Credit Derivatives

i. We have begun to see that credit derivatives are a type of synthetic financial object capable of creating or destroying, extracting or injecting, distributing and redistributing a variety of risks and cash flows. As such, they are also a process by which the economic properties of risk and cash flow are synthetically created or destroyed, extracted or injected, distributed and redistributed to the parties of the exchange.

The counterparty in a synthetic financial exchange could be specific market participants –such as a hedge fund, bank, pension fund, and so on; or through the process of structured finance could be the capital markets more broadly. However, there is no technical impediment to the counterparty either being a horizontally-organized set of nomadic groups, the State, or even some instrument for universality which would render the State, as such, obsolete. It is in fact very possible that the historical-materialist trajectory of synthetic finance points in this very direction.

Counterparties to a credit derivatives exchange are purchasing the economic properties of risk and associated cash flow. In this respect, single-name credit derivatives are a technology for exchanging the risk and cash flow attached to some generic financial asset, the latter of which in turn is in some way virtually connected to some physical object, or what we call a ‘classical object’, e.g. as a house qua physical referent is to a mortgage qua generic financial referent, and so on. And yet we have repeatedly observed that, as with any synthetic exchange, all this occurs without actually exchanging either the generic financial asset or the classical object to which it is ostensibly linked, and which acts as the referent to the (synthetic) exchange. It is therefore no overstatement to say that with the advent credit derivatives we see the ruse of private property laid bare: if a cash flow is capable of being traded without the physicality of the object changing parties, or being moved about in space or transformed whatsoever, it is because the intrinsic essence of any economic object is its exogenously effected heterogeneous mess of economic properties, n-dimensionally determined, and which are not essential or intrinsic to it. So if the truth of any exchange is its objectivity as capital, and whose materiality is ultimately defined by its cash flow, synthetic exchange illustrates the wholly-inobjective nature of the asset, insofar as the asset qua object just ‘happens to be there’ as an extrinsic manifestation of the process of the exchange. Insofar as any economic object is its total set of economic properties, when such objects are in process by way of synthetic financial exchange, such properties are mobile, plastic, and fungible, i.e. capable of being created or destroyed, extracted or injected, distributed and redistributed elsewhere.

For this reason, in our definitions of a credit default swap and total return swap we commenced our illustration that the progressive differentiation of synthetic finance from out of generic finance signals an important phase transition in our dynamical system of economic institutions, with deep historical-materialist significance. In large part, vindication of this assertion is predicated on the progressive fungibility of synthetic symmetry –whose ontological significance will demand a more in depth examination.

Presently, let us consider two elementary concrete examples to solidify our foundational understanding of credit derivatives, as we begin to deepen our understanding of this aforementioned truth.

ii. Our first example is that of a single-name CDS.

Let us say that PB has purchased a senior secured bond issued by Marx Corp., whose notional value is $75 million, payable after 10 years. PB seeks to lessen, or hedge, its risk exposure to Marx Corp. (since PB has become increasingly anxious that the latter has trouble completing projects). PB thus enters into a CDS with PS. The notional value of the CDS is $50 million, with Marx Corp. as the reference entity, and senior unsecured bonds as the reference obligation (the referent). The terms of the CDS contract obligate PB to pay a protection premium of 75 bps to PS over the tenure of the contract, which is five years. According to the terms agreed to in the contract, settlement may be physical delivery or in cash.   

Let us consider some basic material features of the asset convoked into being by this synthetic financial exchange.

To begin with, we have stated at the outset that PB is transacting the CDS for hedging purposes, insofar as PB owns the reference asset –which is the generic financial asset of a senior secured bond of Marx Corp. But this need not have been the case; PB could have just as readily transacted the same swap without owning the debt obligation of the Marx Corp. bond, since the requirement placed by the other two classes of exchange (i.e. classical exchange and generic financial exchange) on the unity of risk and physical possession is altogether dropped from a synthetic financial exchange. That is to say –and importantly–there has still been an acknowledgement of commensurability, equivalence, or symmetry between the synthetic object and its image of value as money –since symmetry is a necessary feature of any exchange, whether of classical objects, generic financial objects, or synthetic financial objects (indeed, lacking symmetry, no price will be agreed to, no exchange will occur). And yet we see that unlike in either a classical exchange or generic financial exchange, there is no necessary conjoining of actual risk exposure to a referent and physical ownership of the referent. For this reason we will say that in a CDS –as in any synthetic financial exchange– there is no required collinearity of risk and physical ownership. This also gives further meaning to our earlier assertion that with the advent of credit derivatives we are either witnessing the progressive abolition of private property, or if it still has any relevance to this class of exchange at all, it should be exclusively defined by substance of its risk and cash flow.

Along this same line of thought, our careful reader will have also become aware that, in the example above, there are a number of other basic ontological differences between the generic financial asset (of the Marx Corp. bond) and that of the synthetic asset (of the CDS). For instance, the actual bond held by PS has a maturity of 10 years, its notional value is $75 million, and it is a senior secured bond. However, by contrast the tenure of the CDS has a maturity of 5 years, its notional value is $50 million, and its referent obligation is a senior unsecured bond. For this reason we will observe that in synthetic financial exchange, in this case a single-name CDS, a number of restrictions, or ‘invariance requirements’, placed on the economic properties of the object in the other two classes of exchange are loosened or altogether dropped. The material significance of this is something we must examine in more depth. Such loosened invariance requirements marking synthetic exchange illustrates for us both the progressive fungibility of synthetic finance over the two other classes of exchange, as well as its natural proclivity for more radical usages.

Let us then briefly dwell on these loosened invariance requirements.

For example:

(a) As we observed above, there is no invariance requirement on collinearity of risk and propriety: e.g. the holder of the synthetically-replicated risk and its cash flow from the generic referent is not required to be owner of or otherwise proprietarily exposed to the generic referent.

(b) There is no invariance requirement on collinearity of tenures: e.g. the generic referent has a 10 year maturity, but its synthetic replica has a 5 year maturity.

(c) There is no invariance requirement on collinearity of notional values: e.g. the generic asset is for $75 million, but the synthetic asset is for $50 million.

(d) There is no invariance requirement on collinearity ‘in-kind’: e.g. the generic financial asset is a senior secured bond, but the synthetically-replicated asset is a senior unsecured bond.

We must further examine the ontological significance of this progressively relaxation on the collinearites present in the other two classes of exchange. What, if any, is the historical meaning of this progressive loosening of invariance requirements concomitant with the differentiation of synthetic finance as a class of exchange? However, for now, to begin with, it is enough that our reader recognizes that the required symmetry –i.e. between the economic object and its image of value as money– on which any act of exchange is predicated are nonetheless still achieved, while yet the invariance requirements on the economic properties of the object placed by classical exchange and generic financial exchange are loosened herein.

This means at least two things. First, it means that there are quantitatively different amounts of symmetry in each of the respective classes of exchange –classical, generic, and synthetic. For if, following the group theorists, symmetry is (a) defined as ‘invariance to change’, and (b) measured by the number of the transformations that leave a property of an object or process invariant to change, then the fact that different classes of exchange have different invariance requirements on their respective economic properties means that, in turn, different amounts of symmetry mark the different acts of exchange; and these different acts of exchange can be grouped into different classes of exchange. Secondly, then, for this reason we know that insofar as synthetic finance as a class of exchange has the least restricted invariance requirements, this means that it has more symmetry than either of the other two classes of exchange from which it has historically differentiated itself. We must deepen our examination of the ontological importance of these truths as we proceed.

iii. Our second example is that of a TRS.

Let us say that P has purchased, and is therefore generically invested in, an unsecured bond issued by Black Corp., which pays a fixed coupon of 7%. P enters into a TRS with R, in which P swaps the actual returns from the Black Corp. bond for the agreed-to spread of LIBOR + 100 bps. This means that under the terms of the contract, P will redistribute to R the actual coupon payments made by the Black Corp., plus or less any change in the market value of the bond. And in return, R agrees to pay P LIBOR + 100 bps.  

Let us consider some basic features of this synthetic financial asset, which is best accomplished by reflecting on the material impact of the TRS for the parties involved.

For instance, for P: while on the one hand and superficially it is the case that P has actually invested in the generic financial asset of a bond issued by Black Corp., on the other hand it is also the case that P is now no longer materially invested in the generic financial asset of a bond issued by Black Corp. And why? Simply, by entering a TRS with R, P has now detached the economic property of risk from that bond, and sold-off that risk to R, i.e. P has materially detached the risk from the generic financial asset by process of synthetic exchange, and redistributed that risk and its cash flow to R.

Conversely, for R: on the one hand and superficially R has not actually invested in the generic financial asset of the Black Corp. bond; but on the other hand by entering into the swap with P, it is also the case that R has purchased from P the risk in the Black Corp. bond –paying to P the purchase premium of LIBOR + 100 bps, and receiving from P the actual returns from the Black Corp. bond– yet without physically owning the generic referent of the Black Corp. bond itself.

From this we can observe that, in this case, the synthetic financial exchange of a TRS equates to an exchange between P and R of the total risks and associated cash flow endemic to holding the Black Corp bond, which are then redistributed in kind between the two parties. P retains as private property the generic asset of the bond, redistributing its actual returns to R. And while technically speaking R has not invested in and can otherwise claim no property ownership of the Black Corp. bond, nonetheless R does receive its actual returns, in turn agreeing to pay P the difference between the base rate spread and the actual returns. And finally, Black Corp. remains unaffected by the TRS nowise.

iv. Let us pause to briefly summarize both the material significance and significance for materialism of what we have thus far considered about synthetic finance, prior to further deepening our examination of its ontology.

We have so far really only made one point, but with a twofold-tiered exposition.

First, we observed in our example of the CDS that a synthetic asset replicates the generic financial asset from which it is ostensibly derived, but in the process loosens a number of invariance requirements on the economic properties that constitute the assets involved in the exchange –and which it is important to note are invariance requirements on the economic properties of the respective objects exchanged in the other two classes of exchange of classical exchange and generic finance. Therefore, while our common terminology often colloquially denotes the ontological status of the synthetic object as some kind of ‘copy’ or ‘simulation, a ‘replica’ that is always ‘derived’ from some ‘underlier’ –the latter of which is the generic referent acting as the ‘model’ for its ‘copy’, and is therefore always perceived to somehow be a more ‘real’ object than its synthetic counterpart– we are increasingly seeing that things are not so simple as this. In fact, that there are far fewer invariance requirements as conditions for the achievement of symmetry in a synthetic exchange means that not only are the economic properties constituting such synthetic assets more pliable and fungible, but now we’re also seeing that synthetic finance, as a class of exchange, has more symmetry than the other two classes of exchange from out of which it has historically differentiated itself. It turns out that synthetic objects aren’t so much ‘less real’ or have ‘less reality’ than other non-synthetic economic objects; rather, they have just as much reality, albeit it is of an apparently different ontological register. For this reason we will later examine why Deleuze says that of the three registers of reality –potentiality, actuality, and virtuality– the synthetic asset still partially belongs to the latter, which is every bit as ‘real’ as the actual, albeit ontologically different in kind.

Secondly, we observed in our example of the TRS that while a superficial understanding of credit derivatives may lend some cause for belief that synthetic finance –because its assets are temporally and linearly ‘derived’ from a generic referent– is an ontological subset of generic finance, once again we see that things are not as straightforward as one might expect. For already in our example of a single-name TRS, we saw that not only is it not the case that the causality of the generic financial asset is unidirectional on the synthetic asset, but now we see that a virtual causality from a synthetic exchange can be every bit as performative, material, and have very real material consequences on either a past (viz. preexisting) or even a future generic financial exchange. This means that the causality of the synthetic exchange on the generic exchange can be either linear or nonlinear –which is once more illustrative of the fungibility of synthetic finance. If the referent from a generic financial exchange appears to act as the underlying model to be copied by the synthetic asset, but then the performative impact of the synthetic exchange retroactively redefines the material terms of its underlier, how can we meaningfully speak of one or the other object as having ‘more reality’, when both sets of objects are constantly feeding into one another, and exogenously remaking each other’s interiority?

This twofold peculiarity requires a more in depth investigation into the ontology of synthetic finance –as a class of exchange that has differentiated itself from the other two classes of exchange, as a set of markets, the objects populating those markets, and in turn their constitutive mobile, fungible, and dynamical economic properties. This a future task for speculative materialism.

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