If the Other Side FailsNeeds one idea
Every instrument depends on somebody continuing to exist. Which somebody, and what happens if they do not, is a different answer in each of five structures.
4 min read · 692 words
What this page is. A map of who has to survive for a holding to be worth what it says. It describes structures, not the standing of any institution, and it makes no claim about the likelihood of any failure. Information and education only.
The question nobody asks first
- Most instruments are assessed on what they pay. The other question is who has to still be there for the payment to arrive, and the answer ranges from "nobody in particular" to "one named company, for the entire term".
- It is a structural question, not a matter of degree. Two holdings with identical economics can sit in different rows below, and in a failure the difference is total rather than gradual.
Five structures
| Structure | Who must survive | What failure looks like |
|---|---|---|
| Direct ownership | The issuer of the asset itself | The company fails; the share is worthless. Nobody else is involved |
| Centrally cleared | The clearing house | A member fails and the clearing house steps in, using margin and a default fund |
| Bilateral OTC | The named counterparty | An unsecured claim for the value of the contract, plus the cost of replacing it |
| Issuer-backed | The bank that wrote the certificate | The payoff is a claim on that bank, however the underlying performed |
| Custodied | Nobody, if segregation held | The assets are yours; the delay and the cash balance are the exposure |
Reading each one
- Direct ownership — a share or a bond you hold is a claim on the issuer and on nobody else. This is the case with the fewest moving parts, and the whole of the risk is the one described on what you get if the company goes bust.
- Centrally cleared — the clearing house becomes the counterparty to both sides, so nobody faces anybody else. It survives a member default using that member's margin first, then the default fund, in a published order. What it costs is daily margin, in cash, on schedule — which is a different risk, and the one the 2022 LDI episode is about.
- Bilateral OTC — a swap between two firms. Collateral reduces the exposure to the change in value since the last exchange, not to zero, and replacing the contract in a stressed market costs more than it did the day before. Margin and collateral is the mechanism.
- Issuer-backed — a certificate or structured note is a debt of the bank that issued it, dressed as exposure to something else. The tracker certificate page states this plainly: perfect tracking of an index is worth nothing if the issuer is gone.
- Custodied — a fund or a broker holding assets in your name. Segregation is what makes them yours rather than the firm's, which is why what happens if my broker fails separates the shares from the cash: the shares are typically returned, the cash is a claim.
What actually varies
- Whether the exposure is the value or the notional. On a cleared or collateralised contract it is roughly the move since the last margin exchange. On an issuer-backed note it is the whole amount. Two orders of magnitude, from a structural difference.
- Whether time is on your side. A collateralised position is re-secured daily. An unsecured claim accumulates for the life of the contract.
- Whether somebody else is watching. A clearing house is monitoring positions continuously. In a bilateral trade the monitoring is whatever the two firms do.
- Whether the failure is correlated with the reason you held it. Protection bought from a firm that fails in the same conditions the protection was against is the sharpest version of this, and it is why the identity of the seller is part of the hedge.
The three questions
- Who owes me, by name? If the answer is a company rather than a market, the holding carries that company's credit whatever its label says.
- Is it collateralised, and how often? Daily, weekly and not-at-all are three different instruments.
- What am I actually left holding on the day after? A claim in a queue, a returned asset, or a replacement cost — and the site's risk profiles mark which of the five failure families that puts each instrument in.