A Pox on Liquidity Derivatives

I know I have written about ideas like this before, but I cannot remember where.  Let me start with a story.  I was at a Society of Actuaries conference in 2001 when I bumped into an actuary who was well-known to most before a meeting.  She recognized me, and I asked her what she was seeing that was new.  She told me, “Liquidity Derivatives.”

I shook my head for a moment and said, “Wait a minute, you mean getting a counterparty to pay cash at a time when liquidity is scarce?”  She giggled and said “Yes.”  I continued, “But wait, who would offer to pay at a time when liquidity is scarce?  She said, “That’s the problem.”  The speaker started to talk, so our conversation ended.

That is why I am skeptical about crisis derivatives.  Felix has commented on this, and he is worth a read here.  Unlike many, I do not think that all events in life can be hedged or insured.  In major disaster situations, no one can marshal the resources to make up for the disaster.  No one can insure against property damage in a war.

Citi has its own index of financial stress.  Here it is over the last 13 years:

Surprisingly, Aleph Blog has its own proprietary index for the same thing.

The graphs go the opposite way, but the correlations are over 80% in absolute value terms, and I can tell you that my measure more directly covers what Citi is going for, because it is the difference between the yield on the two-year Treasury and an index of A2/P2 commercial paper.

So, do you want to be able to fund yourself in a crisis?  Do the following: buy two-year Treasuries, and sell short A2/P2 commercial paper.  Most of the time this is a costly trade, if you can get it done at all.  But access to financing during a crisis is valuable, and should require compensation in advance to obtain it.

As for the Citi product, they should ask the question, “who would be willing to part with liquidity during a liquidity crisis?” and ask the question “Are they unquestionably solvent?”  Insurance is no good if the insurer is insolvent.  If Citi is the counterparty, I for one would not be comfortable.

Let me summarize.  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.