The next logical step in financial innovation that blends the concepts of CDO Tranches, Catastrophe Bonds, and Convertible Debt into single framework designed to early detect and swiftly deflect systemic shocks without resorting to bailouts or bankruptcy resolutions. It is ideally suited for blockchain implementation which is discussed in Part 4.

1. Next Generation
Financial Architecture
Part 1
Convertible Capital Structure
Eugene Kagansky
www.nordo.consulting
Inspired by lectures of
Professor Viral Acharya

2. Next Generation Financial Architecture Page 2 of 5
Introduction
Debt plays a major role in human lives. Debt can help people survive, companies to outperform,
countries to win wars. Failure to service debt can destroy families, companies, and sovereigns.
Debt is a powerful weapon of self destruction of both lenders and borrowers. As such, it shall be
at the center of the next generation financial architecture.
Major religions such as Hinduism1
, Buddhism2
, Judaism3
, Christianity4
, and Islam5
recognize the
dangers of debt and a rare consensus among them has been that lending for interest shall be
prohibited.
The proper way of lending money should be by taking a partner’s stake in the borrower’s
business. This turns zero-sum game between lender and borrower into either win-win or lose-
lose situation which eliminates a conflict of interests between the two parties.
Recognizing that such idealized state may not be achievable (at least in the near term), it could
be used as an inspiration and general direction for developing the next generation financial
architecture.
Objectives
The main objective of the next generation financial architecture is to shift the balance from debt
to equity markets through the standardization of capital structure of public corporations and the
use of innovative financial instruments facilitating efficient management of this capital structure.
The optimal capital structure should feature built-in, preemptive and corrective mechanisms for
dealing with conflict of interests and credit defaults. Such mechanisms would trigger predefined
course of actions for predetermined states of the world.
Financial instruments facilitating this standard capital structure would be debt-equity hybrids
eliminating or reducing the interest or changing its nature and contingent, convertible equity to
achieve an orderly capital restructuring.
1
Vedic texts of Ancient India (2,000-1,400 BC) mention the “usurer” which is interpreted as any lender at interest.
Hindu Sutra texts (700-100 BC).
2
Jatakas (600-400 BC) contain sentiments of contempt for interest were expressed.
3
Prophet Ezekiel equates interest to rape, adultery, murder, and robbery. (Ezekiel 18:8, 13).
4
Some verses from the Holy Bible prohibiting interest are, “Do not charge your brother interest, whether on money
or food or anything else that may earn interest.” (Deuteronomy 23:19).
5
The criticism of interest in Islam was well established during the Prophet Mohammed's life and reinforced by
several of his teachings in the Holy Quran dating back to around 600 AD.

3. Part 1 – Convertible Capital Structure Page 3 of 5
Financial Instruments
Debt-equity hybrids incorporate the element of partnership between lender and borrower and
change the nature of interest of traditional debt instruments. Two debt-equity hybrid
instruments are of a particular importance for their bankruptcy-remote features. Two contingent
equity instruments are essential for implementation of convertible capital structure.
1. Equity-coupon debt
Debt obligation that pays coupon in a form of common stock eliminates the risk of default
on coupon payments. This debt can be in a form of either bond or loan. A standard coupon
size will help concentrate secondary market liquidity for any given maturity and will make
the debt instruments more fungible across similar maturities.
2. Contingent Convertible Annuity
Debt obligation that pays interest for the life of corporate entity and converts into
preferred equity upon predefined daily price decrease of the common stock. This debt
instrument would eliminate default on the final payment of principal. It would be
different from preferred equity in that failure to pay interest on this debt instrument
would constitute a credit event. Absence of the maturity date and the standard coupon
of this annuity would concentrate secondary market liquidity in a single instrument
allowing it to be used as a revolving line of credit.
3. Contingent Preferred Equity
Equity ownership with limited voting rights in exchange for higher claim on assets and
earning that converts into common equity upon predefined daily price decrease in the
common stock. Limited voting rights as opposed to no voting right would compensate for
convertibility. Together these features would reduce the free-rider phenomenon inherent
in equity ownership.
4. Contingent Common equity
Equity ownership with full voting rights that assumes losses implied from predefined daily
stock price decrease as realized losses. Loss recognition takes place in a form of
predefined, prorated reduction of number of common shares owned.

4. Next Generation Financial Architecture Page 4 of 5
Capital Structure
Standard, unsecured capital structure as shown in Figure 1 would provide three means for
preventing and containing systemic risk:
• transparency and comparability across public corporations
• predictability, expediency, and self-sufficiency in restructuring
• continuity of normal business operations
Figure 1. Standard, Contingent, Convertible Capital Structure
Equity and Debt tranches should be all equal in size. This requirement would ensure a balanced
capital structure able to withstand severe financial shocks. Public corporations should be
encouraged to build up their capital structure from the bottom up sequentially through a tax
mechanism imposed upon the notional principal amount of all tranches above any missing
element.
Automatic convertibility into lower tranche of the corporate capital structure triggered by
medium and severe daily decreases of the common stock price would create a powerful
mechanism of preemptive and corrective restructuring respectively. Additionally, either of these
decreases would cause a change in the balance of power among equity holders and directly affect
the board of directors and senior management. It would serve as a deterrent against conduct risk
throughout the organization and discourage the asymmetry of information which inevitably
results in sharp changes of stock price.
Making Operational Liabilities senior to other unsecured debt is necessary for preserving normal
business operations and preventing the spill over of one firm’s problems to the rest of the real
economy. Employees Liabilities should be subordinated to those of clients and suppliers to
ensure employees accountability and minimize moral hazard within the organization.
Clients’ Liabilities
Suppliers’ Liabilities
Employees’ Liabilities
Operational Liabilities
Debt-Equity Hybrids
Convertible Equity
Equity-Coupon Debt
Convertible Annuity
Convertible Preferred Equity
Common Equity

5. Part 1 – Convertible Capital Structure Page 5 of 5
Conclusions
1. Dominance of Debt markets over Equity markets is the main source of Systemic Risk.
2. Shifting the balance of power from Debt to Equity reduces Systemic Risk.
3. Standardization of capital structure of public corporations provides transparency and
comparability across public corporations.
4. Convertibility of the standard capital structure of public corporations allows predictable,
expedient restructuring without disruption of normal business operations.