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Equity v credit derivatives showdown: Difference between revisions
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==Subordinated debt== | ==Subordinated debt== | ||
The {{cddefs}} also deal with subordinated debt which only makes things more complicated | The {{cddefs}} also deal with subordinated debt which only makes things more complicated. Firstly, subordinated debt has many of the equity characteristics that make it much less debt like and insurable. | ||
'''Indeterminate ''when''''': For one thing it is often ''very'' long-dated or even perpetual — repayable at the Issuer’s total discretion — meaning the “repayment”a CDS is meant to reference isn’t there at all, or is epochally distant so as to be more or less meaningless. How does one reschedule a principal repayment obligation that doesn’t exist in the first place? And, really, how ''likely'' is an issuer to reschedule — that is, push pack the scheduled repayment date of — debt that isn’t due for 25 years in any case. To this end there is a technical limitation too: ISDA Standard Reference Obligations are required to have a stated maturity no longer than 30 years. | |||
'''Inconsequential ''what''''': Furthermore the amount you are due to be paid in principal, if and when an Issuer ever has to pay it — treasury will call and roll term capital debt well before it is due precisely to ensure stable long term funding — is hardly the main attraction. Even in a low interest environment, a 30 year discount knocks out about a half of the present value of that promise to pay; in the meantime, the bonds (being deeply subordinated) may pay 5 times as much in interest. So that promise to pay is not the thing. Over time — as we argue [[AT1|elsewhere]], capital investment rewards long-term investment, not speculation — your 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 commoditised way is not straightforward, in the way plain old common equity, or senior unsecured, debt is. | 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 straightforward, in the way plain old common equity, or senior unsecured, debt is. | ||
This makes determining credit events on these new types of capital instruments fraught, and litigationey. It might have been taken to the woodshed but dear old [[Lucky]], we dare say, will still be filling the coffers of our learned friends for some years yet. | This makes determining credit events on these new types of capital instruments fraught, and litigationey. It might have been taken to the woodshed but dear old [[Lucky]], we dare say, will still be filling the coffers of our learned friends for some years yet. | ||
As FT Alphaville neatly put it: | |||
{{Quote|The logic behind it all may at times seem counterintuitive and faintly ridiculous, but then CDS decisions are frequently counterintuitive and faintly ridiculous. The members of the DC are not supposed to rule on how market participants intended the contracts to behave, but on their strict legal definitions, unintended quirks and all.}} | |||
This is surely the Achilles heel of credit derivatives: it is, on this logic, a product designed around clever legal arguments and contorted, mystical thinking, and not actual market dynamics. The DC should, surely, be there ''precisely'' to reflect the collective view of how market participants intended the market to behave. What other value can it offer? | |||
==Thresholds and notionals== | ==Thresholds and notionals== | ||