Matt Leising has an interesting story in Bloomberg about a consortium of insurance companies that will offer an insurance policy to clearinghouses that will address one of the most troublesome issues CCPs face: what to do when the waterfall runs dry. That is, who bears any remaining losses after the defaulters’ margins, defaulters’ default fund contributions, CCP capital, and non-defaulters’ default fund contributions (including any top-up obligation) are all exhausted.
Proposals include variation margin haircuts, and initial margin haircuts. Variation margin haircuts would essentially reduce the amount that those owed money on defaulted contracts would receive, thereby mutualizing default losses among “winners.” Initial margin haircuts would share the losses among both winners and losers.
Given that the “winners” include many hedgers who would have suffered losses on other positions, I’ve always found variation margin haircutting problematic: it would reduce payoffs precisely in those states of the world in which the marginal utility of those payoffs is particularly high. But that has been the industry’s preferred approach to this problem, though it has definitely not been universally popular, to say the least. Distributive battles are never popularity contests.
This is where the insurance concept steps in. The insurers will cover up to $6 to $10 billion in losses (across multiple CCPs) once all other elements of the default waterfall-including non-defaulters’ default fund contributions and CCP equity-are exhausted. This will sharply limit, and eliminate in all but the most horrific scenarios, the necessity of mutualizing losses among non-clearing members via variation or initial margin haircutting.
Of course this sounds great in concept. But one thing not discussed in the article is price. How expensive will the coverage be? Will CCPs find it sufficiently affordable to buy, or will they decide to haircut margins in some way instead because that is cheaper?
As I say in Matt’s article, although this proposal addresses one big headache regarding CCPs in extremis, it does not address another major concern: the wrong way risk inherent in CCPs. Losses are likely to hit the default fund in crisis scenarios, which is precisely when the CCP member firms (banks mainly) are least able to take the hit.
It would have been truly interesting if insurers would have been willing to share losses with CCP members. That would have mitigated the wrong way risk problem. But the insurers were evidently not willing to do that. This is likely because they are concerned about the moral hazard problems. Members would have less incentive to mitigate risk if some of that risk is offloaded onto insurers who don’t influence CCP risk management and margining the way member firms do.
In sum, the insurers are taking on the risk in the extreme tail. This of course raises the question of whether they are able to bear such risk, as it is likely to crystalize precisely during Armageddon Time. The consortium attempts to allay those concerns by pointing out that they have no derivatives positions (translation: We are not AIG!!!) But there is still reason to ponder whether these companies will be solvent during the wrenching conditions that will exist when potentially multiple CCPs blow through their entire waterfalls.
Right now this is just a proposal and only the bare outlines have been disclosed. It will be fascinating to see whether the concept actually sells, or whether CCPs will figure it is cheaper to offload the risk in the extreme tail on their customers rather than on insurance companies in exchange for a premium.
I’m also curious: will Buffett participate. He’s the tail risk provider of last resort, and his (hypocritical) anti-derivatives rhetoric aside, this seems like it’s right down his alley.