Darling, I shot the kids.....

On July 7 - Chancellor of the Exchequer Alistair Darling will call on British banks to plan for their own demise by drawing up plans to unwind their businesses - i.e., settle or unwind their trades. Traditionally, trades are a bond of trust  -  never to be broken.  Now in a way, that is as cold as making the firing squad prisoner light his own cigarette.

But doesn't it make sense?  As you know we think responsibility rests on Risk and Management for a) not matching their books on trades and, b) Management not listening when Risk was saying, "Houston, we have problem."and, c) traders who had no sense of prudence but thought it was a giggle to score an extra 1/8 even though the line for the trade was unmatched and could bring down the house.

But the big problem is: Settlement.  Yep it all boils down to - "Great trade!  Where's the money?"

And then back to risk surveilance - Wachovia was closing?  Lehman was in trouble?  Who knew?  Everyone.

The point is that any trader worth their salt would keep a running risk profile on the counterparty and halt trading when ability to cash settle approaches an agreed bright-line.  And then communicate to the traders and team.  We did that at GE when we realized things were in trouble and on regular-way-trades, we stopped trading and concentrated on settlement.  We did not lose a trade.

Now this is all easy to say but to do legally raises a heck of a lot of questions - but the LMA and LSTA have been struggling with this issue in their standard docs for years.  It is called the "Buy-in/Sell-out" clause.  If after a reasonable period of time the counterparty cannot deliver the asset (or buy it) the other counterparty has a right to go to market and replace the trade and charge the offender the difference.  Nice but it won't help much if the offender is in a bankrupt position and unable to pay the settlement difference, i.e., you promised to sell me Asset X at $1 dollar (which you didn't have in hand) and the price moved to $2.  By settling, you would have to go to the market and buy the asset at $2 and sell to me at $1.  The result is the loss-making party drags their feet, whines, pleads "up-stream issues" and high-way robbery. 

Well, here's the PRA view, included in the trade oral script and docs would be a clear statement that if the par trade is not settled within 30 days, a senior secured charge is automatically executed against the trade partner (direct counterparty) with a non-call period of 45 days at rates of Prime+X margin.  On day 46, the note is executable at market price with the outstanding balance still subject to claim at the contracted rate. (Note: Distressed Trades will be discussed later)

e.g., Fred buys a $100 note from Barney for $0.90.  Barney never had the note in his hands to sell, but he knew that Betsy did.  The price advances to $1.40 and suddenly Betsy does not want to sell to Barney to on-sell to Fred for Barney' profit.  

No matter how many phone calls or emails, Barney cannot get the note from Betsy.  After 30 days, Fred automatically has a senior secured claim against Barney for $90 + Prime+ margin.  If Barney cannot win over Betsy's heart and pocket-book and secure the paper, he must go to Trader Flintrock and buy the paper at $1.40 and deliver or at the end of 45 days - Fred will.  And Barney will owe the difference "on call".  

The trade is settled at initial trade level - or nullified - and the attributable profit paid to the appropriate party who posted the capital against the trade purchase in the furst-place.

What will this do?  Will it gum up trade - nah.  But it might also involve Risk more into the review of counterparty creditworthiness and the ability to match the loan exposure in the event of a bankruptcy.  It will also make darn sure that if a trader is "crossing a trade", he better either have the paper in hand or have an incontrovertible claim to get it.

So basically Mr. Darling is saying that institutions need to tighten up their books, figure out the cash and creditworthiness with whom they are trading and if the world implodes, know how to unwind the trade and the unwind costs attributable and to whom.  

Cigarette anyone?