Streetwise Professor

March 11, 2014

CCP Insurance for Armageddon Time

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.

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  1. Iffy proposition: I know that P&C Actuaries are god like, but how on earth would they price this risk? Even more so, how would they define the size of the risk?

    Speaking of Armageddon time, this reminds me of the joke where an A- Insurer (I think it was ACA but am not sure) made a living wrapping their guarantee around AAA RMBS tranches because the Rating Agencies allowed the calculation of joint probabilities for capital allocations, especially in Europe (those sophisticated devils!). The fact that common sense dictates that an A- guarantee doesn’t mean anything to a AAA, and that Armageddon time is the time when all correlations go to 1, didn’t seem to register.

    Wouldn’t that be the same here? Unless the insurers liability is capped, it would be a one way bet: either it blows or it doesn’t. If it is capped, what use is it? My cynical side is that any underwriter would, worse comes to worse, play chicken with the Fed and Treasury: “let us go under and everything goes. Talk about systemically important!

    Comment by sotos — March 11, 2014 @ 2:11 pm

  2. @sotos. Yes, if this analogous to monolines, then it is a joke. They were lousy with wrong way risk. That’s what the Rating Agencies missed.

    The risk is apparently capped, but things are so preliminary it’s hard to tell.

    My guess is that they will offer this insurance but the price will be so expensive, or the quality so low (due to wrong way risk) that the CCPs will pass.

    The ProfessorComment by The Professor — March 11, 2014 @ 2:45 pm

  3. From your keyboard to G-d’s inbox, Perfesser.

    Comment by sotos — March 11, 2014 @ 2:58 pm

  4. Currently, as default waterfalls are capped, the market is essentially pricing extreme tail risk as near zero. Regulatory concerns around too big to fail CCPs is leading to guidance requiring CCPs to allocate losses as an alternative to insolvency. For a given stress event, the amount to be allocated beyond the waterfall is a constant and will either be allocated ex-post by a court, or ex-ante through changes to CCP contract based rules. Tools such as variation margin haircutting, or the capacity to make unlimited calls, are effectively stake holder self insurance. The insurance company offering may very well not be taken up as too expensive, but it is certainly a valid and potentially complementary option. At the very least, the insurance proposal puts a price on extreme tail risk.

    Whether insurance is reliable is another question (it is no longer regarded by regulators as an acceptable substitute for pre-paid commitments in the default waterfall), but that also applies to participants facing additional calls in Armageddon.

    Comment by Noir — March 11, 2014 @ 9:49 pm

  5. Why bother – the Government’s and Central Banks are the ultimate insurers of this risk (they drove the set-up of CCPs for OTC products and centralised the risks and created the SIFIs) – and what exactly is $10bn going to give you in the situation where the CME, LCH or ICE have run out of cash anyway at their OTC DCO and a Tier 1 or and a couple of Tier 2 Banks have defaulted? The interesting point to watch in the short term is what the loss of GSE status does to Freddie, Fannie, and the Fed Homes subs vis-a-vis clearing of IRS and their forward convexity. – now there’s wrong way risk SWP.

    Comment by Mancunian — March 14, 2014 @ 10:06 am

  6. In FrankenDodd, CCP’s can go talk to the banker at the Fed window if Armageddon happens. Let’s hope it never comes to that. One fear I have is not total financial meltdown, but a failure of CCP’s to price risk correctly. What if their models don’t work, or are off by just this much?


    What if they fail to account for fraud?

    Comment by Jeffrey Carter (@pointsnfigures) — March 20, 2014 @ 7:37 am

  7. Its hard to go to the Fed window if the default fund is exhausted and you have nothing left to sell. Pricing risk is problematic. Back testing margin methodologies will give some comfort that initial margin is adequate in business as usual market volatility. Whether default funds are adequate for a default, or multiple defaults, in extreme volatility depends upon the robustness of stress scenarios underpinning the determination of the size of the fund. That adequacy is known only to CCPs and their regulators. If someone can come up with a credible fraud scenario to take down a CCP, I would like a share of the pie, a more worrisome issue might be investment loss.

    Comment by Noir — March 20, 2014 @ 8:43 pm

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