The Newest Franken-Finance Creation: Liquidity Derivatives

With Wall Street now under the harsh glare of public and government scrutiny, one might assume that big banks -- especially those that benefited most from government support -- would be treading cautiously in trying to expand their trading operations. Fortunately for the financial blogging community, no healthy sense of irony appears to have developed among the credit-trading team at Citigroup (C): They're trying to create a market for liquidity derivatives, which would theoretically allow borrowers to hedge the risk that another financial crisis might makes credit access more costly or less available.Although Citi claims it wants "to get natural buyers and sellers of liquidity together," it's worth considering whether a natural seller of liquidity in times of market distress actually exists. David Merkel of Finacorp Securities, who publishes the Aleph Blog, points out that the counterparty risks inherent in a liquidity derivative are enormous, because it is most vital that the seller make good on its obligation at a time of maximum stress.

This latest attempt at selling "end-of-the-world insurance" makes Felix Salmon of Reuters wonder if financial markets will ever learn that these derivatives almost inevitably have market-altering consequences. But both Merkel and Salmon briefly touch on a point worth exploring more -- that not all risks can be hedged, regardless of how many clever new derivatives are created.

An Added Layer of Complexity

The end goal of a liquidity derivative would be to compensate a borrower unable to access financing because of a systemic event. Of course, the reason a borrower would need to be compensated in such a circumstance is that they have short-term loans that need to be rolled over, and troubled credit markets could prevent that (or at least make it very costly). But using short-term loans and buying a liquidity derivative designed to hedge funding costs adds a layer of complexity to managing cash flow, and financial complexity is something generally worth avoiding.

A much simpler way to hedge this risk is to borrow at longer maturity dates so that a company's financial position is never dependent on the ability to borrow money cheaply at any single point in time. Longer-term loans carry higher interest rates, especially in when, like now, there's a steep yield curve. That's why there's a temptation to push the envelope and take short-term loans. Still, it makes more sense to borrow long and pay a higher interest rate than to try to save on interest expenses while also taking on the counterparty risks inherent in dealing with an untested derivatives market.

Evaluating potential sellers of liquidity is difficult, because the effects of being short liquidity can create a negative feedback loop. While it's tempting to view liquidity derivatives as end-of-the-world insurance and think nobody would ever actually have to pay out on them, they could easily kill a marginal institution.

As hedge fund group D.E. Shaw explains in a note on "Time Portals and Other Illusions," a company that was hypothetically selling credit default swaps on itself would have to make cash payments as collateral if its own bonds declined in value. This cash outflow could easily precipitate another decline in its own bonds due to the weaker cash position, leading to a further deterioration in the cash position.

Repeating a Familiar Mistake

The same situation would exist with liquidity derivatives: A firm that appears as well-capitalized as possible, by having to deliver cash in troubled times, could end up insolvent precisely because of its dealings in liquidity derivatives. All this trouble would likely earn the seller a few dozen basis points (hundredths of a percent). Essentially, buyers of liquidity derivatives would be making exactly the same error in reaching for that last sliver of yield that went on with subprime mortgages, or from sellers of credit default swaps collecting small premiums while taking on huge liabilities.

Some derivatives are useful and help companies hedge events to legitimately manage risk: Currency and commodities derivatives come to mind. Others are simply an outgrowth of the financial Establishment trying to substitute derivatives for thoughtfulness in areas like managing credit risk or financial position. Those exist for dubious reasons, and in the case of credit default swaps, came due at great cost to many through the irresponsibility of a few.

We can only hope that the principle of systemic stability can be placed before the principle of squeezing out every drop of trading revenue possible, and a similar scenario that we've seen other derivatives won't be allowed to unfold with liquidity derivatives.
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