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Equity v credit derivatives showdown: Difference between revisions
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{{Cderiv}} assume you already own the [[Underlying|underlier]], but want to hedge away a specific embedded tail risk: namely, that it blows up. While you needn’t own the underlier to buy or sell {{Cderiv}} — the Robin Potts opinion is at great pains to stress that a [[Credit derivative|CDS]] is not a contract of insurance — generally speaking you ''will''. | {{Cderiv}} assume you already own the [[Underlying|underlier]], but want to hedge away a specific embedded tail risk: namely, that it blows up. While you needn’t own the underlier to buy or sell {{Cderiv}} — the Robin Potts opinion is at great pains to stress that a [[Credit derivative|CDS]] is not a contract of insurance — generally speaking you ''will''. | ||
==Overview and capital structure== | ==Overview and capital structure== | ||
{{cderiv}} address the market value of public, quoted, usually senior unsecured debt obligations — for this discussion, let’s call them “{{cddprov| | {{cderiv}} address the market value of public, quoted, usually senior unsecured debt obligations — for this discussion, let’s call them “{{cddprov|Bond}}s” while [[equity derivatives]] address the value of public, quoted common shares. | ||
The instruments have very different qualities: Bonds repay principal and return income, equities return capital. Unless something really catastrophic happens, the return on a {{cddprov|Bond}} is predictable — interest and principal — and values will be as affected by prevailing interest rates as by deterioration (or improvement) in the Issuer’s creditworthiness. That one really catastrophic thing is the Issuer’s failure: its ''{{cddprov|Bankruptcy}}''. | The instruments have very different qualities: Bonds repay principal and return income, equities return capital. Unless something really catastrophic happens, the return on a {{cddprov|Bond}} is predictable — interest and principal — and values will be as affected by prevailing interest rates as by deterioration (or improvement) in the Issuer’s creditworthiness. That one really catastrophic thing is the Issuer’s failure: its ''{{cddprov|Bankruptcy}}''. | ||
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==Buy side and sell side== | ==Buy side and sell side== | ||
Like all swaps, CDS and equity swaps are optically bilateral and a customer can take a short or long position. But there is still almost always a “[[buy side]]” investor looking to the swap to ''take'' a position, or to hedge an existing exposure, and a “[[sell side]]” swap dealer looking for a commission or premium, who will therefore hedge away the market risk presented by the swap. | Like all swaps, CDS and equity swaps are optically bilateral and a customer can take a short or long position. But there is still almost always a “[[buy-side]]” investor looking to the swap to ''take'' a position, or to hedge an existing exposure, and a “[[sell-side]]” swap dealer looking for a commission or premium, who will therefore hedge away the market risk presented by the swap. | ||
An investor buys a swap to put on a hedge; a dealer buys a hedge put on a swap. The investor seeks to change its market position with derivatives, the dealer seeks to keep its position flat. | An investor buys a swap to put on a hedge; a dealer buys a hedge put on a swap. The investor seeks to change its market position with derivatives, the dealer seeks to keep its position flat. | ||
This is a deep, profound market feature, and the [[JC]] thinks it gets misunderstood too often, and talked about not nearly enough. [[Regulatory margin|Bilateral margin regulations]], for example, were introduced in ignorance of, or disregard for, this distinction. [[When | This is a deep, profound market feature, and the [[JC]] thinks it gets misunderstood too often, and talked about not nearly enough. [[Regulatory margin|Bilateral margin regulations]], for example, were introduced in ignorance of, or disregard for, this distinction. [[When variation margin attacks|They have already contributed to catastrophic loss]]. | ||
==Vibe== | ==Vibe== | ||
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It kind of follows that you can’t “protect” or “insure” the return of common equity. Protection is measured as loss against an expected return: equities do not have one. Equities have just a prevailing market value, which can pogo around unpredictably — literally unpredictable — propelled by macroeconomic and geopolitical conditions and, always, the madness of crowds. | It kind of follows that you can’t “protect” or “insure” the return of common equity. Protection is measured as loss against an expected return: equities do not have one. Equities have just a prevailing market value, which can pogo around unpredictably — literally unpredictable — propelled by macroeconomic and geopolitical conditions and, always, the madness of crowds. | ||
You can set an ''arbitrary'' return — a hypothetical limit — and measure equity performance against ''that'' but this is not ''protection'' but ''speculation''. It is to buy or sell an {{ | You can set an ''arbitrary'' return — a hypothetical limit — and measure equity performance against ''that'' but this is not ''protection'' but ''speculation''. It is to buy or sell an {{eqderivprov|option}}: a true derivative. Equity swaps are in this sense genuinely derivatives, and no one hit up [[Potts opinion|Robin Potts Q.C.]] for an opinion just to check ''they'' weren’t disguised insurance contracts. | ||
Because they have all those deterministic features — due principal, due income, due date — the debt obligations ''are'' intrinsically insurable. They are also far less prone to market fluctuation, and their volatility tends to zero as maturity approaches. There is a lot less call for speculation, therefore (not ''none'', to be clear, just a lot less, and it tends to be highly levered) and a lot more call for protection against those deterministic features. | Because they have all those deterministic features — due principal, due income, due date — the debt obligations ''are'' intrinsically insurable. They are also far less prone to market fluctuation, and their volatility tends to zero as maturity approaches. There is a lot less call for speculation, therefore (not ''none'', to be clear, just a lot less, and it tends to be highly levered) and a lot more call for protection against those deterministic features. | ||
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The {{cddefs}} also deal with subordinated debt which only makes things more complicated, not less. Firstly, subordinated debt has many of the equity characteristics that make it much less debt like and insurable. It pays a lot more of its total return out in interest; over time the principal amount invested becomes of less and less significance. [[Credit Suisse]] [[AT1]]s, paying over 7% p.a., returned something like 45% of their original investment over 5 years, even though they were wiped entirely in April 2023. | The {{cddefs}} also deal with subordinated debt which only makes things more complicated, not less. Firstly, subordinated debt has many of the equity characteristics that make it much less debt like and insurable. It pays a lot more of its total return out in interest; over time the principal amount invested becomes of less and less significance. [[Credit Suisse]] [[AT1]]s, paying over 7% p.a., returned something like 45% of their original investment over 5 years, even though they were wiped entirely in April 2023. | ||
And speaking of [[AT1s]], since the [[global financial crisis]] bank capital structures have, by regulatory fiat, become a lot more complicated. Most G20 nations have enacted Bank recovery and resolution regimes, and while they’re broadly similar, outside the European Union, they are subtly different. And banks have reacted to them in idiosyncratic ways, too: there are multiple tiers common equity tier 1, alternative tier 1, alternative tier 2, and some old fashioned perpetual subordinated instruments which were crafted with no such fine distinctions in mind. And banks have opted different ways of bailing in: some convert to equity by design; some are written off. So generically providing for subordinated debt in a | And speaking of [[AT1s]], since the [[global financial crisis]] bank capital structures have, by regulatory fiat, become a lot more complicated. Most G20 nations have enacted Bank recovery and resolution regimes, and while they’re broadly similar, outside the European Union, they are subtly different. And banks have reacted to them in idiosyncratic ways, too: there are multiple tiers common equity tier 1, alternative tier 1, alternative tier 2, and some old fashioned perpetual subordinated instruments which were crafted with no such fine distinctions in mind. And banks have opted different ways of bailing in: some convert to equity by design; some are written off. So generically providing for subordinated debt in a commoditised, way is not straight, in the way plain old common equity, or senior unsecured, debt is. | ||
This makes determining credit events on these new instruments fraught, and litigationey. Dear old [[Lucky]] is, we dare say, going to be filling the coffers of our learned friends for some years yet. | This makes determining credit events on these new instruments fraught, and litigationey. Dear old [[Lucky]] is, we dare say, going to be filling the coffers of our learned friends for some years yet. | ||
The {{cddprov| | The {{cddprov|Default Requirement}} — credit derivatives’ answer to the {{isdaprov|Cross Default}} threshold — is typically a lot lower: if not specified, USD10m equivalent, whereas under Section {{isdaprov|5(a)(vi)}} you might expect ten or a hundred times that, referenced to a percentage of [[Common equity|shareholder equity]]. | ||
This reflects the different intentions of the provisions: one is to preserve one’s existing position in an ongoing trading arrangement should the counterparty be unable to pay what it owes, by allowing one to terminate and ''avoid'' loss; the other is to ''compensate'' for losses already incurred under a reference instrument (yes, yes, it isn’t ''actually'' insurance and there is no requirement for an insurable loss, but still). | This reflects the different intentions of the provisions: one is to preserve one’s existing position in an ongoing trading arrangement should the counterparty be unable to pay what it owes, by allowing one to terminate and ''avoid'' loss; the other is to ''compensate'' for losses already incurred under a reference instrument (yes, yes, it isn’t ''actually'' insurance and there is no requirement for an insurable loss, but still). | ||
The former position requires the company itself to be done for; if it isn’t, you still have the prospect of full recovery; the latter position is concerned only with the market value of that specific instrument. If it is canned, rescheduled, or defaulted upon such that the original bargain it promised is no longer to be had, then the CDS pays out even if the Reference Entity remains a going concern and chunters happily along back towards insolvency. (If its CDS is triggered that becomes vanishingly unlikely of course, but if there is one thing the market tells everyone, it is YOU NEVER KNOW.) | The former position requires the company itself to be done for; if it isn’t, you still have the prospect of full recovery; the latter position is concerned only with the market value of that specific instrument. If it is canned, rescheduled, or defaulted upon such that the original bargain it promised is no longer to be had, then the CDS pays out even if the {{cddprov|Reference Entity}} remains a going concern and chunters happily along back towards insolvency. (If its CDS is triggered that becomes vanishingly unlikely of course, but if there is one thing the market tells everyone, it is YOU NEVER KNOW.) | ||