Asset-backed securities field guide

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A field guide to ABS

Transformation Financial services are no more immune to the civilisational sweep of the information revolution than any other aspect of our lives, and there was a similar revolution in sophistication and complexity about the same time the personal computer started landing on desks.

The revolution was, at first, curiously non-technological though. That great epochal innovation, the swap, owed nothing really to the digital age beyond perhaps a willingness to look at old things in a new way. All the technology inside a swap was ancient — loans — the innovation was just to juxtapose offsetting loans, in different currencies, between the same parties.

Electronic booking systems perhaps made it easier to manage complicated cashflows, but to that extent, technology has only sped up, and accelerated, the derivatives market, not enabled it.

The JC’s nascent view: the technological since qua non of financial innovation was the word processor. It just became easier to draft, to mash up, to iterate, to duplicate when you didn't have to re-type every page from scratch.

In any case in the financial markets there has always been, and remains, a fundamental distinction between the bilateral and the unilateral. Word processing — on our ad hoc theory — enabled that divide to be bridged. The technology to obliterate it, with electronic clearing, distributed ledgers and so on, perhaps now exists, but if it is emerging, is doing so slowly.

Bilateral

The bilateral world is the one of private, two-party (or definable, small number of parties) “over-the-counter” contracts. Loans, swaps, securities financings, OTC options. Instruments one does not typically trade “on exchange”. Indeed, one does not typically transfer them at all. While risk transfers are possible, by way of novation of sub-participation, they are fiddly and involved. Due diligence is required. Chin scratching. KYC.

The “officious bystander” has none but a voyeur’s interest in these arrangements: she is NFI. Contractual counterparties 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. They can see the whites of each other’s eyes.

Unilateral

Unilateral contracts are available to all the world. We are in the land of carbolic smoke balls: on obligor creates a financial instrument gives it corporeal form 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 on to collect interest or for final redemption. It is, in one way or another, negotiable.

This has its pros and cons. It is more liquid: I can get out of my risk without the borrower's knowledge, by selling it in the market to someone else. And securities tend towards standardisation of terms, precisely to encourage liquidity. This has regulatory advantages: many institutions are permitted to buy security