View source for Template:M intro isda When variation margin attacks

{{quote|
BLACKADDER: Look, there’s no need to panic. Someone in the crew will know how to steer this thing. <br>
CAPTAIN RUM: The crew, milord? ''What'' crew?<br>
BLACKADDER: I was under the impression that it was common maritime practice for a ship to have a crew? <br>
CAPTAIN RUM: Opinion is divided on the subject. <br>
BLACKADDER: Oh, really?  <br>
RUM: Yes. All the other captains say it ''is''; I say it ''isn’t''. <br>
:—Blackadder, Series 2: ''Potato''}}
{{d|Variation margin|/ˌveəriˈeɪʃᵊn ˈmɑːʤɪn/|n|}}

{{Variationmargindescription}}

{{drop|A|ny of the standard}} reference works<ref>Goldsmith, Armitage & Berlin, ''Teach Yourself Law'', Book IV; The Open University Criminology Course, Part I; The ''Perry Mason Book For Boys'', 1962, [[Aleebee|needless to say]].</ref> will tell you that [[variation margin]] is a good thing, apt for ridding the world of the kinds of systemic risk that have the habit of building up in the financial system. Since, like Captain Redbeard Rum, your correspondent is going to run against the conventional wisdom, let us set the scene with a story.

====Once upon a time in America====
{{quote|''Shares of ViacomCBS closed down 9% Tuesday, a day after the company said it would raise $3 billion from stock offerings. The stock offerings come just a few weeks after the company launched its Paramount+ streaming service, and the offerings will help the company bulk up its content. ViacomCBS said it would use the funds to power “investments in streaming,” among other general corporate purposes.''
:—CNBC, March 23, 2021}}
{{archegos capsule}}
=====The curious regulation of variation margin=====
Now here is an interesting thing: instead of buying the stocks outright, [[Archegos]] put on its positions using a product called “[[synthetic prime brokerage]]”. Being based on [[Equity derivatives|equity swaps]], [[synthetic prime brokerage]] is caught by [[Regulatory margin|uncleared margin regulations]]. This meant Archegos’ prime brokers were ''obliged'' to pay out ''un''realised gains<ref>For [[prime broker]]s charging “[[dynamic margin]]” this was partly offset by the effect of increased [[initial margin]] required on the inflated value of the position in question; for those charging only a [[static margin]] amount, there was not even that fig-leaf. </ref> or “[[net equity]]” to [[Archegos]], every day, in [[cash]], in the form of “regulatory [[variation margin]]”.  To be sure, prime brokers could impose  thresholds by way of [[initial margin]] — oh, that’s another story altogether — but over those thresholds, [[variation margin]] is — at least till the next margin call —the client’s money. It is entitled to withdraw it upon request. 

Now this is all completely normal in the world of latter-day [[Derivative|derivatives]]: regulators mandated [[variation margin]] into pretty much every major market on the planet following the [[global financial crisis]] ''in the name of reducing systemic risk'' — but all the same, in the context of [[Archegos]], it made a bad situation worse. It ''forced'' [[swap dealer]]s to lend to their client against appreciating assets that were increasingly likely to then ''de''preciate again.

Imagine if your bank, by law, had to pay you out the cash value of any increase in your home’s value during the term of your mortgage. Nuts, right?

Now had Archegos bought real shares using [[margin loan]]s from its [[prime broker]]s, the brokers would not have ''had'' to pay out the cash value any asset appreciation. To be sure, they may well have ''willingly'' done so – [[margin lending]] is how [[prime broker]]s make their money, after all — but being ''able'' to lend a customer money, and ''having'' to lend it money, are quite different propositions, ''especially on the day the whole world is going to hell''.<ref>It is fair to note that — with the possible exception of the vampire squid — [[Archegos]]’s brokers did ''not'' believe the world was going to hell, at least not until it was far too late. But the principle remains.</ref> 

===== A dissonance =====
So there is a [[dissonance]] between [[Cash prime brokerage|''physical'' prime brokerage]], where lending against [[net equity|assets]] is at the [[prime broker]]’s discretion — oh, sure, you may withdraw your [[net equity]] at any time, but you have to take it [[Payment in kind|in kind]]<ref>Withdrawing [[net equity]] in the form of the [[shares]] themselves, rather than their [[cash]] value, has a very different effect on the [[prime broker]]’s risk profile. It makes the client’s portfolio ''less'' volatile; withdrawing [[cash]] makes it ''more'' volatile.</ref> or liquidate your position, if you want it in [[cash]] — and [[Synthetic prime brokerage|''synthetic'' prime brokerage]], where cash payout of [[variation margin]] is required by law. 

That’s worth dwelling on, by the way: if you buy a share, it goes up and you then ''sell'' it — sure, you get all your cash, but you go ''off risk''. If the share price tanks the next day, no-one loses anything. You’ve closed out your stake and taken your money off the table. With [[variation margin]], you get to keep your stake ''and'' take your money off the table. 

Since, for swaps, this is required ''by [[Regulatory margin|co-ordinated world-wide regulation]]'', it doesn’t take great imagination to read across to physical positions since they are, to all intents and purposes, economically identical. “Hang on a minute,” clients will say, “you have to pay out my cash equity value under a swap, right? So why can’t you may me the cash value of my physical positions in the same way?”

On its face, this is a fair question, to which the answer is either: “Huh. I hadn’t thought of that. Yes, I suppose you are right. Here you go!” — call this the “all other captains” argument; or: “Well that just goes to show what a misconceived idea compulsory two-way [[variation margin]] is. There’s no way on God’s green earth I’m automatically paying out your equity in cash”.

The [[JC]] prefers the latter position.

“Come on,  [[JC]]: we you delight in pretending to be a cranky old bugger. But, really, do you mean to swim against the tide of all that consensus?”

Hold my beer.   
====Banking, in the good old days====
In the good old days — in the time of the [[Children of the Forest]], before the [[First Men]] — the overall vibe of the financial system was circumspect, self-imposed ''[[prudence]]'': musty institutions, staffed by Captain Mainwaring-types, providing stodgy, unflamboyant loans and broking services to clients who were grateful to be offered them, and who would produce whatever [[Surety|sureties]] their banks required as a condition to being allowed to do business.  

The financial services industry cleaved, basically, into two types of participant: ''intermediaries'' and ''customers''. We have waxed [[Look, I tried|elsewhere]] about the countless ways financial services institutions can contrive to interpose themselves into processes that oughtn’t to ''need'' intermediating, but let us, for today’s outing, take it as we find it.

===== Intermediaries =====
Intermediaries come in many shapes and sizes: market infrastructure — [[Exchange|stock exchange]]s, [[clearing system]]s, securities depositories and so on; those who earn only a [[commission]] from their involvement, and take no [[principal]] risk<ref>I include here “[[quasi-agent]]” roles that are conducted on a [[riskless principal]], but (absent insolvency) are economically neutral: thse participants are remunerated by [[commission]] or fixed [[mark-up]] and do not have “[[Skin in the Game: Hidden Asymmetries in Daily Life - Book Review|skin in the game]]”.</ref> — [[Cash brokerage|cash broker]]<nowiki/>s, [[Investment manager|investment managers]], [[Clearing broker|clearer]]<nowiki/>s, [[Market-maker|market-makers]] and [[Intermediate broker|intermediate brokers]]; and those who ''do'' take principal risk, but only by lending to their customers, and generally don’t participate in the upside<ref>Nor, for the most part, down-side, barring “gap losses” where, due to portfolio losses, the customer is insolvent and cannot repay its loan.</ref> of the investments they are financing: [[Bank|banks]].

All of these intermediaries have one thing in common: their remuneration does not depend on how their customer’s investments perform, until they perform ''so'' badly they cause the customer’s bankruptcy. Intermediaries do not have [[Skin in the Game: Hidden Asymmetries in Daily Life - Book Review|skin in the game]]. They are not supposed to lose ''any'' money, let alone billions of dollars of the stuff.

===== Customers =====
Customers, of course, ''do'' have skin in the game: they take all the benefits — less their intermediaries’ fees, commissions and financing costs — and are first<ref>Of course, if the investors should run out of sponges, or their buckets are all full, while there are still some losses left to go round, these get passed to the poor [[Bank|banker]]<nowiki/>s and [[Intermediary|intermediaries]] who may still be owed something. This is why we say investors have a “[[first-loss]]” risk: once they have been wiped from the horizon, any remaining losses go to the investors’ [[Creditor|creditors]], who thus have “[[second-loss]]” risk, whether they like it, or even know it, or not.</ref> to absorb the losses of their investments. They may be [[Professional client|institutional]] ([[pension fund]]s, [[investment fund]]s, multinationals) or [[Retail client|retail]] and while the range of investment products they can invest in will depend on their sophistication and financial resources, usually they are not subject to any kind of prudential regulation. Customers can, and do, blow up.

Speculative investment vehicles like [[hedge fund]]s may be highly [[Vega|geared]] and quite ''likely'' to blow up. This is where intermediaries have some [[second-loss]] tail risk: if the customer has blown up, the intermediary loses anything the customer still owes it. Investment funds have ''no'' capital buffer. When they “[[Gap-risk|gap]]” through zero, their counterparties absorb ''all'' remaining market risk, despite wishing to have none of it. [[Broker]]s, banks and and [[dealer]]s ''do'' have a capital buffer, and if their clients’ positions gap through zero, can usually absorb even significant losses.

In any weather, until the early 1980s, you were either a ''customer'' or an ''intermediary'' and the above was all quite well settled. 

But innovations in the market, technology and regulation began to change things.

====The multi-coloured swap shop====
[[File:Noel.png|right|frameless]]
The [[swap  history|history of swaps]] is interesting and well-documented. It all started in earnest in 1981, with a bright idea [[Salomon Brothers]] had to match up IBM, who needed U.S. dollars but had a load of Swiss francs and Deutschmarks, with the World Bank, which had all the dollars anyone could need but needed to meet obligations in CHF and DEM which it wasn’t able to borrow. The two institutions “swapped” their debts, exchanging dollars for the European currencies and paying [[coupon]]s on them, with an agreement to return the the same values of the respective currencies at maturity.

Everyone else recognised this to be a cool idea, and before you know it, swaps trading was a trillion dollar industry. Okay; this took twenty years, but in the geological history of finance from the time of Hammurabi, a couple of decades is the blink of an eye. 

But anyway, note a few things: unlike traditional banking activity where there is a lender and a borrower, and they stay put throughout the loan, swaps are ''bilateral''.  In one sense, ''both'' parties were lending to each other — hence they were not just parties, but “''counter''parties”.<ref>Or maybe this just means they sat at a counter. This has just occurred to me. Why not? These are [[OTC|over-the-counter]] derivatives, after all.</ref>  In another sense, ''neither'' was: as long as you could [[Set-Off|offset]] the swapped loans at inception, a swap trade is market neutral: each “lends” the other something of equal value.<ref>Law students will know this notion of enforceable set-off is a tricky one, especially if you are trading across international markets, where insolvency regimes are capricious, and might struggle to understand it, in a way they tended not to struggle with ordinary secured lending. Hence the great, tedious topic of [[Close-out netting|netting]], which isn’t wildly germane to this essay except to point out that [[Credit risk mitigation|credit mitigation]] for swaps by set-off, not security, and credit risk can swing around, depending on the market value of the underlying obligations.</ref>

But the respective values of those lent “somethings” do not stay put, and so the economic profile of a swap — being the [[prevailing value]] of one of those “somethings” minus the [[prevailing value]] of the other — does not ''stay'' neutral. Its “[[mark-to-market]] value” will change. Depending on how the cross-rates move, ''either'' party can be owed money. Hence, the concept of “[[moneyness]]”: on any day, either party to a swap can be “[[in-the-money]]”  — if the “something” it owes the other party is smaller than the “something”  the other party owes it — or [[out-of-the-money]], if it owes more than it is due. 

This whole idea of “moneyness”, and either party potentially being owed money, was quite a new thing, and it really challenged the philosophy of financial services regulation. Until now, there had always  been an intermediary and a customer, and you always knew who was who: the intermediary was authorised, regulated to provide its services and appropriately capitalised ''to protect the customer'';<ref>And its depositors: also customers.</ref> the customer didn’t need to be regulated as it the intermediary could obviously look after itself.

Swaps challenged all that: now ''either'' party could be creditor or debtor. It was hard to know who to regulate. Who needed protecting from whom? Did they ''both'' have to be regulated? Or ''neither''? For the first couple of decades, the answer was basically “neither”.<ref name="fwmd">Hence widespread allusions to the wild west, [[Locust|locusts]], [[Black swan|black swans]], casino banking, [[financial weapons of mass destruction]] and so on.</ref>

===== Intermediaries, redux =====
So, the clarity about who was an intermediary broke down a little. Swaps did not necessarily need an intermediary at all, though in practice these days there usually is one: the very first swap, between IBM and the World Bank, was between two customers, or “[[end-user]]<nowiki/>s”, in that each took principal risk to the transaction. And there is an entire realm of swap trades ''between'' intermediaries, where neither side is a “customer” as such.

But the huge preponderance of swap volume is between an [[intermediary]] — a “[[swap dealer]]” — on one side and a [[customer]] — on the other. 

So, are [[swap dealer|swap dealers]] “intermediaries” in the traditional sense, having no “skin in the game”? In one sense, no: being a principal to the swap contract, the [[swap dealer|dealer]] takes the other side of the trade to its customer, and is fully exposed to the [[underlier]]’s performance. But in another sense, yes: it ''is'' an intermediary: [[swap dealer]]<nowiki/>s generally [[Delta-hedging|delta-hedge]] their risk. In many cases are prohibited by regulation from taking proprietary positions.<ref>This is the famous “Volcker Rule”.</ref> In the classic case of [[equity swap]]<nowiki/>s, the [[Swap dealer|dealer]] executes a physical trade in the cash market, holds or finances that position, and prices its swap at exactly that price. It has no net exposure to the trade at all. Economically, it is no different from a broker lending on margin.

And there’s the thing: if you regard a [[Margin lending|margin loan]] as an intermediary lending a customer a fixed sum to buy an asset, it seems absurd that the banker should in some cases be obliged to pay the borrower more money. It’s like, no, dude, ''you'' borrowed from ''me''. If you want your profit, sell your position, pay me back, and ''then'' you can have your profit. Why should it be different because you traded on a swap?

The conventional answer is, “because under a [[swap]], I now have [[credit exposure]] to you for that profit and, you know, [[Lehman]].” Yes, it is our old friend the Lehman [[horcrux]]. Let’s come back to that.

=== Deregulation and electronic trading ===
At about the same time computer-based trading was revolutionising the financial markets, the madcap spirit of 1980s free-love ''laissez-faire'' delivered their radical deregulation. It is not unreasonable to suppose these conditions contributed to an explosion in the market for swaps during the 1980s.<ref>These three forces combined to create a mammoth. [http://faculty.citadel.edu/silver/IF/MBA_course/Chap9_Swap_Evolution.pdf Citadel] estimates USD interest rate swaps volumes went from from zero in 1981 to over half a billion dollars by 1987. </ref>

It did not take long for folks to realise that these new [[swap]] things presented a whole new class of risks.<ref name="fwmd"/> Swaps provide “unfunded” financial exposure to assets: you don’t own the assets, much less pay for them: the idea of exchanging notional amounts fell away and, besides initial margin, you didn’t have to put any money down at all. Given the size of individual swap transactions — typically in the millions of dollars — it didn’t take many transactions before total notional exposures were collossal. Practitioners in the market hit upon two neat tricks to manage these risks: [[netting]] and [[credit support]].

===== Netting =====
We are not really concerned with netting here — the [[JC]] has plenty to say on that topic [[Close-out netting|elsewhere]] — so let’s quickly deal with it: just as you could offset the [[present value]] of the opposing ''legs'' of each transaction to calculate a positive or negative [[mark-to-market]] value for that swap, so too could you offset positive and negative [[mark-to-market]] values for different swap transactions with the same customer to arrive at a single net exposure for your whole {{isdama}}. This idea — [[close-out netting]] — was a stroke of genius, and the brave commandos of {{icds}} encoded this “[[single agreement]]” concept into the {{1987ma}} and its successors. Giving effect to netting contracts, and attaining the capital relief they promise is now a multi-million-dollar industry of weaponised [[tedium]]. 

===== Credit support =====
But even with netting, the [[Leverage|levered]] nature of swap transactions means that overall net exposures can still swing around wildly.

In 1994 ISDA released a “[[credit support annex]]” to the {{isdama}} under which the parties could exchange “[[credit support]]” to offset their respective net exposures. This is all rather complicated and fiddly<ref>See our [[CSA Anatomy]], for as much detail as any one person could want.</ref> but the gist of it is that you calculate your net [[exposure]] under an {{Isdama}} on any day and, if it is over an agreed [[Threshold - VM CSA Provision|threshold]], you can require your counterparty to “post” you collateral for that exposure. If the exposure then swings back towards your counterparty tomorrow, it can require you to return equivalent assets. Rinse and repeat.

This is rather neat, because it “zeroes out” each party’s [[credit exposure]] to the other each day.

Like the {{Isdama}}, the [[CSA]] is a bilateral document: it assumes the parties are equal, arm’s-length counterparties and that each can post to the other. In the early days, [[Swap dealer|swap dealers]] often adjusted their CSAs so that only the customer posted credit support. This made sense, since swap customers tend not to be prudentially regulated or heavily capitalised, whereas intermediaries and swap dealers usually are.  

The solvency risk of banks and intermediaries was managed by prudential regulation, risk weighting and capital ratios. Over this period, the [[Basel Accords|Basel Committee]] published increasingly stringent and detailed rules<ref>Basel I was 30 pages. Basel II, published June 2006 (whoops!) was 347 pages. Basel III, as of September 2021, is 1626 pages.</ref> about how much capital banks should hold against their trading exposures to their customers. 

If at first customers were less bothered about the creditworthiness of their swap dealers,<ref>To be sure, sophisticated investment managers were already requiring their dealers post [[variation margin]] by the the start of the new millennium.</ref> this all changed, fast, during the 2008 financial crisis in which every major dealer had at least a near-death experience, and a number — [[Lehman]], Merrill Lynch, Bear Stearns, and literally dozens of others<ref>This is a [https://en.wikipedia.org/wiki/List_of_banks_acquired_or_bankrupted_during_the_Great_Recession fun list].</ref> had actual ones.

Suddenly the dealers, themselves were a source of systemic risk. 

The regulatory reform machine moved into overdrive; the era of unregulated derivatives was over. Regulators the world over began requiring ''all'' swap counterparties, prudentially regulated or not, to provide [[variation margin]] on all common forms of swap contract: bilateral, daily, and in [[Cash|''cash'']].