Cheapest-to-deliver

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Cheapest-to-deliver
/ˈʧiːpɪst tuː dɪˈlɪvə/ (adj.)

Of the range of valid means of performing a contract, the one that will cost you the least and irritate your customer the most should you choose it.

Credit derivatives

Ar some point in the 1990s someone came up with the idea of credit derivatives. These are derivative contracts — principally the credit default swap — that allow investors to manage credit risk to debt instruments.

Debt instruments are funny in a number of ways: there is generally little upside volatility — they repay at par, so offer little scope for trips to the moon — a lot of potential downside volatility — they can go to zero, if the debtor fails — they come in all shapes and sizes: bonds, medium term notes, bilateral loans, syndicated loans, deposits —and due to the term nature of debt, no two debt instruments are economically (let alone legally) fungible. Each instrument treads its own, albeit correlated, value path.

As such, the market is generally opaque and, “sticky”: debt instruments are illiquid in a way equities, which generally have none of those limitations, are not. By the same token some debt instruments — publicly quoted senior bonds — are a lot more liquid and transparent than others.

You might be able to buy a put on quoted bond at a reasonable price, but good luck with a private term loan.

Since, except in a disaster scenario, debt repayment values are predictable in date and amount — unlike say equities or commodities — as long as your borrower doesnʼt blow up, you will eventually get your money back, so it usually doesnʼt matter much that you canʼt — but when it does matter, it matters a lot.

When you buy debt repayment protection you are necessarily hedging against a crash — not just a change in value.

The credit default swap emerged as a neat way to manage that risk. To cover against losses on an illiquid private bilateral loan, you could buy a credit derivative referencing a publicly quoted debt instrument (whose failure, being public you did not need to prove) and your counterparty must pay you a sum calculated on the estimated market price of a range of observable liquid instruments. This is to be sure, only a proxy for your actual loss, but a lot better than nothing.

Now. A CDS is only better than a bond put if the instrument you hold is not an observable, liquid instrument that you can freely put to someone. If it is, just buy a put! But if it isnʼt, expect some wangling about how to value it. It is one thing setting the trigger for the default, another to chose the instrument by reference to which you calculate its magnitude.

Hence the titular “cheapest to deliver”: where a range of deliverable obligations are specified, the calculation agent — usually the Buyer — gas discretion as to which she will choose. She will choose the cheapest

Whereupon a famous illustration arose. As the noughties wore on, CDS practitioners got more used to the idea that the CDS was a one-to-one cresit hedge for their positions, and whether by habit or for balancesheet reasons,because that is where all the liquidity was, or maybe just because CDS was hip, started to hedge liquid instruments —the kind for which you could buy a put — with CDS as well.

Being a “crash protection” product, almost all CDS expired unexercised, so the embedded cheapest to deliver option wasnʼt obvious to credit protection sellers — typically buy side investors looking for yield enhancement. It was obvious to sell side CDS buyers, who made their P&L precisely by pricing protection they paid by reference to the “Reference Obligation” but delta-hedging by reference to the cheapest to deliver of the “Delivery Obligations”. This mispricing became apparent when a torrent of Credit Events thundered through the market, Sellers affected outrage when Buyers referenced not the freshly-issued, publicly quoted, liquid senior bonds they expected, but rather obscure, deeply subordinated, perpetual notes that hadn’t traded since issue, in 1975, that they¹d never heard of, and which barely scraped into eligibility as Deliverable Obligations by some oversight in the drafting on the Confirmation.

Cue much litigation, but the real lesson: read trade documents with peril-sensitive sunglasses. (The other lesson is that credit derivatives are silly things, but that is a story for another day.)

The credit derivatives market is a shadow of its former self.

Trades are zero-sum games

So where a contract can be fully understood in monetary terms, expect the parties to do the utter bare minimum to discharge it. Look out, in other words, for “cheapest to deliver” options.

These contracts are “transactions”; zero-sum, finite games — neither side has any expectation beyond the competent performance of its literal terms. When that is done, all remaining expectations fall to zero. The parties can walk away and never meet again.

Recall the distinction David Graeber makes between barter and credit. Barter is an interaction between hostiles who cannot afford to leave anything on the table; credit is an interaction between friends who can and should.

Transactions, so regarded, are “trades”: quid-pro-quo, “barter” exchanges between parties who may or may not, otherwise, even like each other. The equity of the bargain is completely contained in the exchange: once performed, no abiding trust or faithfulness remains or is expected.

When we are trading, we should not be surprised when our counterparty exercises a cheapest to deliver option. (in the market a delta-hedged dealer does not have a market position, so will not care how its customer exercises her options.)

But discrete trades are an unusual type of contract. Most commercial arrangements depend on trust. They operate the same way social relationships do, with ongoing, permanently undischarged “social debts” between the parties. These are the ties that bind, which make credit extension feasible. Those in an ongoing commercial relationship do not, if they know what is good for them, exercise cheapest to deliver options. work-to-rule; if there are errors or misunderstandings we are, within reason, forgiving of them. We allow each other flex: as long as we are making a return from the relationship we are happy to leave something on the table in the interests of the longer-term relationship.

CDOs and cheapest-to-deliver

Now: zero-sum contracts like this are — should be — very much the exception. Commercial arrangements — even those governing the trading of zero-sum financial contracts — are not like that. They work best where the counterparties trust each other. This is the difference between a single round and an iterated series of the “prisoner’s dilemma”.

Now this “cheapest-to-deliver” concept is no long-lost curio from the history of the structured credit market. Being a foundational premise of the agency problem, it is in turn a cornerstone of any service industry. You know, such as the financial services industry, or the legal services industry, and the consulting industry.

Any organisation to whom one outsources one’s operational framework for the long term will measure its success by how closely it can tack, on average, to the bare minimum whilst not too regularly over-stepping it.

See also

• Relationship contracts and trades
• Service level agreement
• Worst reasonable endeavours