Model Setup Known Insurer Unknown Insurer Incentives to Insure CCP CDS as Insurance: Leaky Lifeboats in Stormy Seas James R. Thompson Presented at: CES, Munich September 05, 2012 James R. Thompson School of Accounting and Finance, University of Waterloo CDS as Insurance: Leaky Lifeboats in Stormy Seas 1 / 32
Model Setup Known Insurer Unknown Insurer Incentives to Insure CCP What are CDS? • Roughly half of buyers use them purely for speculation, rest use for risk management/hedging. - Fitch Rating Agency 2009, 2010. • China and Germany propose bans on trading without owning underlying. - Bloomberg Sept 13, 2010, June 14, 2010 • New York State trying to regulate CDS sellers as Insurers - New York State Insurance Department, Circular Letter No. 19 (2008) • AMBAC,MBIA,ACA,AIG, many hedge funds did not provide true insurance. James R. Thompson School of Accounting and Finance, University of Waterloo CDS as Insurance: Leaky Lifeboats in Stormy Seas 2 / 32
Model Setup Known Insurer Unknown Insurer Incentives to Insure CCP What are CDS? • Roughly half of buyers use them purely for speculation, rest use for risk management/hedging. - Fitch Rating Agency 2009, 2010. • China and Germany propose bans on trading without owning underlying. - Bloomberg Sept 13, 2010, June 14, 2010 • New York State trying to regulate CDS sellers as Insurers - New York State Insurance Department, Circular Letter No. 19 (2008) • AMBAC,MBIA,ACA,AIG, many hedge funds did not provide true insurance. James R. Thompson School of Accounting and Finance, University of Waterloo CDS as Insurance: Leaky Lifeboats in Stormy Seas 2 / 32
Model Setup Known Insurer Unknown Insurer Incentives to Insure CCP What are CDS? • Roughly half of buyers use them purely for speculation, rest use for risk management/hedging. - Fitch Rating Agency 2009, 2010. • China and Germany propose bans on trading without owning underlying. - Bloomberg Sept 13, 2010, June 14, 2010 • New York State trying to regulate CDS sellers as Insurers - New York State Insurance Department, Circular Letter No. 19 (2008) • AMBAC,MBIA,ACA,AIG, many hedge funds did not provide true insurance. James R. Thompson School of Accounting and Finance, University of Waterloo CDS as Insurance: Leaky Lifeboats in Stormy Seas 2 / 32
Model Setup Known Insurer Unknown Insurer Incentives to Insure CCP What are CDS? • Roughly half of buyers use them purely for speculation, rest use for risk management/hedging. - Fitch Rating Agency 2009, 2010. • China and Germany propose bans on trading without owning underlying. - Bloomberg Sept 13, 2010, June 14, 2010 • New York State trying to regulate CDS sellers as Insurers - New York State Insurance Department, Circular Letter No. 19 (2008) • AMBAC,MBIA,ACA,AIG, many hedge funds did not provide true insurance. James R. Thompson School of Accounting and Finance, University of Waterloo CDS as Insurance: Leaky Lifeboats in Stormy Seas 2 / 32
Model Setup Known Insurer Unknown Insurer Incentives to Insure CCP What we do • Ask: What features of CDS create/increase counterparty risk in the market? • Update the insurance economics framework to handle CDS. • Contrast results with ordinary insurance contracts. James R. Thompson School of Accounting and Finance, University of Waterloo CDS as Insurance: Leaky Lifeboats in Stormy Seas 3 / 32
Model Setup Known Insurer Unknown Insurer Incentives to Insure CCP What we do • Ask: What features of CDS create/increase counterparty risk in the market? • Update the insurance economics framework to handle CDS. • Contrast results with ordinary insurance contracts. James R. Thompson School of Accounting and Finance, University of Waterloo CDS as Insurance: Leaky Lifeboats in Stormy Seas 3 / 32
Model Setup Known Insurer Unknown Insurer Incentives to Insure CCP What we do • Ask: What features of CDS create/increase counterparty risk in the market? • Update the insurance economics framework to handle CDS. • Contrast results with ordinary insurance contracts. James R. Thompson School of Accounting and Finance, University of Waterloo CDS as Insurance: Leaky Lifeboats in Stormy Seas 3 / 32
Model Setup Known Insurer Unknown Insurer Incentives to Insure CCP Unique to CDS • UPDATE 1: Risk of insurer insolvency private information • UPDATE 2: Buyers (banks) can have differing motivations to purchase • UPDATE 3: Contracts cleared through Central Counterparty (CCP) James R. Thompson School of Accounting and Finance, University of Waterloo CDS as Insurance: Leaky Lifeboats in Stormy Seas 4 / 32
Model Setup Known Insurer Unknown Insurer Incentives to Insure CCP Unique to CDS • UPDATE 1: Risk of insurer insolvency private information • UPDATE 2: Buyers (banks) can have differing motivations to purchase • UPDATE 3: Contracts cleared through Central Counterparty (CCP) James R. Thompson School of Accounting and Finance, University of Waterloo CDS as Insurance: Leaky Lifeboats in Stormy Seas 4 / 32
Model Setup Known Insurer Unknown Insurer Incentives to Insure CCP Unique to CDS • UPDATE 1: Risk of insurer insolvency private information • UPDATE 2: Buyers (banks) can have differing motivations to purchase • UPDATE 3: Contracts cleared through Central Counterparty (CCP) James R. Thompson School of Accounting and Finance, University of Waterloo CDS as Insurance: Leaky Lifeboats in Stormy Seas 4 / 32
Model Setup Known Insurer Unknown Insurer Incentives to Insure CCP Main Results • Counterparty risk (usually) higher with opaque insurers. Stable insurers become less stable. Increased competition among insurers can increase counterparty risk. • CDS market characterized by lower quality insurers than traditional insurance due to speculators. Removing speculators may actually increase counterparty risk. • With a CCP, stable insurers can lose competitive advantage and drop out: problem of the commons type result. James R. Thompson School of Accounting and Finance, University of Waterloo CDS as Insurance: Leaky Lifeboats in Stormy Seas 5 / 32
Model Setup Known Insurer Unknown Insurer Incentives to Insure CCP Main Results • Counterparty risk (usually) higher with opaque insurers. Stable insurers become less stable. Increased competition among insurers can increase counterparty risk. • CDS market characterized by lower quality insurers than traditional insurance due to speculators. Removing speculators may actually increase counterparty risk. • With a CCP, stable insurers can lose competitive advantage and drop out: problem of the commons type result. James R. Thompson School of Accounting and Finance, University of Waterloo CDS as Insurance: Leaky Lifeboats in Stormy Seas 5 / 32
Model Setup Known Insurer Unknown Insurer Incentives to Insure CCP Main Results • Counterparty risk (usually) higher with opaque insurers. Stable insurers become less stable. Increased competition among insurers can increase counterparty risk. • CDS market characterized by lower quality insurers than traditional insurance due to speculators. Removing speculators may actually increase counterparty risk. • With a CCP, stable insurers can lose competitive advantage and drop out: problem of the commons type result. James R. Thompson School of Accounting and Finance, University of Waterloo CDS as Insurance: Leaky Lifeboats in Stormy Seas 5 / 32
Model Setup Known Insurer Unknown Insurer Incentives to Insure CCP Players • Insured Party (Bank) ◮ Endowed with loan that can default. • Two Insurers ◮ Either ’good’ or ’bad’ ◮ Both endowed with random portfolio ◮ Both make investment decision. Good invests liquid, bad invests illiquid. James R. Thompson School of Accounting and Finance, University of Waterloo CDS as Insurance: Leaky Lifeboats in Stormy Seas 6 / 32
Model Setup Known Insurer Unknown Insurer Incentives to Insure CCP Bank • Return from an asset (e.g., loan) of R B with probability p , nothing otherwise • It insures loan of size 1. As in Thompson (2010), suffers cost Z if no protection. James R. Thompson School of Accounting and Finance, University of Waterloo CDS as Insurance: Leaky Lifeboats in Stormy Seas 7 / 32
Model Setup Known Insurer Unknown Insurer Incentives to Insure CCP Insurers • Portfolio (realized at interim period) � θ � 0 0 θ dF ( θ ) + θ 0 dF ( θ ) James R. Thompson School of Accounting and Finance, University of Waterloo CDS as Insurance: Leaky Lifeboats in Stormy Seas 8 / 32
Model Setup Known Insurer Unknown Insurer Incentives to Insure CCP Good Insurer • Receives premium P G . • Invests premium in liquid (storage) asset available at t = 1, return: 1. James R. Thompson School of Accounting and Finance, University of Waterloo CDS as Insurance: Leaky Lifeboats in Stormy Seas 9 / 32
Model Setup Known Insurer Unknown Insurer Incentives to Insure CCP Bad Insurer • Bad insurer receives premium P B . • Invests premium in illiquid asset available only at t = 2, return: r > 1. James R. Thompson School of Accounting and Finance, University of Waterloo CDS as Insurance: Leaky Lifeboats in Stormy Seas 10 / 32
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