Credibility derivatives

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Credibility derivatives were once the principal means of hedging tail risk in fashion industry. They grew out of the popular pastime of taste arbitrage, a much simpler physically-settled contract on the spot market.

Origins

The urban myth was that an analyst in the taste arbitrage desk at Wickliffe Hampton by the name of Albert Coldfall, invented the credibility derivative when shopping for records one Sunday in 1987.

Coldfall noticed that his local record store in Chingford, which carried Rick Astley’s turgid debut Whenever You Need Somebody at full price, had sold out of it, while fully fifteen copies of Keith Jarrett’s seminal, hard-to-find and unstintingly cool The Köln Concert lingered disregarded in a sale bin for a pound fifty each.

Not even realising what he was doing, Coldfall snapped up all fifteen copies of the jazz disc, on principle.

Later he happened to pass a vinyl emporium in Soho and, remembering his earlier experience, popped in, just to compare prices. He was amazed to find a queue for The Köln Concert, advertised at £25.99, but only the single copy of Whenever You Need Somebody, in its own sale bin, for 50p. At that moment the shop announced that it had sold out of the Jarrett LP.

Nothing is not an opportunist, Coldfall offloaded his fifteen jazz albums directly to disappoionted shoppers, for £40 each, and realised that once he could set up a long-dated transaction to exchange these items, four handsome profit, with his record shop in Chingford, as long as he could source sufficient Rick Astley records in Soho.

The Soho proprietor eventually agreed and the first credibility swap transaction was executed.

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Before long, credibility derivatives were big business in the clothing industry: a segment of the economy, of course, with significant exposure to sudden, arbitrary changes in the public’s opinion. At first record shops, and soon other sellers of goods largely dependent for their value on arbitrary public opinion, began methodically to hedge their risk to those changing tastes. A popular variation was the “credibility default swap” wherein a seller with significant exposure to inventory of questionable long-term hipness could but protection out to five years. Then, upon the occurrence of a publicly recognised “credibility event”, the proprietor (“Buyer”) could deliver that inventory to the “Seller” against payment of its notional hip value, struck as at the trade date of the contract.

Speculators in the City of London quickly saw the opportunity for levered plays on taste, and the synthetic credibility default swap market exploded. The spreads on credibility default swaps were huge and proved popular with real money managers looking to enhance yield.

But lurking below the surface was disaster in the form of fashion duration mismatch.

Desperate to find a fresh sources of loucheness to feed the demand flooding in from hedge funds and trading desks, fashion standards among originators taste products rapidly declined. Originators talk to layering credibility default risk upon credibility default. This, you would think, was a recipe for disaster, and so it turned out.

Great credibility crash of 1987

It all came to a juddering halt with the in acid-wash jeans crash of 1987. Unable to trade out of positions as the market turned, and unable to fund their obligations to term as liquidity drained from the commercial paper market, many storied couturiers found themselves having to close short enormous long positions. Those who could not care successful found themselves in receipt of container loads of unsellable white denim dungarees.

See also

• Credit default swap