Managing Systemic Counterparty Risk through a Redesigned Financial Architecture

This article proposes a centralized financial utility that would mitigate systemic counterparty risk by guaranteeing against counterparty defaults and providing asset protection to its customers. The utility would hold collateral posted to it by each customer and issue secured counterparty risk bonds (CRBs). The fees paid to the utility by customers seeking counterparty risk protection would be paid as coupons to the CRB holders, and the principal would be repaid at maturity after subtracting any losses from counterparty defaults. This approach has numerous advantages, including creation of a market mechanism to mitigate systemic counterparty risk, protection of financial institutions from counterparty defaults, and enhancements to the regulatory monitoring process.This article proposes a centralized financial utility that would mitigate systemic counterparty risk by guaranteeing against counterparty defaults and providing asset protection to its customers. To be able to provide this guarantee, the utility would hold collateral posted to it by each customer and issue secured counterparty risk bonds (CRBs). The fees paid to the utility by customers seeking counterparty risk protection would be paid as coupons to the CRB holders, and the principal would be repaid at maturity after subtracting any losses from counterparty defaults. The losses from counterparty defaults would be borne by CRB holders, thus preventing systemic meltdowns from counterparty defaults. If overall counterparty risk should arise in the financial system, the coupons demanded by bondholders would increase, which would lead to higher fees for such transactions and result in fewer of those transactions whose costs outweigh the benefits. This self-balancing market mechanism would ensure that systemic counterparty risks could increase only if the bearers of such risks were sufficiently compensated.This approach has numerous advantages, including the creation of a market mechanism to mitigate systemic counterparty risk, protection of financial institutions from counterparty default, and enhancements to the regulatory monitoring process. All financial market participants would be required to take part in the new infrastructure by regulation. This approach is different from the current proposal of a centralized clearinghouse, which is based on mutualization of OTC derivative counterparty risk among financial institutions that are members of the clearinghouse but does not address the mitigation of systemic counterparty risk in case of failure of a large financial institution.If this architecture had been in place during the financial crisis of 2008, it would have required collateral to be posted to offset the counterparty risk generated by excessive leverage at AIG’s subsidiaries. After the failure of Lehman Brothers, losses would have been limited to CRB investors, thereby preventing the spread of panic and fears of counterparty risk to other institutions. The article also discusses some of the challenges in implementing this framework and how it could be expanded to mitigate other risks in the financial system.Editor's Note (added July 2010): A patent is currently pending for some of the ideas expressed in this article.