Messy Markets

Lessons in Reading Fine Print

In case you missed it, Venezuela defaulted last week.

Messy is a word that a lot of people are using to describe the situation.

Whether a country is in default is a deceptively tricky question to answer. It highlights one critical question for investors: what is it that I actually own?

For Venezuela, the saga of uncertainties began when its state-owned oil company failed to make a timely payment on its bonds. Venezuela claimed that cash was on its way. Bondholders agreed that they were okay with holding their breath. Even as S&P and other agencies started to declare the country and its oil company in default, The Emerging Markets Traders Association, an organization that attempts to set standards in these markets, decided to continue to trade bonds with accrued interest. This belied an assumption, or perhaps a hope, that the bonds would continue to be paid.

Meanwhile, ISDA, another trade organization, put off a decision on whether or not to deem the country to be in “technical default”. ISDA, comprised of banks and other market players, is tasked with determining whether or not credit default swaps (those notorious insurance-like contracts) should be triggered. There is lots of fine print around how this goes down, including rules about grace periods and what assets can be implicated. After a few days of delay, ISDA’s members agreed that Venezuela’s missed (late?) payments did constitute a credit event.

Under normal circumstances (if there are such things in a sovereign default), negotiations for an orderly restructuring would now be getting underway. Restructuring is the process whereby defaulted issuers renegotiate the terms of their loans with their bondholders.

But the question of what rights and recourse bondholders have is a complicated one. While some bondholders might agree to negotiate, other bondholders might retain their right to “holdout”, hoping or scheming to get repaid in some other manner. In the case of Argentina’s default, one group of holdouts waited roughly ten years for payment, employing tactics ranging from the litigious to the absurd.

Venezuela is facing its own problems in attempts to restructure. The Trump administration’s sanctions on the country bar US-regulated banks and asset managers from agreeing to a deal. And to make matters worse, those sanctions are also making it difficult for the country to retain legal counsel to advise them on what to do. Due to a larger geopolitical game, bondholders have found themselves without some of the rights they might have otherwise expected.

The last resort option for bondholders is always seizure of assets. But it’s not even clear what assets are up for grabs here. (See the infallible Matt Levine for more on the subject.)

Sovereign debt markets are highly regulated and are known for their pitfalls and their penchant for things to go pear-shaped. But even here, you’ll find plenty of investors who didn’t quite realize what they were getting themselves into. And even with all these established processes and practices and trade organizations and seasoned market participants… well, it’s still a mess.

It all comes back to that slippery and ill-understood question for bondholders: what do I actually own? Answering this question involves lots of time spent reading through heavy bond indentures, gaining an understanding of market practices — and that’s not to mention the money spent on legal fees.

Conventional Warren Buffett wisdom tells us not to buy what we don’t understand. Most people take this as a warning to do your research on the fundamentals of an investment. But for Venezuela, having an understanding of the country’s economic situation would never have been enough. You also need to understand your rights as a bondholder. What do you actually have a claim on?

Anyone investing in tokens would do well to take heed of these lessons. When you are dealing in emerging markets, you are better off treating assets as distressed before the market forces you to. This means doing the due diligence to understand your rights (or lack thereof) as a holder. Crypto is the ultimate emerging market right now. It does not yet have expectations for disclosures. There are no covenants or indentures. It’s not even clear to me where tokens would lie in a cap structure. Market best practices don’t exist and there aren’t really trade associations to set standards.

Good investors in tokens will understand the technology behind what they are buying. Better investors will ask questions about the team and the roadmap for the project. But the investors who will have staying power will be the ones who have researched their rights as holders — and who have done so before the market starts to get messy.