Discredit derivatives

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JC first published this article two years before sustainability-linked derivatives emerged on the scene. Life imitates art, once again.

It is said beatnik Fi-Fi hack and sometime swap pioneer Hunter Barkley came up with the idea of discredit derivatives at the fag end of an epochal synthetic alpha bender he went on with some hedge fund buddies in Mallorca in the dog days of 2016.

The “turpitude swap”, as he called it, was designed for fund managers who, like his buddies, rode the eco-wave with lazy public commitments to ESG principles. In 2010, it seemed like a grand wheeze: toss out easy, throwaway promises no one would check and watch the AUMs come rolling in.

Those carefree days collapsed into press intrusion, performative cavity searches by ESG consultants, and then regulatory sanction the managers were stuck with a problem, so Barkley reasoned, that must be eminently hedgeable. He came up with a product to let these funds “brown-wash” their investment portfolios while keeping the outsized returns.

“It’s ESG avoidance, rather than evasion,” said Barkley.

The idea was simple: in the same way CDO managers extracted the crappy credit profile from a portfolio of mortgages, sliced it off the balance sheet and laid that off on someone with “sufficiently deep market expertise and advanced models to bear the risk indefinitely” — you know, someone like a sleepy Landesbanken from Lower Saxony — then why could they not do the same thing with the ignominy and public shame associated with politically awkward, but still hugely profitable, investments?

There were, he reasoned, colossal pools of monetisable turpitude. Not only the obvious ones like environmental ruination, labour exploitation and weapons manufacture — but also “soft” infamy of prurience, insensitivity and marginalisation. If he could only figure out a way to isolate and strip out what he termed the “odium spread” from the yield, there was potential for massive, scandal-free profit.

In his garden shed on the Isle of Dogs, Barkley set to work. He built a series of instruments — at first, simple put options — laying off the funds’ embarrassment on those who could most easily absorb it; namely — and this was Barkley’s real genius — the badly-run, environment-wrecking corporates that were polluting the hedge funds’ social credibility in the first place.

The hedge fund would write an at-the-money stigma put to, for example, the Golden Crown Palm Oil Company of Sudan Pty. Ltd. (and for which Golden Crown would ask little by way of premium; after all, really, what did it care? It was ripping up the Bandingilo national park already, so what was a little more remorse?), thus getting rid of the fund’s disgrace for investing in that very company.

Objections came soon enough that this was a thinly-disguised “self-referencing discredit derivative”. Sir Jerrold Baxter-Morley, K.C. was engaged to provide an opinion on the matter but he could not get past the essential nature of opprobrium: once it “stains” your balance sheet it cannot then be derecognised by simply transferring it back to the person from whom you acquired it in the first place.

Barkley argued that this was no different from debt value adjustment hedging, and everyone had been cool with that for a good few years, hadn’t they?

Slowly, the product began to catch on. “Before you knew it, it was blazing like the Amazon jungle!” Barkley would later fondly recall.

Mature industry: discredit fault swaps

Eventually, though, people started to bridle again — I mean, could a polluter really just take its own discredit back, and thereby exonerate British hedgies of their ESG obligations for investing in it? Sir Jerrold was again engaged to write an opinion but could not get comfortable that a straight bilateral swap was not a self-referencing discredit derivative or a wagering contract.

Barkley refined the offering by combining it with another of his innovations: cross-political currency “discredit swaps” where, for example, a natural wilderness gas fracking conglomerate could swap its embarrassment at precipitating a series of minor earthquakes on a local indigenous people with a Dutch pornographic film distributor’s regret for generating artificial losses to gain tax relief for its celebrity investors.

For example, having put its limited partners into a tax-advantaged Dutch romantic film partnership, Hackthorne Capital Advisors Master Fund III LLP could lay off its hypothetical porno-tax shame to Golden Crown, who had none, not being implicated in onanistic or fiscal wrongdoing as such (just environmental degradation), and Golden Crown would in turn immediately short out that porno discredit it had just assumed by selling an out-of-the-money-shot put to Antwerp Fruity Motion Pictures, B.V. whence it originated, and Antwerp, who was able to bear an almost unlimited amount of shame for smutty pictures, would deliver to Golden Crown a tranche of its own environmental embarrassment which Antwerp had acquired by selling a put to Snowy Mountain Partners LLC, another hedge fund in the same pickle as Hackthorne, only long palm oil and not smut.

In this way was the so-called “discredit fault swaps” market born.

Hope that’s all clear.

See also

• Sustainability-linked derivatives
• ESG
• Credibility derivatives
• Turpitude
• Hunter Barkley
• CDO squared