Will This Derivative Will Save You From The Next Financial Crisis?

Wouldn't it be deliciously ironic if one of the chief bailout recipients that had a hand in causing the financial crisis designed a derivative that paid out in the event of another financial crisis? I think so, but I wonder if Citigroup appreciates the irony: the giant bank that almost lost its footing during the crisis is considering doing precisely that. Somehow I missed this story last week, but I thought it was still worth writing about, because it's nearly as amusing as it is perplexing.

Here's the news blurb from risk.net:

Credit specialists at Citi are considering launching the first derivatives intended to pay out in the event of a financial crisis. The firm has drawn up plans for a tradable liquidity index, known as the CLX, on which products could be structured that allow buyers to hedge a spike in funding costs.

And here's the index's architect from Citi, Terry Benzschawel, explaining:

"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," he says.

Sounds great, right? Worried about the next financial crisis? Just buy this derivative, and it will hedge your potential losses. Then you'll have nothing to worry about.

Maybe I'm crazy, but that sounds an awful like what credit-default swaps hoped to do on a smaller scale. And if my memory serves me correctly, that didn't go so well. There was that whole mess with AIG where it wrote more of these derivatives than it could afford to be exposed to when things went bad. As a result the government had to come in and bail it out to the tune of something like $180 billion.

So this begs the question: if there's a financial crisis, who will be able to make good on these derivatives and pay the counterparties who wanted to hedge that risk? Pardon my skepticism, I'm just a little skewed by empirical observation. But as it turns out, I'm not the only one with this worry. The article continues:

However, there is concern from academic circles that the counterparty risks involved in such a product could create moral hazard. Chris Rogers, chair of statistical science at Cambridge University, said the only participants able to sell CLX-based products would probably be those who are too big to fail.

"This is basically a kind of insurance product. The main issue is: how good is the party issuing it? If it's going to be paying out huge numbers in the event of a crisis, will it be able to meet it obligations? Insurers can buy reinsurance for their liabilities, but the buck has to stop somewhere - there's a limit to how much a private insurer can pay out. Only the government can cover unlimited losses," he says.

Precisely. Who other than the government could provide a hedge for unforeseen systemic risk? Isn't the whole point that you don't know who, when or how that risk is going to hit? That means there's no counterparty that could be sure that it could handle the exposure. The only reason the government can is because its ability to print or borrow money is almost limitless.

I'll be curious to see how this derivative does. I know I wouldn't buy the thing, because if you buy it, then you're essentially taking a bet that whoever the counterparty is will be able to cover their exposure in the event of a financial crisis. So you are essentially betting on the ability of that financial institution to withstand the crisis. And you can't be too confident of that without the firm having an explicit backstop by the federal government.