofMunicipalBond Interest , TAX FOUND. (July 21 , 2016 ), http://taxfoundation.org /reexamining-tax-exemption-municipal-bond-interest [http://perma.cc/N4BS-VZY6]. A federalism concern regarding the constitutionality of taxing municipal bonds was previously a powerful justification for the exemption . However, the Supreme Court repudiated this reasoning in South Carolinav . Baker, 485 U.S. 505 ( 1988 ).
64. 7 U.S.C. ? 2 ( 2012 ).
65. INT'L MONETARY FUND , supranote 12 , at 73.
72. For example, the SEC has authority to mandate disclosure of short sale positions in equities . See Disclosure of Short Sales and Short Positions by Institutional Investment Managers , 73 Fed. Reg. 61 , 678 (Oct. 17 , 2008 ) (codified at 17 C.F.R. pts. 240 and 249).
73. 17 C.F.R pt. 242.
74. Measures to Address Market Volatility, SEC. & EXCH. COMM'N (July 1 , 2012 ), http://www.sec.gov/oiea/investor-alerts -bulletins/investor-alerts-circuitbreakersbulletinhtm .html [http://perma.cc/RUR8-TWEJ]; Notice of Filingof Amendments No. 1 , SEC. & EXCH. COMM'N ( 2012 ), http://www.sec.gov/rules/sro/bats/2012/34- 67090 .pdf [https://perma.cc/C98V-G6ZJ].
75. Regulation (EU) No. 236 /2012 of the European Parliament and of the Council of 14 March 2012 on Short Selling and Certain Aspects of Credit Default Swaps , 2012 O.J. (L 86) 1 , http://eur-lex.europa.eu/LexUriServ/LexUriServ.do?uri=OJ:L: 2012 : 086 : 0001 :0024:en:PDF [http://perma.cc/UQX7-XQAV]; Press Release, European Commission, Regulation on Short Selling and Credit Default Swaps (Oct. 19 , 2011 ), http://europa.eu/rapid/press-release MEMO-i 1- 713 _en.htm [http://perma.cc/9JPY-XXHY].
76. See supraSection 1IIA.
77. See Lawrence Kryzanowski, Stylianos Perrakis & Rui Zhong, PriceDiscovery in Equity and CDS Markets , 35 J. FIN. MKTS. 21 ( 2017 ).
78. INT'L MONETARY FUND , supranote 12 , at 62.
79. Short-Selling on States Can Pay Off , N.Y. TIMES (Oct. 3 , 2008 , 7 :20 AM), http://dealbook.nytimes.com/ 2008 /10/03/short -selling-on-states-can-pay-off [http://perma.cc/KUW2- ECU5] ("After the insurance companies that specialized in municipal bonds became troubled, creditdefault swaps emerged as an alternative form of insurance. Even though municipalities rarely default on their bonds, the insurance was popular because it made municipal bonds seem utterly foolproof That sense of heightened security made the bonds easier to sell, lowering communities' borrowing costs.").
80. For some academic support of the idea that liquidity in the CDS market can enhance liquidity in the corresponding bond markets, see Giovanni Calice et al ., Liquidity Spillovers in Sovereign Bond and CDS Markets: An Analysis of the Eurozone Sovereign Debt Crisis, 85 J. ECON. BEHAV. ORG . 122 ( 2013 ), and Batchimeg Sambalaibat, A Theory of Liquidity Spillover between Bond and CDS Markets, J. FIN . (forthcoming 2018 ), http://papers.ssrn.com/sol3/papers.cfm?abstract id = 2404512 [http://perma.cc/8MSJ-DMZ6].
81. See supraSection 1IC.
82. See Carney, supra note 52; Sgarlata Chung , Municipal Securities: The Crisis of State and Local Government Indebtedness, Systemic Costs of Low DefaultRates , and Opportunitiesfor Reform, 34 CARDOZO L. REV. 1455 , 1498 ( 2013 ).
83. Cooper J. Howard & Rob Williams , How the Municipal Bond Insurance Market Has ChangedSince the Great Recession , CHARLES SCHWAB (Aug. 6 , 2015 ) (citing THE HANDBOOK OF MUNICIPAL BONDS (Sylvan G . Feldstein & Frank J. Fabozzi eds., 2008 )), http://www.schwab.com/public /schwab/nn/articles/ How-the-Municipal-Bond-Insurance-Market-Has-Changed-Since-the- GreatRecession [http://perma.cc/8JTZ-WW2C].
84. See supraSection 1IC.
85. See Matthew J. Holian & Marc D. Joffe , Assessing Municipal Bond Default Probabilities 17 (MPRA Paper No. 46728 , 2013 ), http://papers.ssrn.com/sol3/papers.cfm?abstractid =2258801 [http://perma.cc/UQD8-NS9J].
86. Ingo Fender & Martin Scheicher , The ABX : How Do the Markets Price Subprime MortgageRisk? , BIS Q. REV. , Sept . 2008 , at 67 , 69, fig. 1.
87. Alessandro Fontana & Martin Scheicher , An Analysis of Euro Area Sovereign CDS and Their Relation with Government Bonds 28 fig.2 (European Cent . Bank, Working Paper No. 1271 , 2010 ), http://www.ecb.europa.eu/pub/pdf/scpwps/ecbwpl271.pdf [http://perma.cc/Y43G-8P2Y].
88. See supraSection IVA.
89. Martin Oehmke & Adam Zawadowski , The Anatomy of the CDS Market, 30 REV. FIN. STUD . 80 , 81 ( 2017 ) ("Whereas hedging motives are reflected to a comparable extent in bond and CDS trading volume, speculative trading, which is likely to be more sensitive to the relative liquidity advantage of the CDS market, is concentrated in the CDS market.").
90. Short-Selling on States Can Pay Off , supranote 79 .
99. Michael Corkery & Matt Wirz, Hedge FundsAre Muscling into Munis, WALL ST . J. (Nov. 11 , 2013 , 8 :01 AM), https://www.wsj.com/articles/hedge -funds-are-muscling-into-munis1384213290 [http://perma .cc/L9L3-UXCE].
100. INT'L MONETARY FUND , supranote 12 , at 61.
101. See generally Nicholas S. Di Lorenzo , Note, Defining a New Punctilio of an Honor: The Best Interest Standardfor Broker-Dealers , 92 B.U. L. REV. 291 ( 2012 ) (discussing the
102. Sharona Coutts , Goldman Sachs UrgedBets Against CaliforniaBonds It Helped Sell , PROPUBLICA (Nov. 11 , 2008 , 2 :05 AM), http://www.propublica.org/article/goldman-sachs-urgedbets- 1109 [http://perma.cc/S4RT-URJS].
103. Press Release, Sec. & Exch . Comm'n, SEC Charges Goldman Sachs with Fraud in Structuring and Marketing of CDO Tied to Subprime Mortgages (Apr . 16, 2010 ), http://www.sec.gov /news/press/2010/2010- 59 .htm [http://perma.cc/9MTS-KTAJ].