Template:M intro repack ABS field guide

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.

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.

“Laterality”: the counter and the exchange

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.

Private: over-the-counter

The bilateral world is the one of private, two-party “over-the-counter” contracts. 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. These are products like shares, bonds, warrants, futures and standardised exchange-traded 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.

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.