8. Dealing with Black Swan events
Techniques for mitigating tail risk
Last updated
Techniques for mitigating tail risk
Last updated
The probability of investor funds being fully committed to losses (i.e. the probability of a ‘Black Swan Event’) is the combined probability of two non-mutually exclusive events occurring together (i.e., the trade portfolio defaults and the primary underwriter defaults simultaneously). This amounts to 0.0001%: small odds, but worthy of mitigation. The figure below (the bi-variate t-copula probability density function) illustrates the joint risk of default “at the tails”. Note that the likelihood of double-default is predicated on the following assumptions:
Following 100k Monte Carlo simulations, the expected loss on bank-intermediated trade finance is 0.01% (= 0.02% default rate on the index * 60% recovery rate).
The Old Mutual Facility, an AAA-rated underwriter with over 10 years of S&P Ratings, guarantees the total notional value of trade receivables. Old Mutual mitigates counterparty risk for both the protection buyer (the bank) and the seller (the investor). It has minor covariance with either party’s default risk (0.2, though Section 3.5 stress-tests up to 0.4 with similar results).
We mitigate the risks in 5 ways:
‘Minimum’ likelihood estimators: First, we select the portfolio of exporters to generate the minimum likelihood that default will occur. Econometric techniques like Logit/Probit/Poisson (MLE) and GMM allow us to predict the “best” portfolio for small sample sizes. We rely on machine-learning techniques like XGBoost and Random Forest for larger datasets. Our paper on AI default estimation details more.
Self-funding reserve: Our financial model shows that monthly returns re-collateralise the reserve. Given a 3% spread on a $200k once-off investment, the $10 million notional is fully re-collateralised in 14 months. Thus, reliance on the underwriter (i.e., “orphaning risk”) is completely mitigated.
$500 million repo facility: Our insurers (Old Mutual facility and NASASA) provide a $500 million credit enhancement to guarantee the notional originated by banks. The National Treasury confirms the facility here. Ongoing coverage tests restrict bank protection to the par value of the guarantee.
Mark-to-market: The “OM Facility” keeps $500k margins as a floating mark-to-market for sudden shocks.
Skin-in-the-game: Originating banks are legally compelled to maintain a 5% equity tranche as “first loss”, minimising “moral hazard.”
Super senior tranche buffer: even investors are over-collateralized. For instance, a 2% super senior tranche offers a 200x buffer over the expected loss of 0.01% on the underlying trade finance portfolio and meets the minimum capital charge set by Basel for short-term self-liquidating loans. Basel itself estimates the buffer covers 99.9% of default stress scenarios.