Potts opinion
|
Credit Derivatives Anatomy™
|
In the primordial times of Credit Derivatives — the Children of the Forest, the First Men and so on — wise people from JP Morgan and ISDA’s crack drafting squad™ worried that a credit derivative might be able to be characterised as an insurance contract. Bad for many reasons, not least of which that offering insurance is regulated business, requiring compliance with capital rules and so on.
The First Men did what prudent pioneers of financial products do, and sought wise counsel. In this case, a Mr Robin Potts QC, who in 1997 opined that a credit derivative should not be characterised as an insurance contract, because as it is generally structured to pay out upon a Credit Event occuring to the Reference Entity whether or not the buyer is exposed to the Reference Entity or otherwise suffers any loss.
At common law an insurance policy is “a contract to indemnify the insured in respect of some interest which he has against the perils which he contemplates it will be liable to.”
Credit default options differ from insurance contracts because their payment obligation does not depend on the Buyer sustaining or even having a risk of loss. The Buyer need not have an “insurable interest”.
This is so even through it could. Mr Potts did recommended, For the avoidance of doubt, “avoidance of doubt” shall mean the removal of (or outright refusal to face up to) any doubt, imprecision, ambiguity, double-entendre, alternative way of looking at things or other cognitive dissonance of any type, kind or nature whatsoever including, without limitation (and for the avoidance of doubt):
- (A) wilful, inadvertent or innocent misunderstanding on the part of any person, whether as the result of ambiguity, syntactic confusion, metaphor or innuendo;
- (B) insecurity, unease, lack of confidence or similar want of conviction about one’s ability, prospects of success or place in the universe, whether or not arising only during moments of weakness, darkness, tiredness or inebriation (and whether or not such insecurity can be easily cured by sobriety, daybreak, a decent lie-in or a hearty walk in the woods);
- (C) lack of certainty as to
- (a) the existence or occurrence of any other person, place or thing when not personally (or, in the case of a tree falling in a forest, hypothetically) observed; or
- (b) one’s own physical existence (it being acknowledged that one’s intellectual existence as a “thinking thing” (res cogitans) is beyond rational scepticism);
- (D) causal scepticism, casual scepticism or casual causal scepticism including
- (a) suspicion as to the necessary connexion, brought about by their apparent conjunction, between an outcome and its putative cause; and
- (b) any tendency to smugly point out others’ confusion between correlation and causation;
- (E) undecidability, incompleteness, uncertainty, irrationality, strange-loopiness, circularity, superposition, the requirement in one’s cosmology for unobserved dimensions or nested universes or any other paradoxes produced by theoretical physics or mathematics now or any time in the future (whether and howsoever “future” may be defined, and irrespective of the then-prevailing space-time geometry);
- (F) hesitation, procrastination, reluctance, lack of resolve or outright denial of plain facts of life; or
- (G) any other analogous neurological state that either party, acting in good faith and a commercially reasonable manner, determines to have materially compromised its ability to articulate itself a sensible and practical way.
that counterparties include a clause stating that they do not mean to enter into an insurance contract.
The Potts opinion is not without its critics — see Oskari Juurikkala’s impassioned arguments in the Helsinki Law Journal — in that but for this artificial distinction, the contracts can fulfil exactly the same role.