Insurance By Other Means: The Third Party Guarantee in the Rearview Mirror

William Hogarth, The Battle of the Pictures (1750) Collection of the Metropolitan Museum

By MIKE MAIZELS January 7, 2024

“Most everyone is willing to take on more risk. Quite often new types of financial intermediaries and new type of financial instruments develop…”—Ray Dalio, 2018

For all the recent buzz of Basel and beyond, it can be hard to remember that events like the art world's annual pilgrimage to South Florida actually represent a minority share in the global art market. While exact numbers are still being tabulated, the following comparison is directionally correct. To support just a few hours of action at its fall evening sales, Sotheby’s sold insurance derivatives worth more than all of the fine objects and tacky souvenirs purchased over the heady week in Miami.  These derivatives—called “third party guarantees”—are a subject of some scandal but little general understanding.

The peculiarities of these instruments are worthy of unpacking, in no small part because the domain may be poised for major changes. Under almost all auction-related circumstances—from Pokemon to Picasso—the seller places a reserve price on an object to be auctioned, an amount less than which she would be unwilling to part with her object. And while there may be reasons to set a reserve high, the seller/consignor of fine art is typically motivated to take the low road. In cases where they reserve is not met, the consignor is charged significant penalties and undergoes the public shame of having their cherished lot “burned.”  The alternative, of course, is simple. If consignors don’t feel safe that their work would achieve their desired price on the open market, they can simply hold onto it. Inverting the old adage, you fail to miss all the shots you don’t take.  

This straightforward system began to change with the unprecedented “financialization” of the art world in the 1980s.  The term means different things to different people—by some metrics, the art industry is woefully underdeveloped in this respect—but the concept essentially boils down to seeking economic return through strategies driven by capital flows rather than by sales or costs. For example, when new Sotheby’s CEO Alfred Taubman took the reins in the 1980s, he made the revolutionary move of providing loans to would-be collectors. These retail-style away loans, unthinkable in the genteel days of old money exclusivity, enticed bidders to join the action earlier and with more gusto, as well as provided Sotheby’s with the “free” revenue stream of interest payments on the loans themselves.  Taubman thought for a time he had stumbled a kind of perpetual motion of commerce—what he described as “a retail business without inventory.” These systems, however, rarely pan out this way. 

As dealer financing drove up demand for artworks from bidders who could now play with house money, a new bottleneck emerged in attracting additional consignments. Early in his tenure, Taubman began expanding the use of what were still euphemistically termed “special arrangements”—off-the-books agreements that, if a work failed to sell, Sotheby’s itself would buy the piece a pre-specified price.  These arrangements supported a dramatic growth in Sotheby’s business. Just the contemporary sales alone exploded during the 1980s—from virtually nothing to well over $100M/year by the end of the decade. And yet, one can see the danger lurking.  Auction houses like Sotheby’s, Christie’s and Phillips are in the business of selling pictures, not buying them. If the tide were to turn, the damage could be catastrophic. 

Which is precisely what happened in the wake of the 2008 Financial Crisis. As customer interest collapsed, the frequency with which auction houses needed to affect such direct purchases jumped by almost 50%. Liability claims to buy unwanted works of nearly $200M came due all at once, imperiling the survival of the auction houses themselves. Sotheby’s and Christies became their own worst customer for pictures no one seemed to want anymore, or at least be willing to pay what everyone wished to agree that they were “worth.” Self-insurance, as always, is risky business. 

Enter the modern 3PG—an agreement with an outside collector brokered by the auction to buy the work at a certain threshold if no one else was willing to. In exchange for this guarantee, the houses would share a percentage of the final sale price if indeed the work successfully sold at open auction. If readers may remember the machinations behind the pre-arranged bids for charity date auctions on Arrested Development, they’ll get the gist. The value alignment created by this arrangement is subtle but important. Namely, 3PG have the salutary effect of transferring the risk of unsold work away from the vulnerable auction house onto the shoulder of speculators explicitly seeking this risk, in exchange for which they could frequently realize gains of 10% or greater on multimillion dollar allocations in the span of a few weeks. Talk about financialzation… 

Third party guarantees (3PG) subsequently exploded in popularity.  Although the opaque nature of the practice makes precise numbers difficult to come by, consensus estimates suggest that these arrangements hit an historical apex of $2B in 2017. The retreat was caused by the maturation of the market—auction houses began to pull back on the rate of revenue sharing, as well as to raise the floor price for a guarantee, which in effect made it more likely the guarantor would end up with an artwork rather than a speculative profit. 

Importantly, this hand-to-hand, backroom deal workflow is limited by the scope of the present universe of 3PG providers—at most a few dozen ultra-wealthy global collector-speculators.  There are, in fact, good reasons that the world is small. Third party guarantors not only need to be able to call on nine figures of liquid cash, but they must also be willing to become the new owners of the object they are underwriting. Moreover, these providers tend to specialize by object types—the same individuals interested in Caravaggio may not be the same as those keen on Kerry James Marshall—with the consequence that these guarantors can exert strong negotiating power as against the auction houses. The resulting specialization with repeated bargaining leads to an arrangement like that of car manufacturers and trusted suppliers: you prefer to work with who you know. 

And yet, the now-multibillion dollar version of what recently began its life as a Band-Aid solution may nevertheless be subject to strategic rationalization.  The endogenous growth of 3PG has coincided with the expansion of technological capabilities, such as distributed ledgers and zero-knowledge cryptography, that are designed to open markets by identifying and vetting transaction counterparties. Consider that, at present, Sotheby’s and Christie’s are often required to work the phones with guarantors up until the last minute—few suppliers with frequent transactions often entail this high friction workflow. However, imagine a novel system where Sotheby’s might issue two dozen Post Impressionist guarantees intended to cover a full season.  Guarantors could buy early at a discount, and be given the option to trade their choices amongst each other as actual lots are secured. The result could be something like a cross between Hotwire and Stubhub—auction houses could dramatically reduce their efforts and uncertainty, and guarantors would be more likely to end up with profit or desired pictures. Such a system would not strictly require technologies like ZK or blockchain—no more than a slow version of AirBnb could be conducted through the US mail—but the right communications protocols can suddenly turned far-fetched fantasy into obvious reality.  

This matters beyond optimizing bidding insurance for auction houses, though that matters on its own terms as well. Such a system of “guarantee aftermarkets” could provide a new way in for global collectors currently too peripheral to join the system directly—in much the same way that Stubhub permits new fans access to baseball tickets original issued to longstanding insiders. And though this access would unfold primarily at the top echelons of wealth, inclusion drives benefits across all tiers.  Guaranteed works end up in museum collections, and guarantee providers come to exert influence over what can be auctioned, and for how much. Providing a way in is likely to have a broadening effect on both the financial and the artistic side of the balance sheet.  

Indeed, capital flows always condition the possibility space of art—from the days of aristocratic patronage to the more recent rise of grant funding and speculative resale.  The question becomes how does one enlarge and enrich the interchange in one domain as an extension and correlate of the other?

With my sincere thanks to Yannai Gonczarowski for many helpful conversations around auction theory and market design. WM