Eighteenth-Century Lessons for Credit Default Swaps
Of late I’ve been reading Niall Ferguson’s The Ascent of Money: A Financial History of the World, and I’ve been struck again at how similar the rise of the modern CDS market is with the rise of maritime insurance at Lloyd’s Coffee House in the early 18th century.
Originally, of course, there weren’t insurance companies. Rather, individual merchants and speculators would meet informally at Lloyd’s Coffee House in London. Suppose that there was a merchant with a ship that was about to make a voyage to America that he wished to insure against loss due to the perils of the sea. He would arrive at Lloyd’s with a written contract promising to pay him so much in the event that his ship went down. He would also arrive with money — or at least the willingness to pay it. He would then circulate through the coffee house, looking for those who were willing to sign the contract. Suppose that the contract promised to pay out 5,000 pounds in the event that the ship went down. Some people would sign for one pound of liability, some for 100 pounds, some for 1,000 pounds. Each underwriter would, of course, be paid by the merchant for their signature in proportion to the amount of liability that the underwriter took on. In the end, the merchant would have an insurance contract on his ship signed by a pool of investors who in aggregate were paid less than the insured value of the ship. Of course, while he was at Lloyd’s the merchant might pick up a bit of money by signing on as an underwriter on another merchant’s insurance contract. Before too long there were people who made their living (or at least tried to) entirely with in Lloyd’s Coffee House.
Thus maritime insurance started out much like the modern CDS market. It was an entirely over the counter trade. (Literally!) There were no reserve requirements for underwriters, there was a lot of speculation by those who didn’t have a clear idea of the risks they were taking on, as well as underwriting by experienced market participants who probably had a very good idea about the perils of the sea. And of course, there was an endemic problem of counter party risk. If an underwriter turned out to be insolvent in the event that a ship did sink off Cape Hatteras, there wasn’t much that the hapless owner could do. There was, I suppose, the consolation of debtor’s prison and the knowledge that you could drive welshing underwriters and their children into a Little-Dorrit-esque existence.
There was a two fold response to the wild world of Lloyd’s. On one side, the common law courts reacted with skepticism if not outright hostility to the contracts written in the smokey coffee rooms. There was a persistent suspicion that these contracts were little more than gambling devices, something disreputable that ought to be suppressed or limited. On the other side, the regulars at Lloyd’s realized that they needed to clean up the insurance market. The result was a system of trading within an association to which one could not gain access unless certain basic proofs of reliability were met. In the end, pay-as-you-go was replaced with insurance based on an insurance pool and investment proceeds, which gradually reduced the problem of counter party risk in insurance. (Although it far from eliminated it.)
I actually think that there are some important lessons to be learned from Lloyd’s. First, over the long term I think that it is pretty clear that the insurance-as-gambling meme turned out to be a legal dead end. Judicial hostility toward insurance contracts injected legal uncertainty into the mix of other risks, but did little or nothing to deal with the underlying problems of counter-party risk and proper risk assessment. These problems, it turned out, were solved despite legal hostility rather than because of it. Second, a completely decentralized market of spot contracts in pure risk allocation doesn’t work horribly well. Regulating the capital requirements of players in the game (or at least insuring their transparency) is absolutely necessary. Better yet is a clearing house system that eliminates counter party risk through asset pooling and the ruthless exclusion of unreliable or undercapitalized players. Not surprisingly, the commercially sophisticated parties at Lloyd’s did both of these things long before the courts and parliament managed to sort out a sensible attitude toward insurance. I suspect that the same will be true of the CDS market.