Yep, that's the derivatives market. And the insurance market. And many other markets where transactions are set up and then play out over time. It is what it is.
No. Insurance is subject to the "insurable interest" doctrine, which generally prohibits using insurance as naked speculation. There are also far more backstops, reserve requirements, government guarantees, etc., designed to prevent this kind of implosion. Not saying it doesn't happen, but we've had since the South Sea Bubble to learn how to regulate insurance to prevent this kind of thing.
The key difference is that insurance is generally regulated from a consumer protection perspective, since many insurance lines are sold directly to unsophisticated consumers. CDSs are, by contrast, sold primarily these days to sophisticated financial speculators, who are presumably fully aware of the kinds of risk involved.
Regulation doesn't get rid of the risk. And it's got zero to do with naked speculation. We simply cannot make risk disappear. Contracting with someone else to eat the risk creates a new risk. Counter party risk just doesn't go away, despite our hopes and dreams.
"South Sea Bubble to learn how to regulate insurance to prevent this kind of thing." - AIG (at the time the biggest insurance company in the US) went down in 2008 during the Great Financial Crisis because they insured sub-prime loans (CDS again).. So I guess there are lots of holes regulators still need to learn....
This is why flood and earthquake insurance often end up being (underfunded) and run by the state.
It's possible that our particular implementation of the insurance markets is deeply flawed, but a general concept of 'Pay X now to be backstopped in the event of catastrophe' is incredibly useful.
I also think that a lot of people pay for insurance that doesn't make a whole lot of sense though. If you could afford to replace the thing you're insuring out of pocket, you probably shouldn't be insuring it.
I only pay for third party car insurance because I can just buy a new car if I total it, but I can't buy a new Lamborghini for the person I crashed into. I don't pay for contents insurance at all because I can buy a new bed and laptop if my house catches fire.
Insurance companies have done the math, your EV for insurance is always going to be negative (on average), you should only insure against costs that you can't afford to pay in one big lump sum if they happen.
Insurance is effectively a loan for things you already own, just put that money in a savings account instead.
These are run through clearinghouses in most money centre jurisdictions.
It’s the pension fund take on overpromise and adultery.
This is misunderstanding BIS's point. The BIS is talking about the size of the market - ie they are concerned about liquidity and system wide risk. They are not saying the pension funds are short trillions via FX swaps.
maybe accounting standards should be updated to record derivatives risk to take into account interest rate and counterparty risk.
The reason for this is that fx swaps dont create exposure to fx or credit swings the way that fx trading or borrowing against future cash flows do because they are fixed rate contracts.
There is counterparty risk but a) that is typically mitigated much more cheaply and us generally less risky and b) you’d move the loss “on book” if the counterparty risk shapes up.
Imagine you go to the bank to get a loan for a new tractor for your business. They ask to see a list of your assets and liabilities (your balance sheet).
You own a house worth $1 million with no mortgage. You have an insurance policy. You have nothing else.
If bushfires start right next to your house as you are meeting the bank manager, you don't say to him/her: I have a house that is worth 900k marked to market because of the bushfire risk, and I marked my insurance policy to be worth $100k.
You have a house worth $1 million. The insurance policy is "off balance sheet" despite the fact it could be worth a lot of money.