Domestic Bonds, Credit Derivatives, and the Next Transformation of Sovereign Debt

Financial markets in poor and middle-income countries are experiencing a fundamental shift. Until recently, most of them were shallow-to-nonexistent and closed to foreigners. Governments often had to rely on risky borrowing abroad; the private sector had even fewer options. But between 1995 and 2005, domestic debt in the emerging markets grew from $1 trillion to $4 trillion dollars. In Mexico, domestic debt went from just over twenty percent of the total government debt stock in 1995 to nearly eighty percent in 2007. Over the same period, derivative contracts to transfer emerging market credit risk surpassed the market capitalization of the benchmark bond index. The growth of domestic bonds and risk transfer technology makes the emerging markets look more mature, or mainstream. Yet a closer look at recent changes suggests that the popular rhetoric of mainstreaming and convergence obscures more than it reveals. Emerging and mainstream markets may share participants and use similar instruments, but this formal resemblance rarely stands for substantive identity. Instead, investors use the same instruments differently in different markets, which, as the examples in the text suggest, can be its own source of risk. Legal scholarship has yet to engage with the shift from foreign-law, foreign-currency to local-law, local-currency bonds and the rise of credit derivatives in the emerging markets. This symposium essay maps the ongoing transformation to highlight gaps between formal and substantive convergence of emerging and mainstream markets and suggest implications for governance, risk management, and future research