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.
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Equity Derivatives Anatomy™
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Here we do the service of comparing, in broad strokes, equity derivatives with the credit derivatives.
Nominally just derivatives attaching to a different part of the capital structure, but don't be fooled. Almost everything about them is different. So, with feeling:
Each has its own definitions booklet — 2002 ISDA Equity Derivatives Definitions and 2014 ISDA Credit Derivatives Definitions respectively — though their genealogies are different.
The equity derivative is an age-old family of products that ISDA simply codified: puts, calls, collars — options, basically — and contracts for difference on shares and baskets of shares. The 2002 ISDA Equity Derivatives Definitions, published in 2002, pulled in share indices, but these are really just complicated, large baskets.
While not perfect — they get a bit gummed up about dividends, and tax can get complicated — the equity definitions do a serviceable enough job of describing what is essentially a straightforward product. It is mainly traded as delta-one exposures and, while hedging can be fraught in times of market dislocation (and hedging costs and losses get passed through to end users, the basic notional value of an equity derivative is not: the market price of a listed share: you can see it printed in 6 point font in the Financial Times every morning, and printed on your Bloomie every second of the day.
Credit derivatives specialists who come to the equity derivatives, as droves did after the collapse of the structured credit market in 2008, tend to be surprised and alarmed at how straightforward and unfunky equity derivatives are. They are just not that fiddly. This is not for want of trying — hello hypothetical broker dealer — but you sense much of that is wanton complicationeering from our risk controller friends: in the decade following the financial crisis, the basic synthetic equity product became markedly more fiddly. No small part of that was fugitive structured credit lawyers overengineering through force of habit and ignorance. The ISDA ninja’s refrain: never hesitate to complicate.
Now, to be sure: while the equity swap product is structurally simple, it is no less risky for it, and you can just as easily lose your shirt, as Archegos’ prime brokers would tell you.
But unlike the dysfunctional credit derivatives definitions, it still mostly worked. As the saying goes, “if it ain’t really broke, don’t fix it”: the market has remained loyal to the 2002 ISDA Equity Derivatives Definitions despite a noble attempt by a squadron of misguided Linklaters complexity bombers to overhaul them in 2011, which failed rather epically. We have quite a bit of fun at the expense of “Flight 19” but we mean well as, undoubtedly, they did too.
But as far as we know, not a single trade has ever been documented under the 2011 Equity Derivatives Definitions. If you happen to know of one, please don’t write in to tell us: that would spoil an impression of outright calamity we are quite happy labouring under.
By contrast the credit derivatives booklet has had quite the Odyssey since the “long-hand” credit default swap product evolved in the late 1990s. In any case the latest version, the 2014 ISDA Credit Derivatives Definitions, is for the true connoisseur of iatrogenic ninjery.
Their original abstract intellectual purity has long since evaporated, brutalised by repeated, savage, real-world market dislocations. They are now a fearful, paranoid, jabbering wreck of gabbling cabbage. It is as if the winsome fever dream of the JP Morgan brainboxes from whose brow they sprang, strained through the gusset of the First Men and then wrung out with 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, twisted and hacked at 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. It is not a pretty sight. Don’t look directly at the definition of Event Determination Date without peril-sensitive sunglasses. It may blind you.
Credit default swaps emerged in the 1990s, the brainchild of JP Morgan boffins. They became highly fashionable and by 2003 had earned their own definitions booklet. As the CDO mania of the noughties crested, the market felt a real need to develop standard terms for a CDS.
Just as it was doing this a cavalcade 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 teaching its own life lesson about the multifarious ways in which over-engineered, too-clever-by-half structured products can surprise their Inventors and find 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 horrifying 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. That has never really changed. The road to hell is, as they say, wallpapered with CDS Confirmations. The credit derivatives have always been a bit of a moving feast.
As a result of their categorical failure to accommodate the various threnodies of the global financial crisis the 2014 ISDA Credit Derivatives Definitions were monstrously overhauled in 2014, while at the same time the product standardised yet further, moving away from single name, bilateral, privately negotiated transactions 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. Equity traders night trade the same name ten times a second.
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 for the new credit derivatives definitions.
In any case, visiting 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.
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