Equivalent

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Warning: metaphysical area approaching. Approach stacked turtles with care.

Equivalent
/ɪˈkwɪvələnt/ (adj.)

1. Finance: In comparison to something else, exactly the same. Fungible. Interchangeable in every respect. If a security, from the same series; having the same ISIN. Not just “broadly similar”.

2. Colloquial: One thing that is equal to or corresponds with another thing in value, amount, function, meaning, etc., without being exactly the same thing. "Banque de France is the French equivalent of the Bank of England".

Financial “equivalence” is not, er, equivalent, to colloquial “equivalence”.

It barely need being said, but let’s say it: this site is about financial stuff. When we talk about “equivalence”, we mean financial equivalence. This is a narrow, specialised meaning. When you get given something — credit support, for example — that at some point you’ll have to give back, the deal is you have to give an identical thing back, in the sense of having not just the same issuer, same maturity date and ranking pari passu with what you were given in the first place, but actually being from the same series, with the same ISIN. For all purposes, the same.

Nowadays, where all securities are held in electronic book-entry form, or on a blockchain or something like that,[1] this doesn’t really mean a great deal, but in the old days, when securities were printed on paper, it did. The only securities commonly printed on paper these days are bank notes: One British five pound note is equivalent to another British five pound note, but is not equivalent to a Jersey five pound note, because even though Jersey is in a currency union with sterling, the Jersey note is not legal tender in England.

So why do we say “equivalent” and not just “the same” or even “identical”?

Largely, to keep accountants happy. “The same” is narrower: it means exactly the same security or banknote that you were originally referring to, with not just the same ISIN but the same individual serial number. A different note from the same series, that happens to be fungible with it, even though in all material respects identical, would not do. If, for example, I give you my security to look after, you must give me that exact piece of paper back. If I title transfer my security to you, with the expectation you will title transfer the same security back, I give up all my ownership of that security. You can do with it what you will, but must at some point give me back a note that is fungible with what I gave you, but not need be exactly the physical piece of paper I gave you, and I am in exactly the same financial position.

As I say, all very moot in the age of electronic book-entry clearing.

Why do accountants care? Shouldn’t the simple fact that they do be enough? Well, it has to do with making sure the original transfer was a valid, absolute title transfer, so that the recipient can be confident it may freely deal with the security as long as it has it, and its only obligation is a debt claim back to the original transferor. This may also be important for the seller, if it is wanting the asset off its balance sheet.[2] If I give you a security by title transfer, but you must give me back precisely the security that I gave you — the very one; not just a fungible equivalent — then this suggests that I retain some claim to or ownership right over the original security I gave you. This in turn implies you are not free to deal with it, as in some way it remains mine: I have not fully transferred title to that security to you. By agreeing you may settle our debt by returning an equivalent security, it puts beyond doubt that you are free to deal with that security as you see fit, and when it comes to reversing out the transaction you can just go and buy in a security from the market, and we avoid the sort of anxiousness that can plague accountants.

Now, when it comes to return it, dilemma: you’ve been mucking around with it. You don’t still have “it”. You could go and buy a new “it” and return that, but the exact old “it” they gave you — that’s goneski.

Look: you got it by title transfer, so it was yours to muck around with, wasn’t it? Or, look, so they only pledged it to you, but you had the right to rehypothecate it, didn’t you? You were allowed to muck around with it.[3]

All true. And just so. In any case, you want to hand over something that is identical to, but isn’t exactly the something that you were given. But it is exactly the same. For most purposes in this day and age that is fine, and indeed will support your title transfer analysis, should you be in the market for a true sale opinion.

When, as all of them these days are, your securities are dematerialised and held in a clearing system, this might seem an arid distinction, but it is one you must keep in mind when considering the fundamentals of our business — close-out netting, stock lending, rehypothecation (anything that involves a title transfer collateral arrangement, really) — lest the whole intellectual superstructure of modern credit risk mitigation should collapse before your eyes. Or on you.

Equivalent” isn’t just “similar”

You may come across someone (in OTC Clearing/CCP space) who wants to modify “equivalent” to mean not just fungible securities of the same Series/ISIN, but “similar ones” – same issuer, but different maturity, and under a different ISIN etc.

Resist this. It is likely to have arisen by way of misapprehension. In most master docs, “equivalent” is carefully defined to be exactly fungible [4]but at the gallop at which most collateral operations managers’ working days pass, they may have missed this, labouring instead under the illusion (based on its ordinary dictionary meaning) that “equivalent” allows redelivery of non-fungible securities of a “similar” type. They may even defend their misapprehension. “Yeah, they may protest, “but what if there’s some illiquidity in the market?”

But — well, you have that exact risk across your entire ISDA collateral book, so it’s a bit late. In practice, if there is a market disruption and you can’t get hold of the necessary collateral, as long as it doesn’t coincide with your own credit deterioration[5], you should be able to hash it out.

And if you are worried about it, go for a cash-only CSA — these days most are — or don’t allow potentially illiquid assets as collateral, or just don’t reuse that asset.

Now there may be a need for the “similar securities” concept in the OTC to CCP space that we haven’t yet divined, doubtful, but let’s say — but we should call that something else – perhaps “Similar Credit Support” – to differentiate it from “Equivalent Credit Support” which is still needed in the CSA to support the title transfer analysis.

See also

References

  1. Actually, maybe it does mean something on a blockchain: each entry in the legible is its own distinct thing, defiantly non-fungible, ontologically, even if it is fungible financially. Odd.
  2. Though, if you simultaneously acquire a right or become obliged to take the equivalent security back, good luck getting it off your balance sheet.
  3. Or, just as commonly and more innocuously, you held it in a dematerialised omnibus custody account, with fungible assets owned by other customers, and never did anything with it, but you still can’t tell whose bit is whose.
  4. See: 1995 English Law CSA: “Equivalent Credit Support”; 2010 GMSLA: Equivalent; Global Master Repurchase Agreement: Equivalent.
  5. I mean, imagine.