The curious structure of an MTN
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The Law and Lore of Repackaging
“bond” as explained to my neighbor Phil
Financial concepts my neighbour Phil was asking about when I borrowed his mower. Index: Click ᐅ to expand:
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You will know old Grandpa Contrarian’s story of the farmer and the sheep. It is illustrated richly in every cove, inlet and waterway of the financial markets, but is no better exemplified than in the genetic structure of a medium term note programme.
These, for the fortunately uninitiated, are architectural structures by which corporations raise funds in the international debt capital markets. Their history is long and mildly diverting at best — the type who naturally deals in debt instruments is not really given to intrigue — but for our purposes it is important.
Conceptual underpinnings
Now: as per the panel summary, a bond of any kind is an IOU, in that it represents an entitlement to be repaid a loan. In earlier epochs one would borrow against a “note” — literally, a signed piece of paper indicating your preparedness to pay a sum to whoever presented it, in exchange for its surrender.
The neat thing about this kind of note is its transferability: the original lender can “negotiate” it — sell it[1] without the issuer’s permission, or even knowledge — and its value will be the present value of the issuer’s promise to pay. A note is a unilateral contract, therefore. A conventional loan is a bilateral contract, and the job of transferring ones rights and liabilities under it is more involved, and often requires the cooperation of the borrower.
The other neat thing about notes compared to loans is that you can easily divide a big borrowing into lots of little notes, rather than a single big one. Thus, you can access a wider pool of lenders — including Belgian dentists, as we will see — each of whom can manage its own exposure without reference to the others, by buying or selling bonds in the secondary market.
Notes therefore are more liquid, transferable things, and while they are outstanding the issuer need not even know who its creditors are: they hove into view only upon payment of principal or interest, when they would show up at the issuer’s office with their instrument in hand.
Industrialisation of debt securities
This all being the case, notes quickly became popular, and the process of issuing, selling and maintaining them industrialised. Notes were “security printed”, like banknotes. Interest payments were represented by perforated coupons that could be detached and presented (or “stripped” and separately traded): for a long-dated bond, where there wasn’t room for all the coupons, there would be “talons” attached entitling the bearer to a fresh strip of coupons. Issuers appointed banks as “paying agents” to handle the mechanics of dealing with holders, paying out on presentation and so on. In some jurisdictions[2] issuers needed to maintain a record of noteholders, so created “registered” notes which were profoundly different in legal concept — title transferred by entry in the register, whereas with a bearer instrument the security itself was the debt and title passed by delivery — and there needed to be terms to deal with certain unwanted contingencies: replacing lost or mutilated notes; provisions for noteholder meetings to consider amendments to terms and so on.
Now an IOU is a simple enough thing: the legal architecture making it all possible was another thing altogether: trust deeds, paying agency agreements, dealer agreements, prospectuses and so on, and the up-front cost of a “stand-alone” debt issuance was formidable. Thus emerged the medium term note programme — a pre-crafted architecture containing all the standard terms, appointments and so on, which an issuer could quickly “tap” when it needed to, in a fraction of the time and cost.
In parallel the information revolution arrived and notes started to trade electronically, in a clearing system[3]. Here noteholders’ interests were represented as electronic entries in their clearing system accounts there was no need for security printing, perforated coupons, a wide network of paying agents, and the identity for the time being of the holders was ascertainable, at least by the clearing system, which had to maintain the records on order to ensure everyone got paid. At the very heart there was still a physically printed note: just one: a “global note”, representing all the nominally issued notes, held by a “common depositary” — a custodian for the electronic clearing systems in which the notes are traded.
Residual DNA
By the 1990s, all notes, bonds and other securities were electronically cleared, and none has been security printed since. Nonetheless, the MTN terms and structure still bear traces of their physical biology, a bit like tailbones, appendixes and male nipples. The basic rationale is “well, the clearing systems might not work one day — you know, there could be some kind of post-apocalyptic, Mad Max-style future with everyone driving round in battle trucks and drinking their own urine — so I might need to change these into security-printed definitive notes, so we better leave these terms in just in case”.
Now the JC would be the last one to pooh-pooh the idea of a dystopian future — given the last few years he rather expects it at some stage, in fact — but, really: if you are eating caterpillars, presenting your coupons to the Luxembourg paying agent is going to be a long way down your list of priorities.
In any case, this useless DNA makes for a great deal more complicatedness than, in practice one really needs. Your bond terms and conditions have to deal with the following:
- Registered or bearer form
- Electronically cleared or definitive
- Where definitive and bearer, mechanics of presenting coupons, talons and so on.
The logical structure of legal documents
This leads us on to one of our pet interests: why are legal documents so convoluted, and what can one do to correct it. For this we need to delve into the underlying logical structure of a contract.
Any legal statement, however Fishily articulated, boils down to a basic logical proposition, rather like software code, with propositions, conditions, logic gates, if/then statements, and so on, only we call them definitions, obligations, rights, discretions, options and so on.
Any logic gate — in legal language, an alternative, choice or option, increases the inherent complicatedness of a proposition.
Take this statement about cricket and rugby balls:
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Or you could render it thus:
Or how about:
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See also
References
- ↑ Or pledge, or lend it.
- ↑ America being a prime example, thanks to the glorious strictures of the Tax Equity and Fiscal Responsibility Act (TEFRA) of 1982, which introduced punitive tax treatment for bearer bonds, on the grounds that they were inherently fishy, income-sheltering things — a quality that never bothered the Belgian dental profession in the same way.
- ↑ In the European markets, there are two major clearing systems: Euroclear and Clearstream.