Credit Default Swaps as Sovereign Debt Collateral

Abstract

A defining friction of sovereign debt is the lack of collateral that can back sovereign borrowing. This paper shows that credit default swaps (CDS) can serve as collateral and thereby support more sovereign borrowing. By giving more bargaining power to lenders in ex-post debt renegotiations, CDS becomes a commitment device for lenders to extract more repayment from the debtor country. This ex-post disciplining effect during debt renegotiations better aligns the sovereign's ex-ante incentives with that of the lender. CDS alleviates agency frictions that are present in any lending contracts but are particularly difficult to mitigate in sovereign debt context. As a result, CDS enables the borrower to raise more external capital.

Keywords: credit default swaps, sovereign debt, moral hazard, debt renegotiation, commitment device, credit derivatives