Equity v credit derivatives showdown

After a long hiatus learning the ways of the 2002 ISDA Equity Derivatives Definitions, the JC is back in the land of credit derivatives, and has been undertaking remedial ninjery with the sacred texts of the 2014 ISDA Credit Derivatives Definitions. You can learn about his travails from NiGEL, in the panel.

Credit Derivatives Anatomy™ Ninja showdown, yesterday From our machine overlords Here is what, NiGEL, our cheeky little GPT3 chatbot had to say when asked to explain: JC: Nigel, tell me a story about a boy who journeyed to a high mountain to train at the feet of an isda ninja for ten years to become a black belt in equity derivatives. NiGEL: The boy was fascinated by the stories of the ISDA ninjas, the elite warriors who mastered the art of equity derivatives. He dreamed of becoming one of them and learning their secrets. He saved up enough money to travel to the high mountain where their dojo was located. He knocked on the door and asked to be accepted as a disciple. The master of the dojo looked at him with a stern gaze and said, “Becoming an ISDA ninja is no game. It is a way of life. You will have to train hard, study hard, and endure many hardships. You will have to forsake your family, your friends, your credibility and your worldly possessions.” The boy said, “Master. I am ready.” The master smiled and said, “Very well. Come in. You are now one of us.” The boy entered the dojo and began his training. He learned how to use as OSLAs, GMSLAs, CFDs, and of course equity swaps. He learned how to fight with his bare hands, using synthetics, lockups, delta-hedges, and close-outs. He learned how to move stealthily, evade NAV triggers, and escape from short squeezes. He learned how to meditate, control his margining, and focus his mind. But most importantly, he learned how to trade equity derivatives. He learned how to analyze the market, calculate the risks and rewards, and execute the best strategies. He learned how to use options, futures, swaps, and other complex instruments. He learned how to hedge his positions, arbitrage opportunities, and exploit inefficiencies. He learned how to deal with volatility, liquidity, and leverage. He studied the ISDA Master Agreement, the standard contract that governed all equity derivative transactions. He memorised it and the 2002 ISDA Equity Derivatives Definitions and all their clauses, definitions, and provisions. He understood its implications, interpretations, and applications. He knew how to handle Events of Default, Termination Events, close-out netting, and collateral management. He passed all the tests and challenges that the master gave him. He earned the respect and admiration of his fellow disciples. He rose through the ranks and achieved higher levels of skill and knowledge. After ten years of training, he was ready for his final test. The master summoned him to his chamber and said, "You have done well, my son. You have learned everything I have taught you. You have proven yourself worthy of being an ISDA ninja. There is only one thing left for you to do." "What is it, master?" the boy asked. "You must face me in a martial swaps showdown," the master said. “It is a duel between two ISDA ninjas, each using their own chosen derivatives definitions booklet as a weapon. I choose the 2014 ISDA Credit Derivatives Definitions. You may chose the 2002 ISDA Equity Derivatives Definitions.We will each choose a portfolio of swaps with different underlying assets, maturities, notional amounts, and fixed or floating rates. We will then exchange cash flows based on these swaps until one of us runs out of money or concedes defeat." "It is exciting," the master said, "but also dangerous. If you lose, you will lose everything you have worked for: your ninja status. Your honour. Your dignity. Your implausibly generous income. And your mortal soul will be cast into — ” “What, Master?” the boy asked. “What? Where will my mortal soul be cast?” The master hesitated. But them the boy understood. It was a place unmentionable to the sworn warriors of the Aïessdiyé. "This is the ultimate test of your skill and courage. This is how we determine who is the best among us." "Then I accept your challenge," the boy said. "Good," the master said. "Prepare yourself. We will meet at dawn in the derelict warehouse where we store our old equipment." The next morning, the boy went to the warehouse with his portfolio of swaps. He saw the master waiting for him with his own portfolio. They bowed to each other and began their showdown. They traded swap after swap with lightning speed and precision. They matched each other's moves with counter-moves. They tried to outsmart each other with clever tactics and tricks. view template Disclaimer: NiGEL’s a neural network, he drinks a lot, and he spends too much time on the internet, so if you listen to anything he has to say you only have yourself to blame. Come to think of it, that is also true of the JC in general. Resources (full wikitext) | (nutshell wikitext) | Anatomy | Narrowly-tailored credit event | Equity v credit derivatives showdown Index: Click ᐅ to expand: Credit Derivatives Tell me more Sign up for our newsletter — or just get in touch: for ½ a weekly 🍺 you get to consult JC. Ask about it here. Premium version of this page

Here we do the service of comparing, in broad strokes, equity derivatives with the credit derivatives.

Documentation

Each has its own definitions booklet — 2002 ISDA Equity Derivatives Definitions and 2014 ISDA Credit Derivatives Definitions respectively — though their genealogies are different.

The 2002 ISDA Equity Derivatives Definitions were published in 2002 and, while not perfect, do a serviceable enough job at describing what is essentially, and usually, a fairly straightforward product, though they get a bit gummed up about dividends. The product traded is for the most part a delta-one exposure to shares, share baskets and indices and, while hedging can be fraught in times of dislocation, and hedging costs get passed through to end users, the basic notional value of an equity derivative is not: the market price if a listed share: you can see it printed in 6 point font in the Financial Times every day.

The 2014 ISDA Credit Derivatives Definitions are for the connoisseur ISDA ninja. Their original abstract intellectual purity has long since evaporated, brutalised repeatedly by savage real-world market dislocation. They are now a fearful, paranoid, jabbering wreck. It is as if the winsome fever dream of some JP Morgan brainboxes, strained through the gusset of the First Men and wrung through some QC opinions has taken root, allowed to flourish, run wildly out of control, threatened life as we know it and then been mercilessly beaten, bent and twisted by a community of embittered banking regulators, themselves branded by the white-hot iron of civilisation-threatening financial disaster.

Indeed, that is pretty much what did happen.

The product emerged in the 1990s, the brainchild of JP Morgan boffins, became highly fashionable, by 2003 had earned its own definitions booklet, and as the CDO mania of the noughties reached fever pitch, it began to standardise. Legions of chancers, grifters and joiner-inners flooded the market and before you knew it there were all kinds of “exotic” structures, each more convoluted and less plausible than the last. Growth was periodically set back by actual credit events in the market, each it's own life lesson about the multifarious ways in which over-engineered, too-clever-by-half structured products can surprise their Inventors by finding unexpected ways to fail. The real “come-to-Jesus” moment for credit derivatives was the credit crunch of 2007 and then 2008’s full blown global financial crisis, which between them revealed the degree to which nice ideas in theory don’t hold up in the sweaty throes of market panic. There was a lot of litigation about misfiring — or allegedly misfiring — credit derivatives.

The 2014 ISDA Credit Derivatives Definitions were, consequently, monstrously overhauled in 2014, and at the same time the product standardised yet further, moving away from single name, bilateral, privately negotiated deals and towards cleared, standardised, broad-based index products. There are still some privately negotiated deals but, compared with equity swaps, which are the bedrock of hedge fund equity long/short strategies, not many. More than ten trades a week on a given Reference Entity rates special mention in ISDA’s credit market summary.

Practitioners will tell you part of their lack of popularity is the sheer complication of the 2014 ISDA Credit Derivatives Definitions. Unlike the 2002 ISDA Equity Derivatives Definitions, the 2003 Credit Derivatives Definitions really didn’t work, the move away was propelled by regulator angst and infrastructural imperative, so there was not the option of flat-out ignoring them, as the market did to the ill-fated 2011 Equity Derivatives Definitions. Even though now impenetrable, they are still finding snafus needing quick fix patches.

In any case visiting the credit derivatives now after a few years away, is like visiting a long lost friend now institutionalised for her own good, straight jacketed, and fed cold soup through a straw. Occasionally she still manages to shout something outrageous and upset the common room.

Synthetic investment versus loss insurance

Equity Derivatives are means of gaining exposure — positive or negative— to an instrument without owning it. The basic point of the contract is to replicate exactly the economic features of the underlier, minus the physical, reporting and funding aspects of being on the register. You buy or sell an Equity Derivatives instead of buying or selling the underlier.

Credit Derivatives assume you already own the underlier, but want to hedge away a specific embedded tail risk: namely, that it blows up. While you needn’t own the underlier to buy or sell Credit Derivatives — the Robin Potts opinion is at great pains to stress that a CDS is not a contract of insurance — generally speaking you will.

Overview and capital structure

Credit Derivatives address the market value of public, quoted, usually senior unsecured debt obligations — for this discussion, let’s call them “Bonds” while equity derivatives address the value of public, quoted common shares.

The instruments have very different qualities: Bonds repay principal and return income, equities return capital. Unless something really catastrophic happens, the return on a Bond is predictable — interest and principal — and values will be as affected by prevailing interest rates as by deterioration (or improvement) in the Issuer’s creditworthiness. That one really catastrophic thing is the Issuer’s failure: its Bankruptcy.

Because there are literally no expectations about what they will pay — not even a redemption date — equities pogo around, depending on the issuer’s quarterly performance, paranoia, market sentiment, geopolitical currents, internet memes, Reddit, whatever Elon tweets about and whatever the madness of collected action believes to be germane to the business of, well, business. Equities could quite easily be up 200% or down 70% over a six-month period with neither making a tremendous statement as to the basic creditworthiness of the Issuer.

So oddly, while you would expect equities to be about corporate default and credit derivatives to be about relative performance in the absence of default, it is the other way round. Credit derivatives, like Bonds, tend to have a fixed term and a fixed premium and, while you can mutually terminate them at market price, there is no right to do so in the absence of a catastrophic failure — any exit is negotiated and dependent on prevailing liquidity. Equity swaps tend not to have a tenor (they may have one, but it doesn’t mean anything) and to be terminable on the client side at any time.

Buy side and sell side

Like all swaps, CDS and equity swaps are optically bilateral and a customer can take a short or long position. But there is still almost always a “buy side” investor looking to the swap to take a position, or to hedge an existing exposure, and a “sell side” swap dealer looking for a commission or premium, who will therefore hedge away the market risk presented by the swap.

An investor buys a swap to put on a hedge; a dealer buys a hedge put on a swap. The investor seeks to change its market position with derivatives, the dealer seeks to keep its position flat.

This is a deep, profound market feature, and the JC thinks it gets misunderstood too often, and talked about not nearly enough. Bilateral margin regulations, for example, were introduced in ignorance of, or disregard for, this distinction. They have already contributed to catastrophic loss.

Vibe

Bear in mind the characteristic distinctions between equity and debt. Equities have no term, no stated repayment, no defined yield or return. They represent what would be left were all such instruments satisfied in full. By contrast senior debt obligations have all those features: a defined repayment amount, due date, and deterministic yield (“deterministic” in that it can be observed objectively by reference to something other than the performance or business condition of the issuer).

It kind of follows that you can’t “protect” or “insure” the return of common equity. Protection is measured as loss against an expected return: equities do not have one. Equities have just a prevailing market value, which can pogo around unpredictably — literally unpredictable — propelled by macroeconomic and geopolitical conditions and, always, the madness of crowds.

You can set an arbitrary return — a hypothetical limit — and measure equity performance against that but this is not protection but speculation. It is to buy or sell an Template:Eqprov: a true derivative. Equity swaps are in this sense genuinely derivatives, and no one hit up Robin Potts Q.C. for an opinion just to check they weren’t disguised insurance contracts.

Because they have all those deterministic features — due principal, due income, due date — the debt obligations are intrinsically insurable. They are also far less prone to market fluctuation, and their volatility tends to zero as maturity approaches. There is a lot less call for speculation, therefore (not none, to be clear, just a lot less, and it tends to be highly levered) and a lot more call for protection against those deterministic features.

Credit events are not concerned with capricious market value fluctuations, therefore, but only portents of utter destruction: indicators that a Reference Obligation really will not pay the whole amount due on the day it is due. This is binary: market indicators that a Reference Entity is merely less likely to be able pay in full on time — ratings downgrades, common equity breaching price triggers and so on — should not trigger a Credit Event. To be sure, they may cause “CDS spreads” to spike — the premium one must pay to buy credit protection on the Reference Entity for new contracts will increase, so the replacement cost of existing trades will have a value — and may thus lead to gains or losses in the mark-to-market value of a credit default swap, but these gains will reflect the present value of that spread differential against the originally traded price, and not anything more profound than that. As long as the Reference Entity does in time repay its debt (or at least not indicate finally that it won’t before the credit protection expires) then the credit derivative will expire unexercised.

Thus Credit Events cross over with, but are different to Events of Default, and are more relentlessly focussed on non-payment in full and on time: Bankruptcy, Restructuring, Repudiation/Moratorium, Obligation Acceleration, Governmental Intervention.

Subordinated debt

The 2014 ISDA Credit Derivatives Definitions also deal with subordinated debt which only makes things more complicated, not less. Firstly, subordinated debt has many of the equity characteristics that make it much less debt like and insurable. It pays a lot more of its total return out in interest; over time the principal amount invested becomes of less and less significance. Credit Suisse AT1s, paying over 7% p.a., returned something like 45% of their original investment over 5 years, even though they were wiped entirely in April 2023.

And speaking of AT1s, since the global financial crisis bank capital structures have, by regulatory fiat, become a lot more complicated. Most G20 nations have enacted Bank recovery and resolution regimes, and while they’re broadly similar, outside the European Union, they are subtly different. And banks have reacted to them in idiosyncratic ways, too: there are multiple tiers common equity tier 1, alternative tier 1, alternative tier 2, and some old fashioned perpetual subordinated instruments which were crafted with no such fine distinctions in mind. And banks have opted different ways of bailing in: some convert to equity by design; some are written off. So generically providing for subordinated debt in a conmoditised, way is not straight, in the way plain old common equity, or senior unsecured, debt is.

This makes determining credit events on these new instruments fraught, and litigationey. Dear old Lucky is, we dare say, going to be filling the coffers of our learned friends for some years yet.

The Designated Requirement — credit derivatives ’ answer to the Cross Default threshold — is typically a lot lower: if not specified, USD10m equivalent, where under Section 5(a)(iv) you might expect ten or a hundred times that, referenced to a percentage of shareholder equity.

This reflects the different intentions of the provisions: one is to preserve one’s existing position in an ongoing trading arrangement should the counterparty be unable to pay what it owes, by allowing one to terminate and avoid loss; the other is to compensate for losses