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| {{a|repack|{{image|Over the counter|jpg|''The OTC Market About To Be Transformed By Word-Processing'', {{vsr|1985}} }} }}=== Transformation === | | {{essay|repack|ABS field guide|{{image|Over the counter|jpg|''The OTC Market About To Be Transformed By Word-Processing'', {{vsr|1985}} }} }} |
| Financial services are not immune to the civilisational sweep of the information revolution. As the consumer world glommed onto digital watches, space invaders calculators, Donkey Kong and the graphic user interface so was the banking world being rocked by a Cambrian explosion of sophisticated financial engineering. [[Swap]]s, [[securitisation]]s and investment management mushroomed in the nineteen-eighties.
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| The revolution was, at first, curiously non-technological.
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| Egged on by the sweet sirocco breeze of economic liberalisation, pioneering financial innovations in the 1980s owed little to the digital age beyond a willingness to look at old things in a new way. The technology inside a [[swap]], for example, is ancient — [[loan]]s — the innovation being simply to juxtapose offsetting ones, in different currencies, between the same parties, and then do some clever monkey-business to calculate a net present value. Even mark-to-market accounting that facilitated this had been around since before the great depression.
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| Electronic booking systems made it easier to manage complicated cashflows, but to that extent, technology only sped the derivatives market up: it did not ''enable'' anything you could not have done with paper and pencil. Likewise, dematerialised [[clearing]] arrived in securities markets in the late 1970s, but had remarkably little impact on how deals were documented or the market infrastructure felt about them. It still doesn’t: indeed, bond market infrastructure is ''still'' predicated on the uneasy fear that [[clearing]] might be just a fever dream, or is liable to be rendered permanently inoperable by some kind of electromagnetic pulse whereupon the world will have to return to its old analogue security-printed ways, festooned with paying agents, [[coupon]]s, [[talon]]s, [[Belgian dentist]]s, and Balearic benders.<ref>For those reading who may be of that belief, here is the thing: if such a catastrophe were to befall the securities market, and its ''worst'' consequence were the permanent failure of the [[clearing system]]s, there would not be the printing capacity on the planet to produce the necessary definitive notes, and that would be true even if the proprietors of said printing businesses weren’t spending their waking hours scavenging the post-apocalyptic streets for uncontaminated dog meat.</ref>
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| Lawyers are, after all, good at studiously ignoring progress when it promises to put them out of work, and just as adept at embracing any progress that promises to create more of it.
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| Therefore, the [[JC]]’s unfashionable view: [[Sine qua non|''sine qua non'']] of financial innovation in the 1980s was the ''[[Microsoft Word|word processor]]''.
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| Once you could type things on a computer, it just became easier to type out ''more'' things; to redraft, mash up, [[Iteration|iterate]], duplicate and propagate. You didn’t have to re-type every page from scratch. You didn’t need to faff around with carbon paper. Once you could send files ''electronically'' — you know, [[fax]] — everything became easier still. It was bummer for sub-60 bike couriers, but hey: Deliveroo.
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| Suddenly we had quite heavily structured derivatives, [[tedious|tediously]] documented, a neat way to aggregate and resell portfolios of small, idiosyncratic assets, and even ways to [[Tranche|reallocate]] the portfolio risk among different classes of investors with different risk/return profiles. A brave new world beckoned, and all thanks to the ease of putting words on paper.
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| For the most part, it hasn’t disappointed.
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| === Laterality: private OTC versus public traded ===
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| For all that explosion in innovation, some things stayed the same. There has always been a fundamental distinction between the ''private'' and the ''public''.
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| Private is basically ''bilateral''; symbolised in financial circles by the ''[[OTC|counter]]''. Public is ''unilateral'', can be held by any number of unconnected investors with no common interest; symbolised by the ''[[exchange]]''.
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| Private is an ''[[OTC]] contract'' and the public a ''traded [[Financial instrument|instrument]]''.
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| ==== Private: [[Over-the-counter|over-the-counter]] ====
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| The bilateral world is the one of private, two-party (or definable, small number of parties) “[[over-the-counter]]” contracts. Contractual counterparties know each other, have a business relationship, are bound into a long-term commitment which they are at liberty to discuss and, if circumstances change, adjust, to meet their common needs. They can see the whites of each other’s eyes. These products are things like [[loan]]s, [[swap]]s, [[guarantee]]s and [[securities financing]]s: instruments one cannot trade “on exchange”.
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| Indeed, one does not typically transfer them ''at all''. While you can transfer the economic risks and benefits of an OTC contract, by [[novation]], [[assignment]] or [[sub-participation]], doing so is fiddly. It often requires the borrower’s consent, [[due diligence]] and legal documentation. Chin-scratching. [[Anti-money laundering|KYC]]. It is laborious.
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| The “[[officious bystander]]” has none but a voyeur’s interest in these arrangements. They are none of her business.
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| ==== Public: traded ====
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| Public contracts are available to all the world. We are in the land of [[carbolic smoke ball]]s: an obligor creates a [[financial instrument]], gives it corporeal form such that it can make its own way in the world, wishes it well and — against payment of [[subscription]] price — lets it go. It might periodically come back, but only to collect interest or for final redemption. It is, in one way or another, ''[[Negotiable instrument|negotiable]]''.<ref>Why did we cross our cheques “not negotiable” back in the day? Does anyone know?</ref> These are products like [[Equity securities|shares]], [[Debt security|bonds]], warrants, [[futures]] and [[Option|options]].<ref>There are OTC options as well, of course.</ref> The instruments themselves may or may not have a term, but individual investors make no formal commitment to hold for any period. They can buy and sell at any time.
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| Unilaterality has its pros and cons. traded products are, by definition, more liquid: I can get in and out of a position without the borrower’s knowledge, let alone permission, by buying selling in the [[secondary market]]. We have no relationship at all: the borrower neither knows nor cares who I am. It grants me no special favours. Exchange-traded products tend towards standardisation of terms, to encourage liquidity. This has regulatory advantages: many institutions can only make investments they can easily get out of, and tradable securities more easily meet that requirement.
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| ==== Meeting of the twixt ====
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| Just as, on our ''ad hoc'' theory, it revolutionised finance so did the [[Microsoft Word|word-processor]] bridge the divide between the “private, fiddly, and bespoke” bilateral contracts and “public, plain and standardised” unilateral instruments. The technology to ''obliterate'' that divide, with electronic clearing, distributed ledgers and so on perhaps now exists, but if it does, is emerging slowly.
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| For the time being there are [[over-the-counter]] contracts, and there are traded ones. But some of the traded ones have a lot more of the characteristics of OTC contracts than they ever used to. An [[asset-backed security]] is often just a portfolio of bilateral contracts — loans, derivatives, options, guarantees — rounded up and put into a [[special purpose vehicle]], which brings no credit exposure of its own, but simply “securitises” the [[asset swap package]], converting it into a traded instrument.
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| Hence the manifold varieties of asset-backed security: the [[securitisation]], the [[collateralised loan obligation]], the [[collateralised debt obligation]], the [[credit-linked note]], and the humble [[Repackaging programme|repackaging]].
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| ===Challenges across the bridge===
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| But, as ever the immovable object of [[substance]] meets the irresistible force of [[Substance and form|form]]. Simply securitising a bilateral contract doesn’t take away the natural nervousness counterparties have to its customised terms. If they are connected bilaterally and a lender can see the whites of the borrower’s eyes it can intervene, push back and make representations should the borrower go about exercising its rights, calculating its rates, or performing its obligations in an unconscionable way. There is a communication channel through which such differences of opinion can be aired and resolved.
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| But once that relationship is intermediated by a traded note, that channel goes away. The borrower need not even know who its lenders are. Its lenders may change, at any time, and there may be a ''host'' of them. Before the advent of clearing systems, notes could just be lost forever. And even if you do know who all the holders are, what if they disagree? What if some care, and some do not? What if you can’t get some of them to pick up the phone, or to present themselves at the offices of the Luxembourg [[paying agent]] for a meeting of Noteholders?
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| When notes were [[definitive]] physical format this problem was truly insurmountable. Now they are [[electronically cleared]], there is at least a way of reliably communicating with all holders for the time being, but it is cumbersome, and getting them all to understand, or agree is something else.
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| The traditional solution has been to appoint a [[trustee]] or [[fiscal agent]] of some sort to represent noteholders interests. This isn’t really much use as trustees won’t lift a finger except to take action that is categorically in the interests of all noteholders — they don’t get paid enough, they say — and the sorts of arguments parties to bilateral contracts get into are shaded, nuanced, and not the sorts of things [[trustee]]s can get [[comfortable]] with taking a position on. The other parties to the structure who might have a view, and the capability to make complicated calculations, tend to have interests that are not aligned with Noteholders’. A swap counterparty, for example, is generally the other side of the trade to the Noteholders.
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| ===Repackagings===
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| This is a fairly insurmountable problem for widely-held, really publicly traded ABS transactions like [[securitisation]]s and [[CLO]]s. Here there really are lots of noteholders, they do not act ''en masse'', so individual noteholders just have to take a view, that they have no realistic seat at the table should things go wrong. Theirs is the bet that those sponsoring the deal are good people, and will not take the proverbial. This trust was found to be misplaced in the [[global financial crisis]].
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| But in smaller scale repackaging deals, things are different. These tend to be tailored deals made to order for a specific investor. They are not usually listed or publicly quoted, the original investor takes down the whole deal and, for the most part, sits on it, perhaps [[securities financing|financing]] it in the market, but staying long the economic risk of the transaction.
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| These products are ''in concept'' tradable, the same caravans in a trailer park are mobile: they don’t really trade: no-one in their right might mind would buy one of these things in the [[secondary market]] without all the [[due dilly]], [[negotiation]] and documentation you’d expect for an OTC [[novation]].
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| Remember the basic proposition of tradable public securities: they are homogenous, standardised, and their failure risk comes down to the ongoing business prospects of the issuer. There is a term, an interest basis, a coupon cycle. Aside from that, it’s all about the issuer’s financials.
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| ''None'' of that is true of an asset-backed security. The one thing that ''won’t'' happen — literally, can’t — is issuer [[insolvency]]. This is a point which confuses even seasoned industry veterans. The rate will be generated from a raft of interacting assets, all of which has its own idiosyncrasies, credit exposures, volatilities, and liquidity profiles. And overlaying that will be the legal terms, which are guaranteed to be Byzantine. All of that needs careful examination by trained professional credit ninjas.
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| So, the original purchaser is most likely stuck with the note. But it ''expects'' to be. Generally, it has commissioned the note format not for the liquidity it offers — for a repack note, it doesn’t — but to ease troubled minds in its operations team responsible for booking, risk managing, hedging and complying with accounting policies and so on.
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| Really, this ''is'' a private, bilateral, over the counter contract, just dressed up, like a [[pantomime dromedary]], to look like something it is not.
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| Using the cumbersome note mechanics to manage valuation disputes, amendments, and unexpected contingencies of the sort that often arise on early unwind is ''possible'' — anything’s ''possible'' — but there’s generally a better way, bilaterally, with the original purchaser standing in for “the noteholders for the time being”. This is ''theoretically'' [[problematic]] — what if the original purchaser has, in the mean time, on-sold its holding? — but not, in the ordinary course, practically so as, for the reasons given, it ''won’t'' have. And the risk it has — again, anything’s ''possible'' — can be resolved by representation, required at the time of any consultation, that it ''is'' the sole noteholder, or speaks for all outstanding noteholders, or in any event [[indemnifies]] the arranger, trustee and transaction parties for losses caused from anything done at its suggestion should it turn out not to be.
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| Another excellent application for an [[indemnity]], by the way: as long as you are telling the truth, it presents no risk at all.
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| {{Sa}}
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| * [[Swap history]]
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| *[[Asset-backed security]]
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| {{ref}}
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For reasons best known to higher forces, having gratefully escaped it more than a decade ago, of late the JC has been pulled back into the parlous world of asset-backed securities. As he refamiliarised himself with the sclerotic exoskeleton and archaic idioms of structured finance documentation in all its cantankery, and bearing in mind many of its features can only be explained by their ancient genealogy, he put together this field guide, which might be of use to innocents. In structured finance, there are no innocents.
Transformation
Financial services are not immune to civilisational sweep though, by gum, practitioners do their best. As the information revolution rolled over us and the consumer world glommed onto digital watches, space invaders calculators, Donkey Kong and the end-to-end architected decentralised network, so did a Cambrian explosion of financial engineering rock the banking world. Swaps, securitisations, risk tranching and various other synthetic financial instruments emerged, grew and then swamped the market. By the mid 1908s the open interest in OTC derivatives was a trillion dollars. By 2022 — despite the global financial crisis and a concerted regulatory push afterwards to centrally clear swaps — by the end of 2022 it was over $20 trillion.[1]
The revolution was, at first, curiously non-technological.
Egged on by the sweet sirocco breeze of economic liberalisation, financial innovations in the 1980s owed little to the digital age beyond a willingness to look at old things in a new way. For example, the technology inside a swap is ancient: loans. The innovation is simply to juxtapose offsetting ones, with different reference rates or currencies, between the same parties, and then do some clever monkey-business to calculate a net present value. Even the mark-to-market accounting techniques that allowed this had been around since the great depression.
Electronic booking made complicated cashflows easier to manage, but even then, technology only sped things up: it did not enable anything you couldn’t do already with a paper and pencil. Likewise, dematerialised electronic securities clearing arrived in the 1970s, but had little impact on how deals were documented or the how market infrastructure felt about them: Fifty years later bond documentation is still predicated on the uneasy fear that clearing might be just a fever dream, prone to permanently cancellation, perhaps by some kind of electromagnetic pulse whereupon the world will have to return to its old analogue security-printed ways, festooned with paying agents, coupons, talons and Belgian dentists on Balearic benders.
(For those who still fear that, here is the thing: if an apocalypse befell the securities market whose worst consequence was the permanent failure of its clearing systems, there would not be the security printing capacity on the planet — nay, in the galaxy — to produce all the definitive bearer bonds needed to carry on outside it, even if the proprietors of those printing businesses weren’t spending their waking hours scavenging the post-apocalyptic streets for uncontaminated dog meat.)
But we lawyers are good at studiously ignoring progress when it promises to put them out of work, just as they warmly embrace it when it promises to create more. The JC has, twice in his career, tried to persuade market participants that bond documentation could be simpler, easier and faster. It has been to hoe an extremely hard row. It is hard to see how ChatGPT will have any greater success.
All the same, security documentation did change in that period. It got longer. A lot longer. An 1980 a bond prospectus, typeset double-spaced in 12 point courier font, might be eighty pages long. By 2020, they were hundreds of pages, in single-spaced, narrow-margined 9 point Arial. Don’t believe me? You are cordially invited to enjoy Aston Martin’s 719-page prospectus for its 5-year senior secured 10.5% notes. How many ways can you say “you might lose all your money”?
Therefore, the JC’s unfashionable view: sine qua non of financial innovation in the 1980s was the word processor.
The moment you could type things out on a computer, it became easier to type out more things; to redraft, mash up, iterate, duplicate and propagate. You didn’t have to restart every page from scratch: you could cut and paste. You didn’t need to faff around with carbon paper. Once you could send files electronically — you know, fax — everything became easier still. It was bummer for sub-60 bike couriers, but hey: Deliveroo.
Suddenly we had quite heavily structured derivatives, tediously documented, neat ways to aggregate and resell portfolios of small, idiosyncratic assets, and even reallocate the portfolio risk among different classes of investors with different risk/return profiles. A brave new world beckoned, and all thanks to the ease of putting words together with out the necessary substrate of paper.
For the most part, it hasn’t disappointed.
For all that explosion in innovation, some things stayed the same. There has always been a fundamental distinction between the private and the public.
Private is basically bilateral; symbolised in financial circles by the counter. Public is unilateral, can be held by any number of unconnected investors with no common interest; symbolised by the exchange.
The private is an OTC contract and the public a traded instrument.
The bilateral world is the one of private, two-party “over-the-counter” contracts.[2] These products are things like loans, swaps, guarantees and securities financings: instruments one cannot trade “on exchange”.
Indeed, one does not typically transfer them at all. While you can transfer the economic risks and benefits of an OTC contract, by novation, assignment or sub-participation, doing so is fiddly. It often requires the borrower’s consent, due diligence and legal documentation. Chin-scratching. KYC. It is laborious.
But OTC counterparties don’t go into this to sling their positions around. They know each other, have a business relationship, are bound into a long-term commitment which they are at liberty to discuss and, if circumstances change, adjust, to meet their common needs, over all of which will hang, heavily, the commercial imperative to be a good egg to one’s valued customers. OTC counterparties can see the whites of each other’s eyes.
The “officious bystander” has none but a voyeur’s interest in these arrangements. They are none of her business.
Public: exchange-traded
Public contracts are available to all the world. We are in the land of carbolic smoke-balls: an obligor creates a financial instrument, gives it corporeal form such that it can make its own way in the world, wishes it well and — against payment of subscription price — lets it go. It might periodically come back, but only to collect interest or for final redemption. It is, in one way or another, negotiable.[3] These are products like shares, bonds, warrants, futures and standardised exchange-traded options.[4] The instruments themselves may or may not have a term, but individual investors make no formal commitment to hold for any period. They can buy and sell at any time.
Traded contracts are unilateral. This has its pros and cons. They are, by definition, more liquid: I can get in and out of a position without the borrower’s knowledge, let alone permission, by buying selling in the secondary market. A borrower and its bondholders can have no relationship at all: the borrower neither knows nor cares who I am. It grants me no special favours. Exchange-traded products tend to be standardised, to encourage liquidity. This has regulatory advantages: many institutions can only make investments they can easily get out of, and tradable securities more easily meet that requirement.
The meeting of the twixt
Just as, on our ad hoc theory, it revolutionised finance so did the word-processor bridge the divide between the “private, fiddly, and bespoke” bilateral contracts and “public, plain and standardised” unilateral instruments. The technology to obliterate that divide, with electronic clearing, distributed ledgers and so on perhaps now exists, but if it does, is emerging slowly.
For the time being there are over-the-counter contracts, and there are traded ones. But some of the traded ones have a lot more of the characteristics of OTC contracts than they did. An asset-backed security is often just a portfolio of bilateral contracts — loans, derivatives, options, guarantees — rounded up and put into a special purpose vehicle, which brings no credit exposure of its own, but simply “securitises” the asset swap package, converting it into a traded instrument.
Hence the manifold varieties of asset-backed security: the securitisation, the collateralised loan obligation, the collateralised debt obligation, the credit-linked note, and the humble repackaging.
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- Communication challenges with investors in debt securities
- The practical problem of benign amendment
- The somewhat anaemic role of a security trustee
- How repackaging fits into all of this
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See also
References
