Liberty Street Economics

« | Main | »

January 6, 2020

The Evolving Market for U.S. Sovereign Credit Risk

The Evolving Market for U.S. Sovereign Credit Risk

How should we measure market expectations of the U.S. government failing to meet its debt obligations and thereby defaulting? A natural candidate would be to use the spreads on U.S. sovereign single-name credit default swaps (CDS): since a CDS provides insurance to the buyer for the possibility of default, an increase in the CDS spread would indicate an increase in the market-perceived probability of a credit event occurring. In this post, we argue that aggregate measures of activity in U.S. sovereign CDS mask a decrease in risk-forming transactions after 2014. That is, quoted CDS spreads in this market are based on few, if any, market transactions and thus may be a misleading indicator of market expectations.

What Might a U.S. Sovereign Default Look Like?

As with corporations, a credit event for a sovereign may take one of several forms, including “fundamental” default, with the government unable to repay its debt obligations in total, and “technical” default, with the government temporarily postponing payments on the debt. In the case of the United States, a credit event would most likely be a technical default—for example, if borrowing were to reach the debt ceiling legislated by Congress. Under such a scenario, the U.S. Treasury might be forced to postpone one or more coupon payments or security redemptions until the ceiling were suspended or increased. The U.S. sovereign CDS spread is thus more likely to reflect the probability of a technical, rather than a fundamental, default.

Aggregate Activity in the U.S. Sovereign CDS Market

The market for U.S. sovereign credit risk has been shrinking since June 2014, as shown in the chart below, with 128 contracts outstanding as of June 11, 2019, less than one-tenth the peak of 1,538 contracts outstanding on September 16, 2011. At the same time, the gross notional value of outstanding positions in the market has also shrunk, to $3.7 billion, from its peak of $32.3 billion on August 26, 2011.

The Evolving Market for U.S. Sovereign Credit Risk

Transactions in the U.S. Sovereign CDS Market

To understand what has driven the decrease in activity in the U.S. sovereign CDS market, we use proprietary transaction-level data from the CDS trade repository maintained by the Depository Trust and Clearing Corporation to track the types of transactions in U.S. sovereign CDS over time. We focus on “risk-forming” transactions, which change market participants’ risk exposures. Risk-forming transactions can be separated into trades, which create new exposures in the financial system; terminations, which remove exposures from the financial system; and assignments, which transfer exposures among market participants.

The chart below shows that, between January 2010 and June 2019, a total of 433 “risk-forming” transactions took place involving a U.S. supervised institution, with the majority of these transactions occurring prior to January 2016. Moreover, out of the 433 total transactions, only 124 are new trades, and these occur almost exclusively prior to January 2014. Starting in January 2014, the majority of transactions are instead assignments, redistributing exposure to U.S. sovereign credit risk within the financial system. Terminations are particularly rare in our sample, with the majority of the 55 terminations taking place in 2010. Thus, the overall decrease in gross notional volume outstanding that we discussed above has likely been driven by a decreased willingness of market participants to create new exposures by initiating trades. As the existing contracts mature, the gross notional volume declines commensurately.

The Evolving Market for U.S. Sovereign Credit Risk

The chart above also shows that during the 2011-2014 period, trades primarily occurred ahead of debt ceiling suspensions, with market participants speculating on whether the debt ceiling would be breached, causing the United States to enter into a technical default. However, the more recent debt ceiling suspensions and subsequent debt ceiling increases seem not to have generated the same type of trading activity.

Who Trades with Whom?

We now turn to studying which institutions were buying and selling protection in the U.S. sovereign CDS market. The chart below shows that, prior to 2015, the majority of transactions involved U.S.-based institutions buying protection from institutions based in advanced European economies. Post 2015, when the majority of transactions were assignments, U.S.-based institutions were assigning their positions to institutions based in advanced European economies. Thus, the market for U.S. sovereign credit risk involves little wrong-way risk: buyers of protection in the U.S. sovereign CDS market are not facing U.S. counterparties.

The Evolving Market for U.S. Sovereign Credit Risk

What about the Observed Spreads?

So, are the quoted U.S. sovereign CDS spreads a useful measure of market participants’ expectations of U.S. sovereign credit risk? The chart below shows that this is unlikely to be the case. First, starting in 2014, not enough trades in the benchmark five-year maturity occur to compute a traded spread on U.S. sovereign CDS: quoted CDS spreads in this market are based on few, if any, transactions. Second, even prior to 2014, the difference between the quoted and the traded spreads was frequently as large as 10 percent of the spread.

The Evolving Market for U.S. Sovereign Credit Risk


The spread on U.S. sovereign CDS has received increased academic scrutiny in recent years, with proposed drivers including the probability of endogenous fiscal default and compensation for inflation risk. Our post suggests that such fundamental factors are unlikely to be the source of variation in quoted spreads because the quoted spreads in recent years are backed by few to no transactions.

Nina BoyarchenkoNina Boyarchenko is an officer in the Federal Reserve Bank of New York’s Research and Statistics Group.

Or ShacharOr Shachar is an economist in the Bank’s Research and Statistics Group.

How to cite this post:

Nina Boyarchenko and Or Shachar, “The Evolving Market for U.S. Sovereign Credit Risk,” Federal Reserve Bank of New York Liberty Street Economics, January 6, 2020,


The views expressed in this post are those of the authors and do not necessarily reflect the position of the Federal Reserve Bank of New York or the Federal Reserve System. Any errors or omissions are the responsibility of the authors.


Feed You can follow this conversation by subscribing to the comment feed for this post.

Having a hard time understanding the meaning of the discussion. All the measures of default risk are relative default risk. You only arrive at an absolute default probability from spreads by assuming both a risk free rate and a recovery rate. The risk free rate widely used to arrive at Sov Spreads (yield – risk free rate) is the exact interest rate you are trying to extract default probabilities from.

The comments to this entry are closed.

About the Blog

Liberty Street Economics features insight and analysis from New York Fed economists working at the intersection of research and policy. Launched in 2011, the blog takes its name from the Bank’s headquarters at 33 Liberty Street in Manhattan’s Financial District.

The editors are Michael Fleming, Andrew Haughwout, Thomas Klitgaard, and Asani Sarkar, all economists in the Bank’s Research Group.

Liberty Street Economics does not publish new posts during the blackout periods surrounding Federal Open Market Committee meetings.

The views expressed are those of the authors, and do not necessarily reflect the position of the New York Fed or the Federal Reserve System.

Economic Research Tracker

Liberty Street Economics is now available on the iPhone® and iPad® and can be customized by economic research topic or economist.

Comment Guidelines

We encourage your comments and queries on our posts and will publish them (below the post) subject to the following guidelines:

Please be brief: Comments are limited to 1500 characters.

Please be quick: Comments submitted after COB on Friday will not be published until Monday morning.

Please be aware: Comments submitted shortly before or during the FOMC blackout may not be published until after the blackout.

Please be on-topic and patient: Comments are moderated and will not appear until they have been reviewed to ensure that they are substantive and clearly related to the topic of the post. We reserve the right not to post any comment, and will not post comments that are abusive, harassing, obscene, or commercial in nature. No notice will be given regarding whether a submission will or will not be posted.‎

Send Us Feedback

Disclosure Policy

The LSE editors ask authors submitting a post to the blog to confirm that they have no conflicts of interest as defined by the American Economic Association in its Disclosure Policy. If an author has sources of financial support or other interests that could be perceived as influencing the research presented in the post, we disclose that fact in a statement prepared by the author and appended to the author information at the end of the post. If the author has no such interests to disclose, no statement is provided. Note, however, that we do indicate in all cases if a data vendor or other party has a right to review a post.