Template:M intro repack ABS field guide
Transformation
Financial services are not immune to the civilisational sweep of the information revolution. As the consumer world glommed onto digital watches, space invaders calculators, Donkey Kong and the graphic user interface so was the banking world being rocked by a Cambrian explosion of sophisticated financial engineering. Swaps, securitisations and investment management mushroomed in the nineteen-eighties.
The revolution was, at first, curiously non-technological.
Egged on by the sweet sirocco breeze of economic liberalisation, pioneering financial innovations in the 1980s owed little to the digital age beyond a willingness to look at old things in a new way. The technology inside a swap, for example, is ancient — loans — the innovation being simply to juxtapose offsetting ones, in different 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 systems made it easier to manage complicated cashflows, but even there technology only sped the derivatives market up: it did not enable anything you couldn’t have already done with paper and pencil. Likewise, dematerialised clearing arrived in securities markets 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, or could be be rendered permanently inoperable 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 reading who may still believe 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 printing capacity on the planet — nay, in the galaxy — to produce all the definitive securities 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 lawyers are, as we know, good at studiously ignoring progress when it promises to put them out of work, just as they warmly embrace it should it promise 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. We doubt ChatGPT will have any greater success.
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.[1] 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.[2] These are products like shares, bonds, warrants, futures and standardised exchange-traded options.[3] 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.