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.


  • Much like CDS, this seems like a derivative that’s looking to be an easy substitute for proper risk management. Buy a derivative, rather than have liabilities of sufficient maturity to tide you over in a crisis? It’ll be interesting to see who actually sells this, and how it functions when it comes time to deliver (assuming it gets off the ground).

  • Greg says:

    Can we please stop with this political correctness and call a spade a spade?

    This is the most incredibly stupid idea Citibank has ever proposed. It is incontestable evidence that the bank needs to be split up and closed.

    For all the dimwits at Citi, here is a history lesson from — oh, last year. People paid this “AAA” insurance company to protect against the mortgage market collapsing. Lets call it *AIG* so no one will know the name of the actual insurance company involved.

    Well, it turns out that the insurance company was happy to collect premiums, but even if they had set aside 100% as reserves it would not have been enough to bail out the markets — losses exceeded the total capitalization of the whole firm.

    Citibank really should be embarrassed for proposing such a moronic idea. I would spend the rest of the afternoon calling them stupid, but I am going to go close my Citi accounts before they get anymore “bright” ideas.

    Citi’s proposal is incontestable proof that the bank isn’t too big to fail — it’s size and group thinking make it too big to ever work

    Shut down Citibank before it costs the country another few trillion!!!!

  • najdorf says:

    What’s really pernicious about liquidity derivatives is not those who would blow themselves up trading them – speculators can blow up with any number of options, and I don’t think it poses any external problems if they want to trade pig guts contracts or movie theater concession receipts futures. The problem here is that creating the derivative would only be the first step in creating terrible structured products to sell to institutional funds that are run by gullible, stupid, or immoral folks. I have two great ideas already:

    “Hey, you’re investing for retirements that are thirty years away. Over the past twenty years, liquidity has fluctuated but it always reappears. Why don’t you sell some liquidity derivatives to speculators/short-term hedgers and collect the free premiums? (all wrapped up in a complex levered structure that yields 8% under good circumstances, blows up under bad circumstances, and pays the bank 1% under all circumstances).”

    along with its counterpart:

    “Hey, all the other pension funds lost their money selling liquidity before a crisis. What a bunch of buffoons! We have a great hedged product for you. You buy some risky illiquid stuff with levered funds, and we hedge all the liquidity risk with these great derivatives! You make 5% with none of that nasty risk! It’s way better than Treasuries!” (and you pay us 1%, and we don’t really make the risk go away, we just defer it or remove the obvious but irrelevant portion and leave the big hidden downside).

    I think the obvious lesson of the ongoing financial crisis is that the world needs more complex, illiquid (what happens when the liquidity derivative market seizes up? “I assure you these assets are money good, they just aren’t trading right now!”), nontransparent, infinitely scalable products laden with hard-to-assess counterparty risk, model/tracking risk, and correlation risk that offer highly skewed return distributions which look like risk-free spreads on a historical basis. If bankers can charge large fees for structuring these products or derive large spreads from trading them, efficient social benefit will surely ensue.

  • Making a CTA or momentum strategy allocation accomplishes a lot of portfolio hedging using cleared futures. Just eyeballing the numbers, since 2000, the Newedge CTA index was up in 8 of the 10 months where the Citi index experienced max rises in stress, and had an average return of +1.54% in those months.

  • najdorf says:

    One additional note based on the linked article – this derivative’s creators purport that it can hedge funding risk. I don’t know everything about how bankers do things, but when I want to hedge funding risk I usually borrow longer-term or with looser covenants. I pay a price for this risk reduction, but at least I have the money in hand and know that a coherent and long-lived set of laws protects my right to repay according to the contract (likewise for my counterparty’s right to repayment, which reduces my funding costs from what they would otherwise be). Contrast this plan to borrowing overnight and buying an untested derivative which may not itself be liquid, may not have collateral posted fully and promptly, and may not accurately hedge an increase in what the market charges me tomorrow. Hmm. I suppose if I were in the business of using other people’s money to takes risks they and I didn’t fully understand and paying myself huge yearly bonuses based on my own assessment of my performance, I might choose the second option.

  • Thank you for all the great posts from last year! I look forward to reading your blog, because they are always full of information that I can put to use. Thank you again, and God bless you in 2010.

  • tito says:

    I think you’re being mean-spirited.

    Citi has simply found a way to share its federal backstop with its clients. This is the spirit of magnanimity.