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. “It was quite the come down.”
The “turpitude swap”, as he termed it, was meant for fund managers like his buddies who rode the eco-wave with lazy public commitments to ESG principles. In 2010 that seemed like a fine wheeze: toss out easy, throwaway promises no one would check and watch the AUMs come rolling in.
When these carefree days collapsed into press Intrusion and cavity searches by freelance ESG consultants, the managers were stuck, so Barkley reasoned, with a problem that must be eminently hedgeable. His product would let11 these funds to “brown-wash” their investment portfolios.
“It’s ESG avoidance, rather than evasion,” said Barkley.
Early years: single-name turpitude puts
Barkley’s idea was simple: if it was okay to extract the crappy credit profile from a portfolio of mortgages A and lay that off on someone with “sufficiently deep market expertise and advanced models to bear the risk indefinitely”[1] why not do the same thing with the unwanted ignominy of outrageous investments?
Barkley began to construct instruments — at first, simple put options — laying off the shame on those who could most easily absorb it; namely — and this was Barkley’s real genius — the very badly-run, environment-wrecking corporates that were polluting the hedge fund portfolios 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 it would ask little by way of premium; after all, really, what did Golden Crown care? It was ripping up the Bandingilo national park already, so what is 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 obviously circular, but Barkley swiftly pointed out that, well, so too was debt value adjustment hedging, and everyone seemed cool with that for a good few years, didn’t they?[2] Did it present any more moral hazard than in D&O liability insurance?
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?
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, Hackthorne Capital Advisors Master Fund III LLP[3] could lay off its 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 immediately swap out the porno discredit it had just assumed to Antwerp Fruity Motion Pictures B.V. whence it originated, and Antwerp would deliver back to Golden Crown 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.
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References
- ↑ Yes, I know what you are thinking: a sleepy Landesbanken from Lower Saxony would be exactly such a someone, right?
- ↑ Indeed, it kept a phalanx of banks out of technical insolvency — and their DVA traders handsomely remunerated — for a good three or four years after the worst excesses of the credit crunch.
- ↑ I had seven goes on the hedge fund name generator before I came up with a fictional hedge fund name that wasn’t actually a real hedge fund name, by the way. Honestly, hedgies: what about some imagination?