Bank devises tradable liquidity index as underlying for derivatives.
Citigroup is working on a new family of derivatives to hedge against liquidity crises. According to Risk magazine, the bank has devised a tradable liquidity index that is, essentially, the sum of Sharpe ratios of various traded instruments, swaps and credit spreads, along with bid-ask spreads and other factors. The index, which it will call CLX, is meant to be a proxy for market liquidity.
Companies seeking to hedge against liquidity crises can enter into derivatives using the index as an underlying, much as bearish investors and hedgers used the subprime mortgage index in 2007 and 2008. While it appears such products would be best suited to investors and prop traders, there could, theoretically, be a use for it among corporates worried about access to, say, the commercial paper market.
However, the providers of liquidity in a contract based on the index would have to have enormous resources or the ability to spread that risk. This has caused some commentators to criticize the move as one that could only be taken by a too-big-to-fail institution, where the ultimate risk is borne by taxpayers.
After all, the seller of this type of insurance against fat-tailed events will usually be subject to the same type of liquidity crisis affecting the buyers, throwing its ability to make good on the contracts into question. Such uncertainty is destabilizing, as the experience of AIG and the monolines during the credit crisis taught. However, it’s too early to make such a determination, because it remains to be seen how the contracts will be configured, and how Citi plans to market them.