Myths and legends of the market
The JC’s guide to the foundational mythology of the markets.™
/səsˌteɪnəˈbɪlɪti lɪŋkt dɪˈrɪvətɪvz/ (n.)
It is said that the ancient people of Easter Island felled every tree on the island while erecting statues to their Gods and ancestors. Without the root systems the island’s topsoil crumbled and eroded, nutrients washed away, plants did not grow and eventually the whole ecosystem was wrecked. The island became all but uninhabitable and has not recovered in 400 years.
The magnificent statues remain, but still: this was quite the disaster in the service of trying to please imaginary people.
This “ecocide” theory, popularised by Jared Diamond a generation ago, is out of favour with hand-wringing snowflakey academic types nowadays. ISDA’s council of elders may feel the same way about the JC’s corresponding “swapicide” theory, in which a community of earnest toilers, bent on vouchsafing collective prosperity but caught in the throes of a voguish delusion that everything is different this time sets about demolishing every tree in sight in the pursuit of mad, hyper-complicated, illogical schemes to solve imaginary problems for nonexistent investors.
No better example could there be than its initiative to introduce sustainability-linked derivatives. What is ISDA up to? Is It trying to stay relevant?  Are we watching an industry association having a midlife crisis?
There has always been something quixotic about an organisation whose avowed purpose is to promote “safe efficient, markets” and which promulgates things like credit derivatives, but even so this feels like a step further through the looking glass; a tumble deeper down the rabbit hole.
The ’squad’s prior follies at least tried to cater to existing use-cases, markets and regulatory imperatives, however cack-handedly. This new push feels like an attempt to create a new market no one is asking for out of — well — hot air.
How “SLDs” are meant to work
If its own discussion paper is anything to go by, no-one (yet!) has much of an idea what a sustainability-linked derivative should look like. ISDA proposes a sort of plug-in to a normal swap, containing a ratchet. This would adjust spreads on the parties’ respective payment obligations dependent on their own compliance (or not) with pre-agreed ESG key performance indicators.
Now, objectively measuring environmental impact is hard, and open to abuse, even when you aren’t talking your own book. But even so, greenwashing risk is the least of the challenges here. Higher up the list is attaining basic intellectual coherence.
For a start, this is not a derivative in any normally understood sense. It is more like an arbitrary penalty clause: a payment derived not from some observable third party indicator, but an internal metric entirely within the counterparty’s gift to game: it knows what targets it can and cannot plausibly meet; its counterparty has — short of due diligence no-one will care to do just to execute a swap (among other things, it might bugger up your marginal carbon footprint) — no idea at all.
Insofar as an SLD is a derivative, it is a self-referencing one. They don’t much like those, usually, at ISDA. There is a reason they don’t let athletes bet on games they are playing in.
So this becomes an open invitation to systematic insider dealing on one’s own operations. And that is assuming a wily trader stays “long” her own firm’s sustainability performance at all times. But swaps are by their nature bilateral. What is to stop her shorting her own sustainability credentials, incentivising her employer’s transition towards carbon and modern slavery?
Secondly, the need for robust, measurable KPIs implies a grand, work-creating, rent-generating, carbon footprint-inflating bureaucratic infrastructure of little drones running about, setting targets, measuring them, publishing them, making determinations about them, resolving disputes about them and so on. Who is going to fund the sustainability determinations committee? And will it not do more environmental damage than it solves?
Thirdly why, exactly, should my trading counterparties care? What has any of this to do with them? What benefit accrues to the environment when my swaps desk pays more or less cash to theirs? Why would they make themselves hostage to my ESG compliance effort? Why would they agree to suffer a penalty just because I have cracked my own gender pay gap? (Isn’t there reward enough in just doing that, by the way? What does it say about economic incentives that we must bribe each other to promote our own staff fairly?) And besides, how are you supposed to hedge that?
Nor will these be a kind of synthetic carbon credit (and, anyway, ISDA already has a product for that). No money flows into tax or environmental protection coffers as a result under this proposal.
Commerce does not work by gifting emoluments to virtuous strangers just because they recycle shopping bags.
Financial sustainability much?
It feels like there is a category error here. The “sustainability” a financial counterparty should really care about is solvency. That kind of good corporate governance — and sorry, millennials: the JC is with Milton Friedman on this: that means shareholder return — is after all reflected in my credit spreads: how likely does the market regard my bankruptcy.
My brokers will not discount my credit premiums just because I care about polar bears. If they don’t get their money back, the happy knowledge that I did my bit for water scarcity will be cold (wet?) comfort. What will matter a lot more is that I make my payments on my swaps.
This is what is coded into my spreads. Spreads are set at trade date and are not then adjusted — hence a rich lifetime of employment for credit value adjustment traders. But in any case, my incentive is to manage my business as best I can so that when I trade I achieve the tightest spreads. That is all the incentive the market has needed, until now, to promote “sustainability”.
There is force in the idea that carbon credits are derivatives not so much of environmental damage as much as of regulatory fashion. SLDs aren’t event that. They aren’t a derivative at all.
- ↑ Guns, Germs, and Steel: The Fates of Human Societies, Jared Diamond, 1997.
- ↑ Sunk without trace: 2011 ISDA Equity Derivatives Definitions, 2022 ISDA Securities Financing Transactions Definitions, 2023 ISDA Digital Asset Transactions Definitions. Those that did bear fruit were no great scream of exhilarating clarity: the 2014 ISDA Credit Derivatives Definitions, 2016 ISDA Regulatory VM CSAs and 2018 ISDA Regulatory IM CSA being cases in point.
- ↑ Recent clumsy land-grabs of ICMA/ISLA territory, and forays into crypto certainly give that impression.
- ↑ Readers are invited to Google it and note how many management consultancies are shilling to help you do it.
- ↑ Readers are invited to Google this, too.