Template:M intro repack ABS field guide

Transformation

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. Swaps, securitisations and investment management mushroomed in the nineteen-eighties.

The revolution was, at first, curiously non-technological.

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 — loans — 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.

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, coupons, talons, Belgian dentists, and Balearic benders.

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.

Therefore, the JC’s unfashionable view: sine qua non of financial innovation in the 1980s was the word processor.

Once you could type things on a computer, it just became easier to type out more things; to redraft, mash up, 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.

Suddenly we had quite heavily structured derivatives, tediously documented, a neat way to aggregate and resell portfolios of small, idiosyncratic assets, and even ways to 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.

For the most part, it hasn’t disappointed.

Laterality: private OTC versus public traded

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.

Private is an OTC contract and the public a traded instrument.

Private: over-the-counter

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 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.

The “officious bystander” has none but a voyeur’s interest in these arrangements. They are none of her business.

Public: 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. These are products like shares, bonds, warrants, futures and options. 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.

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.

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 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.

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.