Sustainability-linked derivatives
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Sustainability-linked derivatives
/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. The decaying root systems compromised the soil, which accelerated erosion, in which nutrients were washed away, plants could not regrow and eventually the whole ecosystem was wrecked. The island became all but uninhabitable.
This was quite the disaster in the service of trying to please some 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[1] in which a community of earnest toilers, meaning to vouchsafe everyone’s onward prosperity, but in the throes of a voguish collective delusion about what is required sets about wasting every tree in sight pursuing mad, hypercomplicated and illogical schemes for imaginary investors who no-one has seen, let alone heard expressing such an interest.
What is ISDA up to? Is It trying to stay relevant? Clumsy land-grabs of ICMA/ISLA territory and forays into crypto give that impression. In any case, the irony that ISDA’s latest foray into the new normal — “sustainability-linked derivatives” — should so resemble a notorious example of environmental disaster is rich.
Even so, this feels like a step further through the looking glass, a tumble deeper down the rabbit hole. Previous follies at least tried to cater to existing markets and regulatory imperatives, however cack-handedly.
Sustainability-linked derivatives feel like an attempt to create a new market out of — ~cough~ — hot air.
How they are meant to work
If its discussion paper is anything to go by, not even ISDA has a clear idea what a sustainability-linked derivative would look like. The best guess is that it would be a sort of plug-in to a normal swap — say an IRS — containing a ratchet device to adjust the parties’ respective spreads dependent on their own compliance (or not) with certain 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 greenwashing risk is the least of the problems here.
Nor is this a derivative in the sense normally understood. It is more like a random 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 be bothered to do (seeing as it will bugger up your marginal carbon footprint) —no idea at all. If it is a derivative, it is a self-referencing one. They don’t much like those, usually, at ISDA.
So this becomes an open invitation to systematic insider dealing on ones own operations. And that is assuming a wily trader stays long only. But swaps are by their nature bilateral. What is to stop buisnesses shorting their own sustainability credentials, incentivising their own transition towards carbon and modern slavery? Why should another swaps trader care?
Speaking of whom, what has any of this to do with one’s trading counterparties? What benefit accrues to the environment when one swaps desk does, or does not, pay, cash away to another? Why would someone else’s swaps desk make itself hostage to my compliance effort? Why should it suffer a discount — a penalty — just because I have cracked my gender pay gap? (Isn't there reward enough in just doing that?) Commerce does not work by offering emoluments to virtuous strangers. Swaps traders certainly don’t. Besides, how are you supposed to hedge that?
The sustainability a counterparty should really care about is that of its counterparties’ solvency. That kind of good corporate governance — and sorry, millennials, the JC is with Milton Friedman on this: that means focus solely on shareholder return — is after all reflected in my credit spreads: how likely does the market regard my bankruptcy.
My brokers will not let me off my credit premiums just because I care about the polar bears. If they don’t get their money back the knowledge that I did my bit for African water scarcity will be cold (wet?) comfort.
This is coded into my spreads when I trade swaps. But once traded, these are not then adjusted during the life of the trade — 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. Hardcore Libtards may differ — we are all libtards now — but nothing has changed.
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. These aren’t even derivative at all. They penalise, and reward, innocent parties.
See also
References
- ↑ 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.