Citi reinvents end-of-the-world insurance
In hindsight, one of the silliest and most dangerous excesses of the Great Moderation was the large number of companies — foremost among them AIG, although there were lots of monoline insurers in the same trade — basically selling insurance on the world coming to an end. It’s a great trade: either the world doesn’t come to an end, and you make lots of money, or the world does come to an end, and it doesn’t matter ‘cos you’re bust anyway.
Now, however, after seeing how that trade worked out, we’re wiser, and no large and leveraged financial institution would have the chutzpah to start selling world-coming-to-an-end insurance. Would they?
Credit specialists at Citi are considering launching the first derivatives intended to pay out in the event of a financial crisis…
“The great thing about the index is that it hedges your funding costs while being very simple to trade. I believe it will reduce the systemic risk in the industry, akin to how the advent of swaps means people don’t worry about interest-rate exposures any more – they just pay a fee to hedge it,” [says Citi's Terry Benzschawel].
Like a swap, the contracts envisaged by Citi would be entered into without an up-front premium, with money changing hands according to the index’s movements around a fair strike value.
I’d forgive you if your eyes started rolling after just the first four words: the phrase “credit specialists at Citi” is not exactly the kind of thing which instills enormous confidence in analysts and investors these days. After all, it was credit specialists at Citi who ended up losing the bank billions of dollars on trades which were meant to be too safe to fail. And this trade is in many ways even worse than the one put on by AIG, because Citi doesn’t even get any insurance premiums up front, but still needs to pay out enormously in the event of a crisis.
We learned in the crash of 1987 that when financial markets start selling products which insure a portfolio against catastrophic loss, the very existence of those products can destabilize the market and make it more prone to crashing. And, of course, we learned that such insurance has a tendency not to get paid out on exactly when it’s most needed. But heaven forfend that the market should ever learn from its mistakes.
It’s crucial, in financial markets, that investors walk into risky asset classes with their eyes open, rather than kidding themselves that they can simply hedge those risks away by buying a fancy financial product from Citigroup. But the only people who can stop this from happening are the technocrats at the systemic-risk regulator we desperately need to step in and get sensible about these things. And those people, unfortunately, don’t yet exist.
Update: Citi spokesman Alex Samuelson responds via email:
I just wanted to make clear a few points:
- The Liquidity Index (CLX) is a product that we are considering, but have not launched. It is true, however, that we have developed an index to track market liquidity and we have had customer inquiries over the years asking to purchase liquidity protection.
- In possibly trading the index, Citi would act as a market maker, not a provider of liquidity. Citi would not take any position. We are only exploring the ability to make a market in liquidity by bringing natural buyers and sellers together. This would not be a prop trading business.
- We believe that the CLX could be a financially useful product in that it meets a marketplace need to be able to hedge one’s risk of liquidity drying up by purchasing liquidity from those firms that are natural providers of liquidity (insurance companies, pension funds, individual money market funds).
Thus, if it moves forward, the product could allow firms that depend on financing to exist to protect themselves from spikes in liquidity and provide a mechanism for people with excess liquidity to profit from that in an easy and transparent fashion.
Update 2: David Merkel weighs in.
Liquidity derivatives are not a reasonable product. You never want to be asking for something when it is in scarce supply, because the odds are it will be very difficult to deliver.