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Equity v credit derivatives showdown: Difference between revisions
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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 commoditised | 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 instruments fraught, and litigationey. | 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. | ||
==Thresholds and notionals== | |||
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]]. | 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 | This reflects the different intentions of the contracts: the ISDA looks to protect an 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; credit derivatives 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). Equity derivatives broadly seek to create exposure, long or short, to the issuers of publicly traded instruments. | ||
The | The ISDA thus requires the company itself to be properly done for to be triggered if it isn’t, you still have the prospect of full recover. Credit derivatives are concerned only protecting the redemption value of specific instruments. If they are 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 — even if it eventually chunters back towards solvency. (If its CDS is triggered in the meantime that becomes vanishingly unlikely of course, but if there is one thing the market tells everyone, it is YOU NEVER KNOW.) | ||