Market infrastructure still at risk from too big to fail

How do you insure the uninsurable and can you really be prepared to cover everyone’s losses in the event of a major economic crisis? While regulators are grappling with this issue, some market participants have raised concerns about its viability.

In its response to the CPSS-IOSCO consultation on the recovery of financial market infrastructures, CME Group warned that providing the kind of insurance needed to cover the failure of a clearing members would be very challenging.

If we envision some future crisis where a clearing member fails, financial market infrastructure insurance policies would, according to CME, have to be very carefully executed to provide the kind of assurance that would be effective over the timescales in which it is needed.

The key problem is that, should a major financial market infrastructure be pushed to the point where resolution or recovery are needed, then it would have suffered catastrophic losses and the insurance policy needed to cover it would be of some significant size indeed.

Such a policy would also need to be regularly tested to ensure that payments made from it were timely, with continuous coverage and no risk of claw-back provisions.

The issue here is that it may be impossible to ever insure financial markets against catastrophic events. The problem of too big to fail seems set to continue, with risk being transferred to clearing houses instead of banks, but ultimately the same problem - of having one major part of the financial infrastructure fail will have grave consequences for the rest of the market – persists.

Remember the case of AIG, which insured many of the mortgage-backed securities products and other complex derivatives, which ultimately led to the financial crisis in 2008. The insurance giant had to be bailed out by the US Government because the liabilities were simply too much for it to handle.

So, transferring the risk to other parts of the financial system will not solve the problem, but there is a silver lining.

Improved reporting and central clearing should at least enable market participants to see the position of counterparties more easily and enable swifter recovery due to better information. This in and of itself should reduce the impact that panic can have on markets and, hopefully, prevent the sequence of events, which might cause a major failure in the first place.

So, while you can never insure against the most difficult of circumstances, steps taken since 2008 should help to make sure the market can handle these kind of major events in a much calmer and more informed manner.