The Libor Change Is Coming

One trick that you learn pretty early on in the derivatives business is that every derivatives trade comes with a little lottery ticket that is sometimes called “restructuring value.” The idea is that if you are a bank, and you have a complicated long-term derivatives trade on with a client, there is some chance that the client will, at some point during the life of the trade, come to you and say that they need to modify or cancel it for some reason. Maybe their views have changed, maybe the trade has moved against them in an embarrassing way, maybe it has moved in their favor and they want to harvest the cash, maybe they’re getting acquired and closing out their old trades, maybe new rules have made the trade less attractive, maybe they have some weird tax or accounting need, I don’t know, there are all sorts of reasons that they might want out of their long-term derivative contract with you. You, meanwhile, are a bank; your derivatives trades are all hedged, and you don’t care unduly about staying in or getting out of any particular trade. And you have a contract, so they’re stuck dealing with you. The negotiating leverage is all on one side. And so you charge them an arm and a leg to change the deal.

You generally can’t know that this will happen in any particular trade. And there are some types of trade where it basically never works; there are tons of liquid derivatives products with no real leverage where, if the customer wants out of the trade, you just have to get out at a reasonable bid/ask spread. But if you have a big enough portfolio of complicated illiquid derivatives trades, you will occasionally hit the jackpot on one of these restructurings, and it can make your year. It can be worth doing all of your trades at “scratch” — with zero expected value to you, based on conventional modeling assumptions — just for the chance that one or two of them will one day result in lucrative restructurings.