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Can you short municipal bonds with a cryptocurrency derivative? This is notoriously impractical in traditional finance, but there could be a crypto-based derivative designed around it. Is this a thing?

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Generally, to short a bond, you must borrow it, usually from a broker, and then sell it in the bond market. To make money you have to buy the bond back for less money and make money on that difference.

The problem is that brokers won't lend out tax-free municipals, because the lender collects tax-free rates but pays the short seller taxable interest.

If you are buying a derivative on these bonds, the market has to hedge out the exposure at some level. Market makers are still stuck with the tax-free to taxable interest issue when delta hedging their book.

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  • $\begingroup$ But let's say we are not actually short selling, we are entering into a derivative contract on a crypto exchange. Let's say for example an interest rate swap, LIBOR+1% for the yield on Cleveland, OH bond issue 186343D71, which as of this moment happens to be pretty close. If Cleveland goes belly-up, financially speaking that muni bond yield spikes nicely and victory ensues. $\endgroup$
    – user46252
    Dec 18 '20 at 7:01
  • $\begingroup$ Thats an interest rate swap. Not shorting municiple bonds. You can take out interest rate swaps or Credit Default swaps on muni bonds. Municipal bond portfolio managers face three forms of credit risk, the risk that the issuer will default, the risk that the credit spread will increase, and the risk that an issue will be downgraded. Municipal credit default swaps can be used to create equivalent credit exposure to a municipal entity that can be obtained in the municipal cash market. $\endgroup$ Dec 18 '20 at 7:11
  • $\begingroup$ I guess my initial question might have misrepresented my intentions. I'm thinking of a strategy to benefit from the financial distress of US cities, and my understanding is you cannot do that easily in traditional markets. I'm agnostic as to the what the exact instruments are that need to be used, Are interest rate swaps or credit default swaps available to retail muni bears who think a lot of mid-size cities are going the way of Detroit? And is this a thing people do to bet against muni bonds? $\endgroup$
    – user46252
    Dec 18 '20 at 7:41
  • $\begingroup$ Swaps aren't available at the retail level, muni or not, and for good reason. At the institutional level, muni credit swaps may exist at a bilateral level, but with these risks being difficult to hedge, you are likely to get a "thanks but no thanks" from swap dealers. Credit muni swaps pretty much disappeared post GFC. MCDX may be of interest to you. As for betting against munis, keep in mind they are extremely defensive and have incredibly low default rates, especially on GO credits. $\endgroup$
    – Kch
    Dec 18 '20 at 20:52
  • $\begingroup$ @Kch Single-name (US) muni CDS referencing states definitely still trade. City of Cleveland - maybe not so much. :) $\endgroup$ Dec 18 '20 at 21:16
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You can easily short a sovereign or municipal debt credit by buying CDS protection in the same currency in which their debt is denominated. For example, if you want to bet that the French EUR-denominated Obligations assimilables du Trésor (OATs) or USD-denominated general obligations of U.S. states of California or Illinois will be perceived by the markets as more crdit-risky, or even default, and if you can trade CDS (have an ISDA agreement with someone willing to sell you such CDS protection), buy at least 5 million notional of CDS protection, and you're all good. (But of course, European regulators don't want you to do this.)

You'd only denominate a trade in currency (or cryptocurrency) other than the one they owe if you want to take a view on how this currency will react to a credit (or some other) event, i.e. a quanto CDS. For example, in the 1990s LTCM used to trade CDS on Italy sovereign denominated in ITL, USD, and XEU - in order to take a view on how these currencies would react not to a sovereign default (that did not seem likely) but to Italy's failure to join EUR (which did seem likely and would have moved Italy CDS spread a lot). Likewise, you could buy USD-denominated CDS protection on France sovereign to include a view on how USD/EUR rate would react to changes in France creedit.

For example, a few years ago, before the most recent Venezuela sovereign default, I was working on CDS-like Bitcoin (XBT) trades contingent on Venezuela sovereign creidt. They were Bitcoin NDFs (making them derivatives:) - extinguishing and appearing, i.e. one party pays an upfront, and the other party owes / doesn't owe a Bitcoin (or an observed USD price of a Bitcoin) if Venezuela defaults / doesn't default. Clearly they include a view on what how Bitcoin price would react to Venezuela credit widening and eventually defaulting. Thes trades never happened, but a gold (XAU) linked to credit is pretty vanilla these days (i.e. one party promises to pay another the spot price of a troy oz of gold at maturity unless some reference entity defaults prior to that). I don't see how referencing cryptocurrency is any different from another currency or precious metal.

A (surmountable) practical problem is that debtors don't like the idea of someone expressing a view on their creditworthiness in CDS and other markets. Government and municipal debtors, in particular, think they can bully market participants and suppress credit-price discovery.

For example, EU tried to ban both short-selling bonds and buying CDS protection: https://ec.europa.eu/commission/presscorner/detail/en/MEMO_11_713

And here is an example of the Commune of California getting its panties in a knot over CDS:

https://www.reuters.com/article/us-economy-california-cds/six-california-underwriters-pressed-again-on-cds-idUSTRE64467920100505

https://www.latimes.com/archives/la-xpm-2010-aug-19-la-fi-california-swaps-20100819-story.html

https://www.bloomberg.com/news/articles/2010-09-28/california-treasurer-lockyer-calls-for-ban-on-muni-credit-default-swaps

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  • $\begingroup$ I cannot thank you enough for this explanation. These are exactly the kinds of things I'd like to do. I don't work for an institution that deals in derivatives like you describe, but I do have to read a lot of macroeconomic analysis and growth forecast/outlook literature that I wish I could act on. My understanding is that in the cryptocurrency ecosystem individuals can get exposure through instruments that are not available elsewhere, which is why I asked the original question. Is that true? Because if it is then I'm going to do a lot of homework on what you've written here and similar things $\endgroup$
    – user46252
    Dec 19 '20 at 3:00
  • $\begingroup$ As an individual, you can go around making bets with your friends -making up an example, if Cleveland, is bankrupt within 5 years, then I pay you a million satoshi, and if it doesn't, then you pay me 1,000 oz of XAG. Such bets are likely to violate some laws, but are no more likely to get you in legal trouble than similar-sized bets on basketball or football games. But institutions aren't going to trade with you, even a vanilla CDS, let alone exotics, unless you have tens of millions of dollars to bet. "Fun" instruments are not available to retail investors, sorry! $\endgroup$ Dec 19 '20 at 3:13

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