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

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 risks. It proposes the enactment of a federal mandate that systemically significant financial entities (or participants in systemically significant financial sectors) 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 risks in the over-the-counter derivatives market. Reinsurers would bear a percentage of derivative 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 counter-parties, 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 provide teeth with expanded reserve requirements to ensure reinsurers are equipped to handle this role.

Keywords: Gatekeepers, Derivatives, Systemic Risk

JEL Classification: K00, K22