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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.  
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.  
====Trades are zero-sum games====
Where a contract can be fully understood in monetary terms, expect the parties to do the utter bare minimum to discharge 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 game|zero-sum]], [[Finite and Infinite Games|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.  
These are “transactions”; [[Zero-sum game|zero-sum]], [[Finite and Infinite Games|finite games]] — neither side has any expectation beyond the competent performance of its literal terms. When that is done, all remaining expectations fall to zero. The parties can walk away and never meet again.


So it should not surprise anyone that the owner of a [[Option|financial option]] will exercise it to her own maximum benefit. That is why she bought it.
Transactions, so regarded, are “trades”: quid-pro-quo, “[[barter]]” exchanges between parties who may or may not, otherwise, even like each other. The equity of the bargain is completely contained in the exchange: once it is done no abiding trust or faithfulness remains or is expected.  


Nonetheless, this ''did'' surprise purchasers of managed [[CDO]]s with loosely-defined [[Reference Obligation - Credit Derivatives Provision|Reference Obligations]] when, in a torrent, the [[Reference Entity - Credit Derivatives Provision|Reference Entities]] began suffering [[Credit Events - Credit Derivatives Provision|credit event]]<nowiki/>s during the [[global financial crisis]]. They were outraged to find managers were valuing credit losses not against a [[Reference Entity - Credit Derivatives Provision|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.  
====Cheapest-to-deliver====
We should not, therefore,  be surprised if the person to whom we sold an [[Option|financial option]] exercises it to her own advantage. That is why she bought it.  ''That was the deal''. So we draw our trade documentation to be clear and to ''avoid'' giving away unintended options.
 
A famous example arose in the CDS market during the financial crisis. Credit derivatives designate a specific {{cddprov|Reference Obligation}} that triggers a {{cddprov|Credit Event}}, but a wider class of {{cddprov|Deliverable Obligation}}s that the {{cddprov|Buyer}} may use to value its credit loss should one happen. This gave Buyers a “cheapest-to-deliver” option and, when the world was in flames and everyone’s hair was on fire they exercised it, selecting the cheapest {{cddprov|Deliverable Obligation}}s they could find.
 
This should not have, but ''did'', surprise credit derivative ''Sellers''. When a torrent of {{cddprov|Credit Events}} thundered through the market, Sellers affected outraged when Buyers  referenced not the freshly-issued, publicly quoted, liquid senior bonds they expected, but rather obscure, deeply subordinated, perpetual notes that hadn’t traded since issue, in 1975, that they¹d never heard of, and which barely scraped into eligibility as {{cddprov|Deliverable Obligation}}s by some oversight in the drafting on the Confirmation.
 
Cue much litigation, but the real lesson: read trade documents with peril-sensitive sunglasses. (The other lesson is that [[credit derivative]]s are silly things, but that is a story for another day.)
 
====Relationship contracts are not zero-sum games====
But discrete trades are an unusual type of contract. Most commercial relationships (even trading ones) are based on trust. They operate the same way social relationships do, with ongoing, permanently undischarged “social debts” between the parties. These are the ties that bind, in which credit is possible. We do not work-to-rule; if there are errors or misunderstandings we are, within reason, forgiving of them. We allow each other flex: as long as we are making a return from the relationship we are happy to leave something on the table in the interests of the longer-term relationship.
 
====CDOs and cheapest-to-deliver====


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.<ref>The other real lesson is that [[Credit derivative|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.</ref>


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 prisoner’s dilemma|single round]] and an [[Iterated prisoner’s dilemma|iterated]] series of the “[[prisoner’s dilemma]]”.  
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 prisoner’s dilemma|single round]] and an [[Iterated prisoner’s dilemma|iterated]] series of the “[[prisoner’s dilemma]]”.  
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{{sa}}
{{sa}}
*[[Relationship contract]]s and [[trade]]s
*[[Service level agreement]]
*[[Service level agreement]]
*[[Worst reasonable endeavours]]
*[[Worst reasonable endeavours]]

Revision as of 18:31, 6 March 2024

The Jolly Contrarian’s Glossary
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Cheapest-to-deliver
/ˈʧiːpɪst tuː dɪˈlɪvə/ (adj.)

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.

Trades are zero-sum games

Where a contract can be fully understood in monetary terms, expect the parties to do the utter bare minimum to discharge it.

These are “transactions”; zero-sum, finite games — neither side has any expectation beyond the competent performance of its literal terms. When that is done, all remaining expectations fall to zero. The parties can walk away and never meet again.

Transactions, so regarded, are “trades”: quid-pro-quo, “barter” exchanges between parties who may or may not, otherwise, even like each other. The equity of the bargain is completely contained in the exchange: once it is done no abiding trust or faithfulness remains or is expected.

Cheapest-to-deliver

We should not, therefore, be surprised if the person to whom we sold an financial option exercises it to her own advantage. That is why she bought it. That was the deal. So we draw our trade documentation to be clear and to avoid giving away unintended options.

A famous example arose in the CDS market during the financial crisis. Credit derivatives designate a specific Reference Obligation that triggers a Credit Event, but a wider class of Deliverable Obligations that the Buyer may use to value its credit loss should one happen. This gave Buyers a “cheapest-to-deliver” option and, when the world was in flames and everyone’s hair was on fire they exercised it, selecting the cheapest Deliverable Obligations they could find.

This should not have, but did, surprise credit derivative Sellers. When a torrent of Credit Events thundered through the market, Sellers affected outraged when Buyers referenced not the freshly-issued, publicly quoted, liquid senior bonds they expected, but rather obscure, deeply subordinated, perpetual notes that hadn’t traded since issue, in 1975, that they¹d never heard of, and which barely scraped into eligibility as Deliverable Obligations by some oversight in the drafting on the Confirmation.

Cue much litigation, but the real lesson: read trade documents with peril-sensitive sunglasses. (The other lesson is that credit derivatives are silly things, but that is a story for another day.)

Relationship contracts are not zero-sum games

But discrete trades are an unusual type of contract. Most commercial relationships (even trading ones) are based on trust. They operate the same way social relationships do, with ongoing, permanently undischarged “social debts” between the parties. These are the ties that bind, in which credit is possible. We do not work-to-rule; if there are errors or misunderstandings we are, within reason, forgiving of them. We allow each other flex: as long as we are making a return from the relationship we are happy to leave something on the table in the interests of the longer-term relationship.

CDOs and cheapest-to-deliver

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

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