What Is Plain Vanilla?
Plain vanilla is the most basic or standard version of a financial instrument, usually options, bonds, futures, and swaps. It is the opposite of an exotic instrument, which alters the components of a traditional financial instrument, resulting in a more complex security.
- Plain vanilla is the most basic version of a financial instrument and comes with no special features.
- Options, bonds, other financial instruments, and economic modes of thinking can be plain vanilla.
- Plain vanilla is associated with low risk whereas exotic instruments are associated with higher risk.
- A plain vanilla strategy was deemed necessary after the financial crisis of 2007, which led to the creation of the Dodd-Frank Wall Street Reform and Consumer Protection Act.
Understanding Plain Vanilla
Plain vanilla describes the simplest form of an asset or financial instrument. There are no frills, no extras, and it can be applied to categories such as options or bonds.
Plain vanilla can also be used to describe more generalized financial concepts, such as trading strategies or modes of thinking in economics. For example, a plain vanilla card is a credit card with simply defined terms. Plain vanilla debt comes with fixed-rate borrowing and no other features, so the borrower has no convertibility rights.
A plain-vanilla approach to financing is called a vanilla strategy. Calls for this came after the 2007 economic recession when risky mortgages contributed to the housing market collapse. During the Obama administration, many pushed for a regulatory agency to incentivize a plain vanilla approach to financing mortgages, stipulating—among other tenets—that lenders would have to offer standardized, low-risk mortgages to customers.
Plain Vanilla Instruments
A vanilla option gives the holder the right to buy or sell the underlying asset at a predetermined price within a specific timeframe. This call or put option comes with no special terms or features. It has a simple expiration date and strike price. Investors and companies will use them to hedge their exposure to an asset or to speculate on an assets price movement.
A plain vanilla swap can include a plain vanilla interest rate swap in which two parties enter into an agreement where one party agrees to pay a fixed rate of interest on a certain dollar amount on specified dates and for a specified time period. The counterparty makes payments on a floating interest rate to the first party for the same period of time. This is an exchange of interest rates on certain cash flows and is used to speculate on changes in interest rates. There are also plain vanilla commodity swaps and plain vanilla foreign currency swaps.
Plain Vanilla vs. Exotic Options
In the financial world, the opposite of plain vanilla is exotic. So an exotic option involves much more complicated features or special circumstances that separate them from the more common American or European options. Exotic options are associated with more risk as they require an advanced understanding of financial markets in order to execute them correctly or successfully, and as such, they trade over-the-counter (OTC).
Examples of exotic options include binary or digital options, in which the payout methods differ. Under certain terms, they offer a final lump sum payout rather than a payout that increases incrementally as the underlying asset’s price rises. Other exotic options include Bermuda options and quantity-adjusting options.
Plain Vanilla and Dodd-Frank
There was a push to make the financial system safer and fairer in the wake of the 2007 global financial crisis. This was reflected in the passing of the Dodd-Frank Wall Street Reform and Consumer Protection Act in 2010, which also enabled the creation of the Consumer Financial Protection Bureau (CFPB). The CFPB enforces consumer risk protection in part through regulating financing options that call for a plain-vanilla approach.
In 2018, President Donald Trump signed a bill easing back some of the restrictions on all of the nations banks except those considered to be the largest. This included raising the threshold at which they are deemed too important to fail from $50 billion to $250 billion and allowing the institutions to forego any stress tests. The CFPB was also stripped of some of its power, notably its enforcement of cases involving discriminatory lending practices.