Citi's Financial Crisis Derivatives Should Be Banned

Feb.11.10 | About: Citigroup Inc. (C)

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The new financial derivative designed by credit specialists at Citi (NYSE:C) should be banned. It's too dangerous to exist, adding unfathomable levels of systemic risk, and depends entirely on arbitraging implicit government backing.

You might have heard that Citi has constructed the CLX, which is an index designed to allow firms to sell a kind of insurance against a future liquidity crisis. The idea is that buyers would invest in CLX products that would pay off as funding costs for financial institutions increased and require payments as they decreased.

The very first problem with this product is that it is meant to involve no upfront costs. Buyers and sellers of liquidity would go long and short the CLX by drawing up contracts that promise payments when certain index levels are triggered. That will make entering the contracts cheap, in terms of up front costs.

"The great thing about the index is that it hedges your funding costs while being very simple to trade. I believe it will reduce the systemic risk in the industry, akin to how the advent of swaps means people don't worry about interest-rate exposures any more – they just pay a fee to hedge it," he says.

But without an upfront premium or a reserve requirement, the CLX trades will be 100% exposed to counter party risk. This means that to the extent that a firm buying CLX liquidity protection is just trading liquidity risk for counter party risk. We don't want people not worrying about liquidity exposure because they've taken on counter-party exposure.

Worse, this trade could make the biggest sellers of liquidity protection dangerously important to the financial system. They would wind up as the only fir m's that would need to be bailed out in the event of a crisis, since the firms that bought CLX protection from them would get backdoor bailouts when that protection paid off. This tracks very closely with what we saw with the AIG bailout.

The only firms that will be able to sell the insurance will be firms deemed too big to fail. That is, you wouldn't buy this kind of insurance from a firm you believed might also face a liquidity risk. You would only buy it from a firm you thought was protected from liquidity risk, and that kind of protection ultimately must come from the US government. So, ultimately, the sellers would be making private profits from the existence of public guarantees. They get all the upside, while the taxpayer gets all the risk

We're much bigger fans of financial innovation than many who write about finance but this goes too far. It should be killed or, perhaps, taxed 100 percent. Why shouldn't all the profits go to the taxpayers who ultimately bear the risk for these instruments?

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