The R&D departments at the big banks are still experimenting in their laboratories. The latest idea for financial "innovation" comes from Citigroup. It is working on the first derivatives that would pay out in the event of another financial crisis.
The Citi "specialist" working on this tradable liquidity index spoke to Risk.net:
"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.
Considering that Citi stands in fourth position with $32 trillion in notional amounts of derivatives contracts as of the third quarter of 2009, according to the Office of the Comptroller of the Currency, and has yet to demonstrate that it has only the slightest idea about what it should do with them, this is rather startling.
Yes, financial innovation is inherent to functioning markets, but creating something based on something that obviously didn't' work out in the first place, (and/or that you have trouble understanding) seems ludicrous. Ain't 2006 anymore people.
It's crucial, in financial markets, that investors walk into risky asset classes with their eyes open, rather than kidding themselves that they can simply hedge those risks away by buying a fancy financial product from Citigroup. But the only people who can stop this from happening are the technocrats at the systemic-risk regulator we desperately need to step in and get sensible about these things. And those people, unfortunately, don't yet exist.
And until they do, Wall Street will continue to concoct wishful-thinking formulas for managing, transferring, masking, slicing, dicing risk. Whatever word you want to use. It's unregulated gambling. And that would be fine if the banks and the AIG's of this world would face the entire consequence for losing their game.