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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.

Like a swap, the contracts envisaged by Citi would be entered into without an up-front premium, with money changing hands according to the index's movements around a fair strike value.

The team is in talks with multi-dealer platforms over distribution rights, although Benzschawel expects most large banks, including Citi, to move into the market eventually. He has also drawn up a hedging
strategy for sellers of the index, although he would not comment on the
details.

"We are focused on viewing it from a brokers' perspective – we want to get natural buyers and sellers of liquidity together. But we do have an explicit hedging programme, based on the underlying assets in the
index. There is a basis risk, but the beauty is that as this widens,
the strategy involves buying up assets whose prices are falling,
thereby providing liquidity to the market," he says.

However, there is concern from academic circles that the counterparty risks involved in such a product could create moral hazard. 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.