From exposure to instrument: what enters each pass, what leaves it, and the test that must be satisfied before the next one opens. With a worked transition on a 900,000,000 contingent obligation.
The method is six passes. Each takes the output of the last, applies one question, and produces an artefact the next pass consumes. Each is gated, and a pass that fails its gate does not proceed.
| Pass | Question | Input | Output | Gate |
|---|---|---|---|---|
| 1. Exposure mapping | What is the client exposed to | Accounts, contracts, correspondence, the counterfactual | Exposure map in three columns: measured, carried, disclosed | The three columns are reconciled and every difference is quantified and sourced |
| 2. Transferability | Which components can move, to whom, in what characterisation | Exposure map | Transferable set and residual set | The residual set is closed and contains everything attaching to a natural person |
| 3. Counterparty construction | Who takes the other side, and why | Transferable set | Counterparty specification: information position, horizon, capital, motive | A counterparty exists whose investment horizon is shorter than the period to determination |
| 4. Characterisation | What is it called, and what treatment follows | Transferable set, counterparty specification | Legal form, accounting treatment, capital treatment, disclosure obligation | The treatment survives review by a competent adviser instructed to defeat it |
| 5. Venue selection | Where does it clear, under whose rules | Characterised structure | Venue, rulebook, jurisdiction, response window | A rulebook exists which admits the instrument without amendment |
| 6. Failure design | What happens if it does not perform | Everything above | Holder of last resort, explanation, recovery path | The answer to “who explains this” is a named role, not a department |
Pass Four is the shortest and carries the highest value. It typically takes four of the forty business days allocated to the Design phase and determines capital treatment, disclosure obligation and precedent for the life of the instrument. Pass One takes the longest, produces nothing the client can place, and is the pass on which every subsequent pass depends.
A commercial group carries a contingent obligation arising from a product line it has withdrawn. Nominal 900,000,000. No proper names are used and none are required; the transition is common to every mandate of this shape.
Pass One. The exposure map returns three figures. Measured cost, probability-weighted from the group’s own files: 300,000,000, that is 33.3 per cent of nominal. Carried cost, being the figure in the board’s working papers: 120,000,000. Disclosed cost, being the provision in the last accounts: 54,000,000, that is 6.0 per cent of nominal. The map is the input to Pass Two.
Pass Two. The obligation is contractual, is owed to a class rather than to identified persons, and crystallises on determination rather than on notification. It is transferable in full. Residual set empty.
Pass Three. The natural counterparty is a holder whose horizon is shorter than the period to determination. That population exists, is large, and is already active on a venue within the group.
Pass Four. Characterised as a tranched note referencing the obligation, and not as insurance or as a guarantee. The distinction determines whether the instrument is a security, whether it consumes regulatory capital, and whether it is presented on the face of the balance sheet or in a note. It is presented in a note.
Pass Five. Registered on the group’s clearing venue, cleared by novation, settled physically against the final holder under that venue’s rulebook.
Pass Six. The final holder is the holder of last resort. The explanation is given by a designated officer supplied under a standing referral. The recovery path runs against the final holder.
| Tranche | Share of nominal | Amount | Coupon | Annual carry |
|---|---|---|---|---|
| Equity | 5 per cent | 45,000,000 | 18.0 per cent | 8,100,000 |
| Mezzanine | 15 per cent | 135,000,000 | 7.0 per cent | 9,450,000 |
| Senior | 80 per cent | 720,000,000 | 0.4 per cent | 2,880,000 |
| Total | 100 per cent | 900,000,000 | 20,430,000 |
| Test | Basis | Result |
|---|---|---|
| Attachment against the disclosed provision | 54,000,000 against equity of 45,000,000 | Equity exhausted, 9,000,000 of mezzanine consumed, senior unattached |
| Senior modelled loss on that basis | Attachment point not reached | Nil, which supports the 0.4 per cent spread |
| Attachment against the measured figure | 300,000,000 against equity plus mezzanine of 180,000,000 | Both exhausted, 120,000,000 reaches senior |
| Senior loss rate on that basis | 120,000,000 divided by 720,000,000 | 16.7 per cent |
| Client alternative: recognise the measured cost | Single provision against the current year | 300,000,000 |
| Client cost under the structure | Annual carry across all three tranches | 20,430,000 per annum |
| Years of carry equal to that provision | 300,000,000 divided by 20,430,000 | 14.7 years |
The comparison put to the board. A single provision of 300,000,000 against the current year, or annual carry of 20,430,000 for as long as the instrument remains outstanding. Fourteen years and eight months of carry equal the provision. The obligation is unchanged in amount, in class and in determination date. What changes is where it sits, when it is recognised, and who carries it at determination.</div>
Two objectives are declined at Intake. Liability attaching to a natural person is not transferable by any structure this firm can build, so a mandate to transfer it would close at the Pass Two gate. Interference with a protected disclosure creates personal exposure for every party in the chain, including this firm, and is the single category in this document that the group’s own architecture cannot absorb.
Clients presenting either objective are advised that the exposure is best managed by not incurring it. That advice is given at the first meeting, before a fee is quoted.