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

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.”).