Cheapest-to-deliver
Cheapest-to-deliver
/ˈʧiːpɪst tuː dɪˈlɪvə/ (adj.)
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Of the range of valid means of performing a contract, the one that will cost you the least and irritate your customer the most should you choose it.
Any person whose contractual obligations can be fully understood in monetary terms is bound to do the utter bare minimum to discharge them. These are “transactions”; zero-sum, finite games — there is no expectation of anything beyond reasonable performance of the literal terms. When the contract ends all performance expectation falls to zero. It is like a barter situation between hostile tribes: the equity of the exchange is encapsulated in the deal: no abiding trust beyond the terms of the deal is expected.
So it should not surprise anyone that the owner of a financial option will exercise it to her own maximum benefit. That is why she bought it.
Nonetheless, this did surprise purchasers of managed CDOs with loosely-defined Reference Obligations when, in a torrent, the Reference Entities began suffering credit events during the global financial crisis. They were outraged to find managers were valuing credit losses not against a Reference Entity’s freshly-issued, publicly quoted, liquid senior bonds, but by reference to some obscure, deeply subordinated, perpetual note that hadn’t traded since it was issued via private placement in 1975, and which only counted as “debt” by the skin of its teeth.
The bondholders got jammed with “cheapest-to-deliver” shoe-scrapings. Cue much litigation, but the real lesson: when you take the other side of a customised financial option, you must read the documents with peril-sensitive sunglasses.[1]
Now: zero-sum contracts like this are — should be — very much the exception. Commercial arrangements — even those governing the trading of zero-sum financial contracts — are not like that. They work best where the counterparties trust each other. This is the difference between a single round and an iterated series of the “prisoner’s dilemma”.
Now this “cheapest-to-deliver” concept is no long-lost curio from the history of the structured credit market. Being a foundational premise of the agency problem, it is in turn a cornerstone of any service industry. You know, such as the financial services industry, or the legal services industry, and the consulting industry.
Any organisation to whom one outsources one’s operational framework for the long term will measure its success by how closely it can tack, on average, to the bare minimum whilst not too regularly over-stepping it.
See also
- ↑ The other real lesson is that credit derivatives is a silly asset class, because it almost guarantees this kind of looseness and buried optionality. But that is a story for another day.