Collateral (1.3) — A Primer
What would defecting here cost you elsewhere?
What It Is · Key Takeaways · Do's and Don'ts · Pair With · Things to Explore
Jewish merchants trading out of eleventh-century Cairo consigned goods to distant ports they would never see, into the hands of men they had no practical way of suing. So they partnered up: one sold another’s flax in Palermo and was repaid with the same service on his behalf in Alexandria. In 1055 a trader in Jerusalem, Abūn ben Ṣadaqa, was accused of taking money from a dead merchant’s estate. Accused, but not charged in court. Instead, his correspondents stopped answering. One of them, in Alexandria, faced local embarrassment merely for receiving and reading his letters. Abūn denied the allegations and his denials met no resistance. But nothing changed.
What It Is
Collateral is credibility based on what an actor would lose outside the negotiation if he broke his word. It is the third pattern of Credibility, the first category of the Negotiation Pattern Language (NPL), where Ethos meets Substance. Track Record, a pattern grounded in the past, examines what an actor has done. Status assesses what his current position in a relevant hierarchy demands and allows. Collateral judges what defecting would cost him elsewhere. It is the only one of the three that works by deterrence. The question is not whether he is honest, but how expensive betrayal is.
The word doing the heavy lifting is elsewhere. Anything at risk inside the transaction itself belongs in structure: penalty clauses, escrows, cancellation rights. Collateral is external to the deal: a reputation to protect, relationships worth preserving, a license or accreditation to perform a profession. To have a constraining effect, the exposure needs to be real, it has to be visible to the counterparty, and the loss needs to be costlier than performing is.
Exposure comes in four forms, imposed by different people. Reputational is the general opinion of a market: the supplier who stops being invited to bid. Relational is a list of named people withdrawing something he depends on: the investor who made the introductions stops making them, the old client stops taking the reference calls. Positional relates to the seat itself, where the news costs a man his office and everything that came with it. Financial arises when the actor has personal skin in the game, not just his organization’s money at risk: a guarantee, co-invested capital. Because all four are claims on the future, the pattern has an expiry date. The same partner worth trusting to look after your interests mid-career may no longer be, close to retirement.
Key Takeaways
I. Everything visible still looks the same when the deterrent has died.
An actor may still show up with the same track record and status he always had, but with his future exposure gone. In appearance, nothing has changed. In reality, there is no longer an elsewhere for consequences to land in. A moral hazard setup may be equally invisible from the outside: the actor’s status hasn’t changed, in this case the exposure is still there—but somebody else absorbs the loss (a parent company, an insurer, a lender of last resort). In both varieties, the consequences don’t fall on the actor, who is therefore undeterred.
II. Showing exposure costs nothing; describing exposure proves nothing.
Genuine exposure is not automatically visible. An actor who is exposed, and counting on this collateral doing credibility-enhancing work, gives up nothing by opening it up for scrutiny. Constructive application of this pattern comes down to actively arranging the collateral to be inspected: introductions that let a counterparty ask about you when you are not in the room, public statements and commitments. Conversely, when a counterparty actively hides what he has riding on the exchange, that has information value. The actions reveal what the words try to conceal.
III. The bigger a counterparty’s world, the more of it is at stake in your deal.
A founder may have a lot at stake in the individual deal, but has little exposure outside of it. For the investment fund on the other side of the table, the deal may only be one in a hundred, and it is their reputation in all those others where they have a lot to lose. The question is whether their audience compares notes. In advisory, reinsurance and private equity, the repeat player cannot afford to be seen defecting; a big corporate dealing with many small suppliers who never meet is barely deterred at all.
IV. The enforcement machinery in a draft is a statement about the counterparty.
Warranties and penalties, limitations and cancellations—they exist to guarantee performance without relying on one’s word. To a real gap, they are the right answer. It comes with a signal though. A heavy legal draft tells you how the counterparty weighs your collateral. If you are the lead negotiator, consider whether you want to leave this signal-sending at the discretion of your legal department’s zeal.
A Few Do’s and Don’ts
Don’t Automatically assume the exposure covers your area.
Collateral is domain-specific, and not all of it travels to other fields. A surgeon’s standing among surgeons disciplines how he treats patients but does not constrain him in a real estate negotiation. And yet a man may experience his reputation as something he personally owns rather than something an audience bestows on him, causing the surgeon to take his professional standards into the property deal after all. Regardless of how sincerely it is felt, consider whether the actor’s exposure truly is to the domain that matters to you.
Do Look for stakes, not statements.
If a counterparty does not have much existing exposure, you can ask him to build it. Asking for a co-investment, a personal guarantee, or going on record to people who will remember: each of these costs nothing if he intends to perform and a great deal if he does not. Ask for one and observe what happens.
Don’t Treat a commitment as irreversible before you have priced the exit.
Irreversibility can be cheaply staged or hedged: commitments with disclaimers, guarantees with waivers, clauses with escapes. Test three things before you credit collateral: whether the exits are closed, whether the observers can act, and whether what is staked is the actor’s to lose.
Do Make the exposure run in both directions.
Symmetric arrangements, with both sides standing to lose from defection, have durability built in. It is a good thing to have agreements with strong external enforcement options; better still when the parties structure such enforcement internally. Some ancient and illegal examples are crude but remarkably effective, from exchanging first-borns between royal courts to organized crime codes of silence in which every member is at once hostage and enforcer. Introduced after the first dispute, these techniques signal distrust. To build them well, build them early.
Pair With
Status (1.2). Position generates exposure: the higher you sit, the deeper you can fall. The mechanism is reliable enough that most counterparties stop checking. Something working, most of the time, is a recipe for risk.
Structural Integrity (2.3). The fallback pattern when exposure is absent or cannot be verified. What cannot be trusted needs to be formalized, turning the relationship contractual. The surplus transactional cost needs to be carried to the extent trust remains absent from the relationship.
Reversibility (6.3). Exposure is the main source of soft reversal cost: what changing your mind costs you, compared to keeping your word. This is why repeat plays unfold differently from a one-off.
Things to Explore
The origin text
Avner Greif, “Reputation and Coalitions in Medieval Trade: Evidence on the Maghribi Traders” (1989). The case source. Eleventh-century Jewish merchants had no court spanning the distances of the Mediterranean, and Greif argues they enforced agreements by collective boycott: cheat one merchant, and none of them will employ you again. Read it with Jeremy Edwards and Sheilagh Ogilvie’s 2012 attack in the Economic History Review, if you are interested in the footnote battles on how much was covered by legal infrastructure after all. Search handle: Maghribi traders reappraised.
A case of moral hazard
Joseph Cassano’s testimony to the Financial Crisis Inquiry Commission, 30 June 2010. Cassano ran the London unit that wrote AIG’s credit default swaps. In August 2007 he told investors it was “hard for us, without being flippant, to even see a scenario within any kind of realm of reason that would see us losing one dollar in any of those transactions.” Thirteen months later the American government committed $182 billion to AIG. Reading the testimony itself reveals more than the coverage. He is unrepentant and argues that few if any losses would have been realized had the contracts not been unwound in the bailout. He may be right. Question is who would have carried the position for the time it took to find out. The transcript is free on the FCIC archive at Stanford Law.
A case of immoral hazard?
Ecuador, 2008–09. Sovereign credit rests almost entirely on this pattern, as no legal apparatus sits on top of the sovereign to force it to pay. In 2008 Ecuador stopped paying two bond issues which a government commission had declared illegitimate. The default was caused by unwillingness to pay as opposed to inability, a rare enough event that it sent specialists scrambling for precedents. By June 2009 Ecuador agreed to buy the paper back for 35 cents on the dollar, an offer 91 percent of bondholders accepted. Observe how long Ecuador subsequently stayed out of the credit market, and what coupon it paid upon return.
And one you would not expect
The storeroom at the Ben Ezra synagogue, Fustat. Jewish law forbids destroying a text that might carry the name of God. For nine centuries, the congregation in old Cairo didn’t throw anything in Hebrew letters away. Scripture—but also court records, marriage contracts, schoolboys’ exercises and commercial complaints—it all went into a storeroom. Solomon Schechter of Cambridge was given permission in 1896 to take what he liked, and took 193,000 fragments back to England (“I liked all”).
Almost ten centuries later, scholars are still debating how far the news about Abūn actually traveled: three hundred miles to Alexandria, or the whole way to Palermo. Regardless of the right answer, on the authority of the merchant’s own letters: he never rebuilt his network.
Collateral is pattern 1.3 of twenty-seven. The two axes, the nine categories and the full set are laid out in The Negotiation Pattern Language.