Insuring Against a Derivative Disaster: The Case for Decentralized Risk Management

Author:Jeffrey Manns
Position:Associate Professor, George Washington University Law School
Pages:1575-1627
SUMMARY

This Article makes the case for a decentralized riskmanagement strategy for identifying and defusing future bubble markets. It suggests how the government can enlist private "gatekeeper guarantors" to provide integrated insurance and monitoring roles to complement the government’s management of systemic risk. It proposes the enactment of a federal mandate that requires systemically significant financial entities (or... (see full summary)

 
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1575
Insuring Against a Derivative Disaster:
The Case for Decentralized
Risk Management
Jeffrey Manns
ABSTRACT: This Article makes the case for a decentralized risk-
management strategy for identifying and defusing future bubble markets. It
suggests how the government can enlist private “gatekeeper guarantors” to
provide integrated insurance and monitoring roles to complement the
government’s management of systemic risk. It proposes the enactment of a
federal mandate that requires systemically significant financial entities (or
participants in systemically significant financial sectors) to secure private
guarantees to cover a percentage of their potential liabilities above a loss
threshold. Gatekeeper guarantors would act as “circuit breakers” of systemic
risk by serving as self-interested monitors of risk taking and tying clients’
coverage to ongoing constraints on risk taking. Gatekeeper guarantors
would serve as “bailout buffers” by providing financial backing in the event
of defaults and thereby mitigating the government’s potential liability
exposure. This expansive role would come with government oversight to
ensure that gatekeeper guarantors satisfy reserve requirements, so that they
can credibly serve as sea walls in the face of future financial tsunamis. This
Article will illustrate the potential for decentralized risk management by
showing how a mandate for private reinsurance (or its functional
equivalent) may reduce systemic risk in the over-the-counter derivatives
market. Reinsurers would bear a percentage of derivatives participants’
liability, which would incentivize reinsurers to charge premiums reflecting
their risk assessments and to monitor and condition clients’ liability
exposure. The repeat-player status of reinsurers would position them to force
derivatives participants to change their risk exposure as market conditions
unfold. Reinsurers would have leverage to push insured parties to demand
disclosures from counterparties, thereby heightening transparency and
reducing risks for their clients and the market as a whole. Government
monitoring could build on existing state oversight of reinsurers, but it would
Associate Professor, George Washington University Law School. I would like t o thank
participants in faculty workshops at Cornell, Vanderbilt, George Washington, and the National
University of Singapore for their constructive comments.
1576 IOWA LAW REVIEW [Vol. 98:1575
also provide teeth with expanded reserve requirements to ensure reinsurers
are equipped to handle this role.
INTRODUCTION .................................................................................... 1577
I. THE CASE FOR GATEKEEPER GUARANTORS .......................................... 1582
A. THE RATIONALE FOR GATEKEEPER GUARANTORS............................. 1585
B. THE GATEKEEPER GUARANTOR FRAMEWORK ................................... 1588
C. THE SIGNIFICANCE OF INSTITUTIONAL ACCOUNTABILITY .................. 1591
D. LEARNING FROM THE MISTAKES OF BOND INSURERS ......................... 1592
E. LEVERAGING THE POTENTIAL OF REINSURERS .................................. 1595
F. DESIGNING RESERVE REQUIREMENTS TO ENSURE FINANCIAL
WHEREWITHAL .............................................................................. 1598
G. THE DEGREE OF GATEKEEPER GUARANTOR LIABILITY EXPOSURE ...... 1601
II. THE APPEAL OF A REINSURANCE MANDATE FOR DERIVATIVES ............ 1602
A. THE LOGIC BEHIND CLEARINGHOUSES ............................................ 1606
B. THE CLEARINGHOUSE CRITIQUE ..................................................... 1607
C. THE POTENTIAL FOR REINSURERS AS GATEKEEPER GUARANTORS
FOR DERIVATIVES ............................................................................ 1611
D. IMPROVING ON MARGIN REQUIREMENTS ......................................... 1612
E. IMPACT OF REINSURANCE MANDATE IN REDUCING THE DEGREE OF
SPECULATION ................................................................................. 1614
III. ADDRESSING POTENTIAL OBJECTIONS ................................................. 1615
A. EXIT AND LIQUIDITY CONCERNS ...................................................... 1615
B. POLITICAL CHALLENGES ................................................................. 1618
C. IMPLEMENTATION CHALLENGES ..................................................... 1620
D. THE DANGER OF REINSURER OVERSTRETCH ..................................... 1623
E. MAKING INTERCONNECTIONS SERVE A PRODUCTIVE PURPOSE ........... 1624
F. LEVERAGING MARKET PRICING TO CREATE AN INTEGRATED
PRIVATE–PUBLIC BACKSTOP ........................................................... 1625
CONCLUSION ....................................................................................... 1627
2013] INSURING AGAINST A DERIVATIVE DISASTER 1577
INTRODUCTION
The recent bailouts and financial reforms underscored the danger that
the federal government will overstretch its resources and abilities in
centralizing risk management and internalizing the costs of private sector
failures. In the long run the federal government lacks the means to act as
the sole overseer and backstop of the financial world on its own. Instead, this
Article makes the case for embracing a strategy of decentralized risk
management to identify and take the air out of future bubble markets. This
proposal shows how the federal government can enlist private “gatekeeper
guarantors” to provide integrated insurance and monitoring roles to police
systemic risk, while subjecting these private actors to reserve requirements to
ensure their financial wherewithal. It proposes the enactment of a public
mandate that requires systemically significant financial entities (or
participants in systemically significant financial sectors) to secure private
guarantees to cover a set percentage of their potential liabilities.1
Gatekeeper guarantors would act as “circuit breakers” of systemic risk by
serving as self-interested private monitors of risk taking. They would be in a
position to identify excessive risk taking by making ongoing disclosures a
condition of guarantees. They would have the ability and incentive to
demand that insured parties temper risk taking or lose the coverage.
Gatekeeper guarantors would also serve as “bailout buffers” by providing
financial backing to systemically significant institutions in the event of
defaults and thereby mitigate the government’s potential liability exposure.
This expansive role for gatekeeper guarantors should come with
government oversight to ensure that gatekeeper guarantors face and meet
reserve requirements, so that they can serve as credible sea walls in the face
of future financial tsunamis. This Article will illustrate the potential for
decentralized risk management by showing how a mandate for private
reinsurance may reduce systemic risk in the $450 trillion over-the-counter
derivatives market.2
1. The Dodd-Frank Act designated commercial banking groups with assets of $50 billion
or more as “systemically important financial institutions” (“SIFIs”), and it empowered the
Financial Stability Oversight Council—in consultation with the Federal Reserve—to determine
which additional non-bank financial institutions should be treated as SIFIs. See Arthur E.
Wilmarth, Jr., The Dodd-Frank Act: A Flawed and Inadequate Response to the Too-Big-To-Fail Problem,
89 OR. L. REV. 951, 993–96 (2011). SIFIs are subject to special prudential standards and are
potentially subject to Orderly Liquidation Authority (“OLA”) wind-ups. See id. In contrast, this
Article embraces a broader conception of “systemically significant” firms that may be subject to
a gatekeeper guarantor mandate.
2. Reform of the Over-the-Counter Derivative Market: Limiting Risk and Ensuri ng Fairness:
Hearing Before the H. Comm. on Fin. Servs., 111th Cong. 147 (2009) [hereinafter Derivative Market
Reform Hearing] (prepared statement of Henry T.C. Hu, Director, Division of Risk, Strategy, and
Financial Innovation, U.S. Securities and Exchange Commission) (“The derivatives market has
grown enormously since the late 1990s to approximately $450 trillion of outstanding notional
amount in June 2009.”).

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