Proving that it has learned nothing from the arrogance of Chuck Prince and Citi’s subsequent demise, Citi plans crisis derivatives.

Credit specialists at Citi are considering launching the first derivatives intended to pay out in the event of a financial crisis. The firm has drawn up plans for a tradable liquidity index, known as the CLX, on which products could be structured that allow buyers to hedge a spike in funding costs.

Like the untraded US rates liquidity index (USRLI), the CLX is constructed as a sum of the Sharpe ratio – deviations from the mean divided by volatility – of various market factors, such as equity volatilities, Treasury rates, swap spreads, corporate bond swaption-implied volatilities, and structured credit spreads. Citi will make the CLX tradable by using fixed historical values for the mean and volatility parameters, eliminating the need for costly recomputation from lengthy time series.

Although the design of the index serves as a proxy measure for liquidity, Terry Benzschawel, a managing director of quantitative credit trading strategy at Citi in New York and head of the team researching the product, says it also tracks more traditional measures such as bid-ask spreads, trading volumes and the USRLI. He compares the potential impact of CLX to that of the interest rate swaps market.

“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.

Chris Rogers, chair of statistical science at Cambridge University, said the only participants able to sell CLX-based products would probably be those who are too big to fail.

“This is basically a kind of insurance product. The main issue is: how good is the party issuing it? If it’s going to be paying out huge numbers in the event of a crisis, will it be able to meet it obligations? Insurers can buy reinsurance for their liabilities, but the buck has to stop somewhere – there’s a limit to how much a private insurer can pay out. Only the government can cover unlimited losses,” he says.

The last thing we need is another product few will understand, and fewer still use for actual hedging rather than speculation.

Don’t we have enough derivatives already?

Please remember there always has to be someone on the other side of the trade. Think everyone will be hedged properly? I don’t. In fact I guarantee you they won’t.

This product will be offered by those too big to fail. They will collect premiums on selling the product until it blows up. Crisis derivatives are yet another reason for many to scream for the reintroduction of Glass-Steagall, to separate banks from speculative trading.

I do not care if banks blow up providing that taxpayers do not have to bail them out. However, unless there is clear, distinct separation of banking from trading, such products heighten risk of another bailout.

The treasury (taxpayers) already guarantee $300 billion of Citigroup assets. We do not need more garbage or speculation on Citi’s balance sheet for taxpayers to underwrite. Nor do we need the derivative king, JPMorgan Chase, betting on systemic collapses.

I asked my friend “HB” to chime in on this product. He writes …

This is yet another example that shows fundamental conceit. Systemic risk is not lowered by the introduction of new derivatives, it is heightened. The risk doesn’t go away after all, it is just shifted.

Moreover, since derivatives need speculative participants to provide trading liquidity, they actually ADD to overall systemic risk.

That Citi would introduce such a product is a huge sign that the bottom is not in, and another huge crisis is coming.

Mike “Mish” Shedlock
Click Here To Scroll Thru My Recent Post List