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===''Is'' it bilateral though?===
===''Is'' it bilateral though?===
But there is a better objection: for all our automatic protestations to the contrary, the ISDA is not ''really'' a bilateral contract, and it ''is'' often financing contract, in economic effect even if not in formal structure. Where there is a customer gaining exposure to a risk and a dealer providing delta-hedged exposure to that risk, a swap is a sort of “synthetic loan”.
But there is a better objection: for all our automatic protestations to the contrary, the ISDA is not ''really'' a bilateral contract, and it ''is'' often a financing contract, in economic effect even if not in formal structure. Where there is a customer gaining exposure to a risk and a dealer providing delta-hedged exposure to that risk, a swap is a sort of “synthetic loan”.


You could analyse an interest rate swap as off-setting fixed rate and floating rate loans. Seeing as the same amount of principal in the same currency flows in both directions at the same time, the principal flows cancel each other out — they “net” to zero.  
You could analyse an interest rate swap as off-setting fixed rate and floating rate loans. Seeing as the same amount of principal in the same currency flows in both directions at the same time, the principal flows cancel each other out — they “net” to zero.  
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“Aha, JC: quite so. But this implies, does it not, that the parties are ''not'' lending to each other?”
“Aha, JC: quite so. But this implies, does it not, that the parties are ''not'' lending to each other?”


The difference is in how the two sides manage their respective positions.
Well, yes: but the difference is in how the two sides manage their respective positions. Beyond the cramped star system of inter-dealer relationships, there is a boundless universe where one party is a “dealer” and the other a “customer”. This is the great majority of all swap arrangements.  


We should not let ourselves forget: beyond the cramped star system of inter-dealer relationships, there is a boundless universe where one party is a “dealer” and the other a “customer”. This is the great majority of all ISDA arrangements.   
The difference between ''customer'' and ''dealer'' does not depend on who is “long” and who “short” — customers can be long ''or'' short — nor on who pays fixed and who pays floating.   


The roles of ''customer'' and ''dealer'' are different. The difference does not depend on who is “long” and who “short”, nor on who pays the fixed rate and who pays the floating. Hence, the expressions “[[sell side|sell-side]]” — the dealers, who ''sell'' exposure and “[[buy side|buy-side]]” — their customers, who ''buy'' it.  
For the customer the object of transacting is to ''change'' its market exposure: to get into a positions it did not have before, or get out of one it did. This sounds obvious. But, being a bilateral contract, you might think it follows that the dealer is changing its position, too. But it is not. A dealer is there to provide exposure without taking any itself, and thereby to earn a commission. The dealer intends to say ''flat''.    


For the customer the object of transacting is to ''change'' its market exposure: to get into a positions it did not have before, or get out of one it did. This sounds obvious. But, being a bilateral contract, you might think it follows that the dealer is changing its position, too. But it is not. A dealer is there to provide exposure without taking any itself, and thereby to earn a commission. The dealer intends to say ''flat''.   
==== Swaps are usually synthetic loans ====
But how does this make a swap into a “synthetic loan” from the dealer to the customer? Let’s take an example. The JC’s fictional hedge fund [[Hackthorn Capital Partners]] owns USD10m of [[Lexrifyly]], and wants to get into the fabulous new start-up [[Cryptöagle]]. It can do one of three things:


Now, a swap is a principal obligation, so entering into one necessarily does changes the dealer’s  exposure — but the dealer must then “[[Delta-hedging|delta hedge]]” its position away, executing an offsetting position somewhere else. It might do this by buying the underlying asset, of futures, or entering into a offsetting swap by which matches off its  “long” exposure against another “short” exposure with another counterparty.   
(i) sell [[Lexrifyly]] outright and buy [[Cryptöagle]];


There are plenty of ways to [[delta hedge]], but the basic economic principle is that the dealer has not changed its market position. It has not, over all, made an investment. It has not borrowed anything.     
(ii) hold [[Lexrifyly]] and borrow to buy [[Cryptöagle]];


Provided the [[dealer]] knows what it is about, its main risk in running a swap portfolio is not therefore market risk — it should not really have any — but ''customer credit'' risk. Should a customer fail, the dealer’s book is no longer matched: its hedge is now an outright position.  
(iii) hold [[Lexrifyly]] and get synthetic exposure to [[Cryptöagle]] via a swap.


Hence, having adequate collateral from each customer, to cover the risk that it fails, is very important.
For argument’s sake let’s say on the investment date, both [[Cryptöagle]] and [[Lexrifyly]] trade at USD1 per share, so the acquired and sold positions are each for 10m shares. Here are the positions:


==== Swaps are usually synthetic loans ====
{{Quote|{{divhelvetica|
But how does this make a swap into a “synthetic loan”? Compare a swap with an actual loan:
'''Outright sale'''<br>
If it sells its [[Lexrifyly]] outright, the position is as follows:
:''Sold: USD10m [[Lexrifyly]].
:''Borrowed'': Zero.
:''Amount owed'': Zero.
:''Bought'': 10m [[Cryptöagle]].
:''Net position'': ''10m [[Cryptöagle]] shares + zero [[Lexrifyly]] + zero loan''


{{Quote|{{divhelvetica|
[[Hackthorn Capital Partners]] owns USD10m of AUM. It wishes to buy USD10m of [[Cryptöagle]]. It can either: ''sell'' its existing AUM and use the proceeds to buy Cryptöagle, or ''keep'' its existing portfolio and borrow USD10m.


'''Sale'''<br>
If it sells its existing portfolio outright, the position is as follows:
:Sold: USD10m.
:Borrowed: Zero.
:Amount owed: Zero.
:Bought: 10m Cryptöagle @ USD1 per share.
:Amount due: [[total return swap|total return]] on 10m Cryptöagle.
'''Loan'''<br>
'''Loan'''<br>
If it keeps its existing portfolio and borrows, the position is as follows:
If it keeps its [[Lexrifyly]] and borrows, the position is as follows:
:Sold: Zero.
:''Sold: Zero.
:Borrowed: USD10m.
:''Borrowed: USD10m.
:Amount owed: floating rate on USD10m.
:''Bought'': USD10m [[Cryptöagle]].
:Bought 10m of Cryptöagle @ USD1 per share.
:''Net position'': ''10m [[Lexrifyly]] shares + 10m [[Cryptöagle]] shares - USD10m - accrued interest''
:Amount due: [[total return swap|total return]] on 10m existing portfolio and 10m Cryptöagle.}}}}


Note the cashflows in the loan scenario:   
'''Swap'''<br>
If it keeps its [[Lexrifyly]] and puts on a swap struck at USD10m, the position is as follows:
:''Sold: Zero.
:''Borrowed: Zero.
:''Swap outgoings'': Floating rate on USD10m
:''Swap incomings'': USD10m [[Cryptöagle]] - USD10m.
:''Net position''''10m [[Lexrifyly]] shares + 10m [[Cryptöagle]] shares - USD10m - accrued interest''
}}}}


{{Quote|{{divhelvetica|
Even though there is no physical loan, the investor’s payment profile is the same. It pays a floating rate, and has the USD10m notional value of the loan deducted from its pay-out. And like a loan, the equity swap gives Hackthorn exposure to [[Cryptöagle]] whilst keeping its existing portfolio, which Hackthorn uses to fund cashflows on its new capital asset. This is a form of ''[[leverage]]''. The floating rate Hackthorn pays is ''implied funding''. The dealer will only accept this if it is satisfied Hackthorn has enough capital to finance its swap payments and settle any differences at termination. This is the same risk calculation a bank lender would make.<ref>To keep it simple, I have ignored the scope for synthetic margin loan and rehypothecation.</ref> 
During the loan, Hackthorn pays a floating rate on USD10m and is exposed to the market price of [[Cryptöagle]].


On termination, Hackthorn sells [[Cryptöagle]] to repay the loan. If sale proceeds exceed the loan repayment, Hackthorn keeps the difference. If they don’t, Hackthorn must fund the shortfall from its portfolio and book a loss.
But, hang on: this is a bilateral arrangement, right, so isn’t the converse true of the dealer? Isn’t the dealer, in a sense, “borrowing” by paying the total return of the asset to get “exposure” to the floating rate in the same way? Indeed, is not a “short” swap position, for a dealer, exactly the same as a “long” swap position for a customer?


Hackthorn’s net exposure is therefore: ''USD10m - Cryptöagle spot price''.
Generally not, because in providing these swap exposures to its customers, the dealer is not changing its own market position. It delta-hedges. At the same moment it puts on a swap, it executes an offsetting hedge. The customer ''buys'' an exposure: that is, starts ''without'' and ends up ''with'' a “position”; the dealer manufactures and then sells exposure: it starts ''without'' a position, takes an order, creates a position and then transfers it to the customer, leaving the dealer where it started, ''without'' a position. Hence, the expressions “[[sell side|sell-side]]” — the dealers — and “[[buy side|buy-side]]” — their customers.  
}}}}


These are the same cash flows you would expect under a delta-one equity derivative:
Now, a swap is a principal obligation, so transferring exposure “''+x''” to a customer necessarily involves the dealer acquiring exposure “''-x''” — but that “''-x''” exposure corresponds to a “+''x''” exposure the dealer has already acquired by “[[Delta-hedging|delta hedging]]” in the market.<ref>The  dealer may need to borrow money to fund its hedge, but this is exactly what the customer’s floating rate pays for. This is “borrowing on the customer’s behalf”.</ref> It might do this by buying the underlying asset, of futures, or entering into a offsetting swap by which matches off its  “long” exposure against another “short” exposure with another counterparty.   


{{Quote|{{divhelvetica|
Customer’s final position is ''+x''.    
During swap, Hackthorn pays floating rate on USD10m and dealer pays total return on Cryptöagle. On termination, if the swap termination amount is negative, Hackthorn pays it to dealer. If it is positive, dealer pays Hackthorn. <br>
The swap termination payment is ''USD10m - Cryptöagle spot price''.
}}}}


Like a loan, the equity swap gives Hackthorn exposure to [[Cryptöagle]] whilst keeping its existing portfolio, which Hackthorn uses to fund cashflows on its new capital asset. This is a form of ''[[leverage]]''. The floating rate Hackthorn pays is ''implied funding''. The dealer will only accept this if it is satisfied Hackthorn has enough capital to finance its swap payments and settle any differences at termination. This is the same risk calculation a bank lender would make.<ref>To keep it simple, I have ignored the scope for synthetic margin loan and rehypothecation.</ref>
Dealer’s is ''(-x +x)'', or zero.  


But, hang on: this is a bilateral arrangement, so isn’t the converse true of the dealer?
Provided the [[dealer]] knows what it is about, its main risk in running a swap portfolio is not therefore market risk — it should not have any — but ''customer credit'' ''risk''. Should a customer fail, the dealer’s book is no longer matched: its delta-hedge is now an outright long or short position.     


Isn’t the dealer paying the cashflow of the asset to get exposure to the floating rate in the same way? Isn’t it, in a sense, “borrowing” by paying a total return? Or look at it this way: is not a “short” swap position, for a dealer, exactly the same as a “long” swap position for a customer?
Hence, having collateral from each customer is important for the dealer. As long as each of the dealer’s other customers it providing it collateral, and the dealer is competently delta-hedging, being paid cash collateral by the dealer is far less important for the customer


Generally not, because in providing these swap exposures to its customers, the dealer is not changing its own market position. It delta-hedges. At the same moment it puts on a swap, it executes an offsetting hedge. The dealer’s net position on its derivative book will generally be flat. You don’t need to borrow money to take no position.<ref>The  dealer may need to borrow money to fund its hedge, but this is exactly what the customer’s floating rate pays for. This is “borrowing on the customer’s behalf”.</ref>
Is that the sound of [[Lehman]] [[horcrux]]<nowiki/>es sparking up I hear? 


==== On the case for one-way margin ====  
==== On the case for one-way margin ====  
In recent years — ironically, just as the “dealer” vs “customer” dynamic has become more pronounced<ref>After the [[GFC]], bank proprietary trading fell away to almost nothing.</ref> — the global regulatory-industrial complex,<ref>This label is not just sardonic: there really is a cottage industry of of “regulatory change management professionals”, in-house and out, who owe their last decade’s livelihood to ''accommodating'' quixotic regulatory initiatives like this. They are a powerful lobby with a direct interest in maintaining the rate of regulatory churn.</ref> still fighting last decade’s war, has forged rules which overlook this. Notably, the coordinated worldwide approach to bilateral [[regulatory margin]]. As swap positions move in and out of the market, counterparties must post each other the cash value of the net market movements each day. This is a little like closing positions out at the end of each day and settling up, with a key difference: you ''don’t'' close out your positions. The valuations at which the parties exchange margin are guestimated. The parties stay on risk.  
In recent years — ironically, just as the “dealer” vs “customer” dynamic has become more pronounced<ref>After the [[GFC]], bank proprietary trading fell away to almost nothing.</ref> — the global regulatory-industrial complex,<ref>This label is not just sardonic: there really is a cottage industry of of “regulatory change management professionals”, in-house and out, who owe their last decade’s livelihood to ''accommodating'' quixotic regulatory initiatives like this. They are a powerful lobby with a direct interest in maintaining the rate of regulatory churn.</ref> still fighting last decade’s war, forged rules which overlook this plain asymmetry. Notably, the coordinated worldwide approach to bilateral [[regulatory margin]]. As swap positions move in and out of the market, counterparties must post each other the cash value of the net market movements each day. This is a little like closing positions out at the end of each day and settling up, with a key difference: you ''don’t'' close out your positions. The valuations at which the parties exchange margin are guesstimates. The parties stay on risk.  


Well — ''one'' of them does — the customer: the one who initiated the trade, to put itself into a market position of some sort. The other party, remember, is delta-hedged. It didn’t initiate the trade, but accommodated it, on the precise grounds that its market position would not change, and its credit position, against the customer, would be satisfactory.
Well — ''one'' of them does — as per the above, the customer has risk; the dealer does not. The customer was the one who initiated the trade, to put itself into a market position of some sort. The dealer didn’t initiate the trade, but accommodated it in the expectation only of commission and on the explicit grounds that its market position would not change and the customer’s credit position would be satisfactory.


Requiring margin — even guestimated margin —from a ''customer'' who is net [[out-of-the-money]] makes sense: if the customer fails, the dealer’s corresponding hedges are defeated. It will be left with an open market exposure to all of the customer’s positions. From a systemic risk position, this is the last thing anyone wants: a dealer whose customer positions are all effectively hedged can’t go bust. So, daily [[variation margin]] ''to the dealer'' mitigates the dealer’s market risk to date; [[initial margin]] covers it for the forward market risk should it have to close out its hedge portfolio against the defaulting client.  
Requiring margin — even guesstimated margin —from a ''customer'' who is net [[out-of-the-money]] makes sense: if the customer fails, the dealer’s hedges are defeated and it will be have open market exposures to the customer’s positions. From the point of view of systemic risk, the last thing anyone wants is a dealer whose hedges fail. That is when it can go bust. So, daily [[variation margin]] ''to the dealer'' mitigates that risk to date; [[initial margin]] covers it for the future, should the dealer have to close out hedges against a defaulting client.  


As long as the dealer is covered, market disruption is minimised, and the dealer’s own solvency — the deterioration of which, due to its interconnectedness with the rest of the market, may well present a systemic risk — is not threatened.  
As long as the dealer is covered, there will be minimal market disruption and the dealer’s own solvency is not threatened.  


But requiring a ''dealer'' to post margin to its customer to cover the customer’s net in-the-money positions makes no sense whatsoever:
But requiring a ''dealer'' to post margin to its customer to cover the customer’s net in-the-money positions makes no sense whatsoever.


First, customers — and here I mean buy-side market participants ''who do not themselves post systemic risk''<ref>There are different considerations for those who pose market risk, but these should be dealt with by equivalent capital regulation and limitations on leverage and so on: in a perfect world, buy-side entities would never get so big as to pose systemic risk.<> — there are trading on their capital, dealers are not.<ref>Dealers hold capital primarily against counterparty failure, remember, not market risk itself: absent counterparty failure they should have none.</ref> They are putting themselves in harm’s way. Part of the thrill of taking on risk is ''that you have risk''.  
First, customers — and here I mean buy-side market participants ''who do not themselves post systemic risk''<ref>There are different considerations for those who pose market risk, but these should be dealt with by equivalent capital regulation and limitations on leverage and so on: in a perfect world, buy-side entities would never get so big as to pose systemic risk.<> — there are trading on their capital, dealers are not.<ref>Dealers hold capital primarily against counterparty failure, remember, not market risk itself: absent counterparty failure they should have none.</ref> — are the ones who are willingly putting themselves in harm’s way. They are taking on risk: that is what they are there for. Of course, dealers ''do'' present some risk of insolvency, and customers should only tolerate so much exposure to that risk, but the customer has other levers to manage it. They can close out their positions, take profits and re-establish their position at the current level, or with another dealer, for one thing. If they do that, the dealer can close out its hedge, pass on gains whilst being off risk, and then restrike its hedges and initial margin at the higher level if need be.<ref>A grave factor in [[Credit Suisse]]’s losses on [[Archegos]] was “margin erosion” caused by massive appreciation on its swap positions. While Credit Suisse was unusual in not using “dynamic margining” (which solves the “margin erosion” problem) to its [[Synthetic prime brokerage|synthetic equity derivatives]] book, “static” [[initial margin]] is the rule for other asset classes, and for [[regulatory IM]].</ref> ''This is not the same as paying out the [[mark-to-market]] of a unrealised swap''.  


Dealers are [[delta-hedge]]d against every customer. They are not “the other side of the trade”. A dealer’s “position” against a given client being “under water” in itself does not change the dealer’s risk of insolvency. Of course, dealers ''do'' present a risk of insolvency, and customers will tolerate so much exposure to that risk, but the customer has other levers to manage it. They can close out their position, take profits and re-establish the position at the new level, or with another dealer, for one thing. That enables the dealer to close out its hedge, pass on the hedge gains and reset hedges and initial margin at the higher level.<ref>A grave factor in [[Credit Suisse]]’s losses on [[Archegos]] was “margin erosion” caused by massive appreciation on its swap positions. While Credit Suisse was unusual in not using “dynamic margining” (which solves the “margin erosion” problem) to its [[synthetic equity derivatives]] book, “static” [[initial margin]] is the rule for other asset classes, and for [[regulatory IM]].</ref> This is not the same as paying out the [[mark-to-market]] of a unrealised swap.  
To be sure, customers might not ''like'' doing this — realising a taxable gain and having to stump up more [[initial margin]] when re-establishing positions blows the kumara, for sure — but none of these are good reasons for anyone but the customer. Withholding [[variation margin]] on profitable positions gives customers the choice: you can ''either'' keep your position open, but your money with the dealer, avoid tax and live with the “dealer risk”, ''or'' book your gain and get your money back and start again. This encourages prudent behaviour. If nothing else, it incentivises customers to diversify their risk across dealers.  


To be sure, customers might not ''like'' doing this — realising a taxable gain and having to stump up more [[initial margin]] when re-establishing positions blows, for sure — but none of these are good reasons for anyone but the customer concerned. Withholding [[variation margin]] on profitable positions gives customers the choice: you can ''either'' keep your position open, but your money with the dealer, avoid tax and live with the “dealer risk”, ''or'' book your gain and get your money back and start again — encourages prudent behaviour. If nothing else it incentivises customers to diversify their risk. And it does not automatically lever up the customer’s portfolio. For what do we think the customer will ''do'' with all that free cash [[VM]] its dealer keeps sending it?  If it was planning to just sit on it, wouldn’t just — ''leave it at the bank''?
And it does not automatically lever up the customer’s portfolio. For what do we think a customer will ''do'' with all that free cash [[VM]] its dealer keeps sending it?  If it was planning to just sit on it, wouldn’t just — ''leave it at the bank''?


Secondly, [[dealer]]s and [[bank]]s are already capitalised and regulated for systemic risk.<ref>[[Broker/dealer]]s that are not deposit-taking banks are more lightly capitalised. But nor — for that very reason — can they hold customer assets and cash on their balance sheet, but must hold it on trust for customers with a client money bank that ''is'' capital regulated.</ref> There are already constraints on how they must operate, and how much capital they must hold against the contingency of portfolio losses. It holds this capital, in large part, to protect against the risks presented to it ''by its customers''. Customers like thinly capitalised, highly-levered investment funds.  
Secondly, [[dealer]]s and [[bank]]s are already capitalised and regulated for systemic risk.<ref>[[Broker/dealer]]s that are not deposit-taking banks are more lightly capitalised. But nor — for that very reason — can they hold customer assets and cash on their balance sheet, but must hold it on trust for customers with a client money bank that ''is'' capital regulated.</ref> There are already constraints on how they must operate, and how much capital they must hold against the contingency of portfolio losses. Dealers hold this capital, in large part, to protect against the risks presented to them ''by customers''. Customers like thinly capitalised, highly-levered, investment funds. If no customer ever fails, nor will a delta-hedging dealer.  


That risk is amplified if dealers must pay away their own cash to reflecting their clients’ unrealised gains on a derivative portfolio already 70% financed by the dealer. It's just mad: “Hi. You owe me 70pc of the value of the stock you bought largely with my money, and you want ''me'' to pay you margin if the stock goes up?”
That risk is amplified if dealers must pay away their own cash to reflecting their clients’ unrealised gains on a derivative portfolio ''already 70% financed by the dealer''. It’s just mad: “Hi. You already owe me 70% of the value of the stock you bought largely with my money, and you want ''me'' to pay you margin if the stock goes up?”


This is all the more mad where the dealer is hedging with a physical asset. No-one pays variation margin on gains on a physical asset.<ref>Dealers can, and do, manage this by financing their physical portfolios. They would do this anyway, but variation margin requirements more or less oblige then to.</ref>
This is all the more mad if the dealer is hedging with a physical asset. ''No-one pays variation margin on gains on a physical asset''.<ref>Dealers can, and do, manage this by financing their physical portfolios. They would do this anyway, but variation margin requirements more or less oblige then to.</ref>


Now you might make the case that this capital regulation has been a bit of disaster, and some have<ref>Notably Gerd Gigerenzer, who has tracked the expansion in length of the Basel accords against the persistent rate of bank failure.</ref> but one lot of crappy regulations is not a prescription for ''more'' crappy regulations. Even if, as in this case, the new regulations were also proposed by the Basel committee too.<ref><ref> Especially not when they undermine the first lot.  
Now you might make the case, and some have,<ref>Notably Gerd Gigerenzer, who has tracked the expansion in length of the Basel accords against the persistent rate of bank failure.</ref> that capital regulation has been a bit of disaster, but one lot of crappy regulations is not a prescription for ''more'' crappy regulations. Even if, as in this case, the new regulations were also proposed by the Basel committee too.  


And this is ''exactly'' what bilateral variation margin does. Capital is the measure of “unallocated cash” available to meet the claims of general creditors. Cash being fungible, ''any'' cash on the balance sheet counts towards the capital ratio. A counterparty with an uncollateralised paper gain of $100m against a dealer still has a claim to that $100m: it can close out at any time, and even if the dealer fails first ''it still has a claim on that amount from the dealer’s capital reserves''. It is just lining up with other creditors who also have claims.
For this is ''exactly'' what bilateral variation margin does. Capital is the measure of “unallocated cash” available to meet the claims of general creditors. Cash being fungible, ''any'' cash on the balance sheet counts towards the capital ratio. A counterparty with an uncollateralised paper gain of $100m against a dealer still has a claim to that $100m: it can close out at any time, and even if the dealer fails first ''it still has a claim on that amount from the dealer’s capital reserves''. It is just lining up with other creditors who also have claims.


===Voluntary margin===
===Voluntary margin===

Revision as of 13:36, 10 December 2023

In this episode of the JC’s series of unfeasibly deep explorations of superficially odd things in the ISDA metaverse, consider the bilateral nature of the ISDA Master Agreement and its curious designators: “Party A” and “Party B”, and that curious descriptor of both of them: “counterparty”.

These set the ISDA apart; give it a sort of otherworldly aloofness; a sense almost of social justice. Other banking and broking transactions use labels which help you orient who, in the power structure, is who: a loan has a “Lender” (always the bank) and “Borrower” always the punter. A brokerage has “Broker” (master) and “Customer” (servant).

But not the ISDA Master Agreement. From the outside its framers — the First Men — opted for the more gnomic, interchangeable “Party A” and “Party B”.

Why? Well, we learn it from our first encounter of an ISDA Schedule. Bilaterality.

Bilaterality

A belief in even-handedness gripped the ones whose deep magic forged the runes from which the First Swap was born.

For most finance contracts imply some sort of dominance and subservience: a large institutional “have” indulging a small commercial “have-not” with debt finance for the privilege of which the larger “have” extracts excruciating covenants and enjoys a preferred place in the queue for repayment among the have-not’s many scrapping creditors.

But swaps, as the First Men saw them, are not like that.

“A swap contract,” they intoned, “is an exchange among peers. It is an equal-opportunity sort of thing; Biblically righteous in that, under its awnings, one be neither lender nor borrower, but an honest rival for the favour of the Lady Fortune, however capricious may she be.

“We are equals. Rivals. Counterparties”. Covenants, privileges of credit support and so on may flow either way. They may flow both ways. In our time of regulatory margin, they usually do.

And, to be sure, swaps are different from loans and brokerage arrangements. They start off “at market” where all is square. Either party may be long or short, fixed or floating. At the moment the trade is struck, the world infused with glorious possibility. One fellow’s fortunes may rise or fall relative to the other’s and, as a result, she may owe (“out-of-the-money”) or be owed (“in-the-money”). And swaps, too, are professional instruments. Moms and pops, Belgian dentists and the like may take loans and buy bonds, but they don’t, and never have, entered ISDA Master Agreements.[1]

Now the ISDA Master Agreement itself never uses the terms “Party A” or “Party B”. Being genuinely bilateral, it never has to. Being arbitrary assignations at trade level the labels only get a mention once the symmetry breaks down in the Schedule and in Confirmations, to be clear who is who on a given trade: who is paying the fixed rate and who the floating; which thresholds, maxima, minima, covenants, details, agents and terms apply to which counterparty. This much is necessarily different. Nothing beyond: the ISDA Master Agreement assumes you already know who is who, having agreed it in the Schedule.

So we agree: for this relationship we will call you “Party B”, and me “Party A”.

These colourless and generic terms hark from a time where, we presume, the idea of “find and replace all” in an electronic document seemed some kind of devilish black magic. Some kind of Tipp-Ex-denying subterfuge.

But anyway. These generic labels still lead to practical difficulties. A dealer with ten thousand counterparties in its portfolio wants to be “Party A” every time, just for peace of mind and literary continuity when perusing its collection of Schedules, as we know dealers on occasion are minded to do.[2] If, here and there, a dealer must be “Party B”, this can lead to anxious moments should one misread such a Schedule and infer its infinite IM Threshold applies to the other guy, when really, as it ought, it applies to you. Frights like this are, in their way, quite energising. You quickly get over them when you realise it is your error of construal, not the negotiator’s of articulation.

Less energising are actual errors: as a group, negotiators are redoubtable, admirable creatures but, like all of us fallible and prone to oversight: they may, by lowly force of habit, forget to invert the “Party” labels when inserting the boilerplate PPF Event rider for that one time in a thousand when the firm is not “Party A”. It is easily done, and just the sort of thing a four-eyes check will also miss: If it does, no-one will never know — unless and until it is too late.

Is it bilateral though?

But there is a better objection: for all our automatic protestations to the contrary, the ISDA is not really a bilateral contract, and it is often a financing contract, in economic effect even if not in formal structure. Where there is a customer gaining exposure to a risk and a dealer providing delta-hedged exposure to that risk, a swap is a sort of “synthetic loan”.

You could analyse an interest rate swap as off-setting fixed rate and floating rate loans. Seeing as the same amount of principal in the same currency flows in both directions at the same time, the principal flows cancel each other out — they “net” to zero.

“Aha, JC: quite so. But this implies, does it not, that the parties are not lending to each other?”

Well, yes: but the difference is in how the two sides manage their respective positions. Beyond the cramped star system of inter-dealer relationships, there is a boundless universe where one party is a “dealer” and the other a “customer”. This is the great majority of all swap arrangements.

The difference between customer and dealer does not depend on who is “long” and who “short” — customers can be long or short — nor on who pays fixed and who pays floating.

For the customer the object of transacting is to change its market exposure: to get into a positions it did not have before, or get out of one it did. This sounds obvious. But, being a bilateral contract, you might think it follows that the dealer is changing its position, too. But it is not. A dealer is there to provide exposure without taking any itself, and thereby to earn a commission. The dealer intends to say flat.

Swaps are usually synthetic loans

But how does this make a swap into a “synthetic loan” from the dealer to the customer? Let’s take an example. The JC’s fictional hedge fund Hackthorn Capital Partners owns USD10m of Lexrifyly, and wants to get into the fabulous new start-up Cryptöagle. It can do one of three things:

(i) sell Lexrifyly outright and buy Cryptöagle;

(ii) hold Lexrifyly and borrow to buy Cryptöagle;

(iii) hold Lexrifyly and get synthetic exposure to Cryptöagle via a swap.

For argument’s sake let’s say on the investment date, both Cryptöagle and Lexrifyly trade at USD1 per share, so the acquired and sold positions are each for 10m shares. Here are the positions:

Outright sale
If it sells its Lexrifyly outright, the position is as follows:

Sold: USD10m Lexrifyly.
Borrowed: Zero.
Amount owed: Zero.
Bought: 10m Cryptöagle.
Net position: 10m Cryptöagle shares + zero Lexrifyly + zero loan


Loan
If it keeps its Lexrifyly and borrows, the position is as follows:

Sold: Zero.
Borrowed: USD10m.
Bought: USD10m Cryptöagle.
Net position: 10m Lexrifyly shares + 10m Cryptöagle shares - USD10m - accrued interest

Swap
If it keeps its Lexrifyly and puts on a swap struck at USD10m, the position is as follows:

Sold: Zero.
Borrowed: Zero.
Swap outgoings: Floating rate on USD10m
Swap incomings: USD10m Cryptöagle - USD10m.
Net position: 10m Lexrifyly shares + 10m Cryptöagle shares - USD10m - accrued interest

Even though there is no physical loan, the investor’s payment profile is the same. It pays a floating rate, and has the USD10m notional value of the loan deducted from its pay-out. And like a loan, the equity swap gives Hackthorn exposure to Cryptöagle whilst keeping its existing portfolio, which Hackthorn uses to fund cashflows on its new capital asset. This is a form of leverage. The floating rate Hackthorn pays is implied funding. The dealer will only accept this if it is satisfied Hackthorn has enough capital to finance its swap payments and settle any differences at termination. This is the same risk calculation a bank lender would make.[3]

But, hang on: this is a bilateral arrangement, right, so isn’t the converse true of the dealer? Isn’t the dealer, in a sense, “borrowing” by paying the total return of the asset to get “exposure” to the floating rate in the same way? Indeed, is not a “short” swap position, for a dealer, exactly the same as a “long” swap position for a customer?

Generally not, because in providing these swap exposures to its customers, the dealer is not changing its own market position. It delta-hedges. At the same moment it puts on a swap, it executes an offsetting hedge. The customer buys an exposure: that is, starts without and ends up with a “position”; the dealer manufactures and then sells exposure: it starts without a position, takes an order, creates a position and then transfers it to the customer, leaving the dealer where it started, without a position. Hence, the expressions “sell-side” — the dealers — and “buy-side” — their customers.

Now, a swap is a principal obligation, so transferring exposure “+x” to a customer necessarily involves the dealer acquiring exposure “-x” — but that “-x” exposure corresponds to a “+x” exposure the dealer has already acquired by “delta hedging” in the market.[4] It might do this by buying the underlying asset, of futures, or entering into a offsetting swap by which matches off its “long” exposure against another “short” exposure with another counterparty.

Customer’s final position is +x.

Dealer’s is (-x +x), or zero.

Provided the dealer knows what it is about, its main risk in running a swap portfolio is not therefore market risk — it should not have any — but customer credit risk. Should a customer fail, the dealer’s book is no longer matched: its delta-hedge is now an outright long or short position.

Hence, having collateral from each customer is important for the dealer. As long as each of the dealer’s other customers it providing it collateral, and the dealer is competently delta-hedging, being paid cash collateral by the dealer is far less important for the customer.

Is that the sound of Lehman horcruxes sparking up I hear?

On the case for one-way margin

In recent years — ironically, just as the “dealer” vs “customer” dynamic has become more pronounced[5] — the global regulatory-industrial complex,[6] still fighting last decade’s war, forged rules which overlook this plain asymmetry. Notably, the coordinated worldwide approach to bilateral regulatory margin. As swap positions move in and out of the market, counterparties must post each other the cash value of the net market movements each day. This is a little like closing positions out at the end of each day and settling up, with a key difference: you don’t close out your positions. The valuations at which the parties exchange margin are guesstimates. The parties stay on risk.

Well — one of them does — as per the above, the customer has risk; the dealer does not. The customer was the one who initiated the trade, to put itself into a market position of some sort. The dealer didn’t initiate the trade, but accommodated it in the expectation only of commission and on the explicit grounds that its market position would not change and the customer’s credit position would be satisfactory.

Requiring margin — even guesstimated margin —from a customer who is net out-of-the-money makes sense: if the customer fails, the dealer’s hedges are defeated and it will be have open market exposures to the customer’s positions. From the point of view of systemic risk, the last thing anyone wants is a dealer whose hedges fail. That is when it can go bust. So, daily variation margin to the dealer mitigates that risk to date; initial margin covers it for the future, should the dealer have to close out hedges against a defaulting client.

As long as the dealer is covered, there will be minimal market disruption and the dealer’s own solvency is not threatened.

But requiring a dealer to post margin to its customer to cover the customer’s net in-the-money positions makes no sense whatsoever.

First, customers — and here I mean buy-side market participants who do not themselves post systemic riskCite error: Closing </ref> missing for <ref> tag — are the ones who are willingly putting themselves in harm’s way. They are taking on risk: that is what they are there for. Of course, dealers do present some risk of insolvency, and customers should only tolerate so much exposure to that risk, but the customer has other levers to manage it. They can close out their positions, take profits and re-establish their position at the current level, or with another dealer, for one thing. If they do that, the dealer can close out its hedge, pass on gains whilst being off risk, and then restrike its hedges and initial margin at the higher level if need be.[7] This is not the same as paying out the mark-to-market of a unrealised swap.

To be sure, customers might not like doing this — realising a taxable gain and having to stump up more initial margin when re-establishing positions blows the kumara, for sure — but none of these are good reasons for anyone but the customer. Withholding variation margin on profitable positions gives customers the choice: you can either keep your position open, but your money with the dealer, avoid tax and live with the “dealer risk”, or book your gain and get your money back and start again. This encourages prudent behaviour. If nothing else, it incentivises customers to diversify their risk across dealers.

And it does not automatically lever up the customer’s portfolio. For what do we think a customer will do with all that free cash VM its dealer keeps sending it? If it was planning to just sit on it, wouldn’t just — leave it at the bank?

Secondly, dealers and banks are already capitalised and regulated for systemic risk.[8] There are already constraints on how they must operate, and how much capital they must hold against the contingency of portfolio losses. Dealers hold this capital, in large part, to protect against the risks presented to them by customers. Customers like thinly capitalised, highly-levered, investment funds. If no customer ever fails, nor will a delta-hedging dealer.

That risk is amplified if dealers must pay away their own cash to reflecting their clients’ unrealised gains on a derivative portfolio already 70% financed by the dealer. It’s just mad: “Hi. You already owe me 70% of the value of the stock you bought largely with my money, and you want me to pay you margin if the stock goes up?”

This is all the more mad if the dealer is hedging with a physical asset. No-one pays variation margin on gains on a physical asset.[9]

Now you might make the case, and some have,[10] that capital regulation has been a bit of disaster, but one lot of crappy regulations is not a prescription for more crappy regulations. Even if, as in this case, the new regulations were also proposed by the Basel committee too.

For this is exactly what bilateral variation margin does. Capital is the measure of “unallocated cash” available to meet the claims of general creditors. Cash being fungible, any cash on the balance sheet counts towards the capital ratio. A counterparty with an uncollateralised paper gain of $100m against a dealer still has a claim to that $100m: it can close out at any time, and even if the dealer fails first it still has a claim on that amount from the dealer’s capital reserves. It is just lining up with other creditors who also have claims.

Voluntary margin

No-one of this stops the dealer recognising the “equity” in a customer’s unrealised mark-to-market gains and extending credit — increasing lines — against it. This is what margin lenders and cash prime brokers do every day of the week.

But this lending is discretionary, and dealers can apply the haircuts, credit terms and diversification criteria as they see fit. The dealer can decide where and when to draw its lines.

Imagine if lending banks were forced to pay mortgage customers the value of unrealised gains on their house prices. Imagine how much worse the global financial crisis would have been then.

“But, but, but, JC: there is a difference. Where a house is concerned, the customer owns the house. It has no credit exposure to the bank for the house. If the bank fails, the customer keeps its house. With a swap, the customer would lose everything. All this is true. But, equally the customer’s personal capital outlays for that house — its real investment — is 20% (at the time of the GFC it might have been closer to 0%). This is a levered play.

The same is true of a derivative exposure. It is an implied loan. The customer puts down its initial margin — economically equivalent to a deposit — and gets the return of the whole asset. The bank’s interest is to optimise its funding and to earn a commission on the opening and closing of the trade. It agrees to lend 70 percent of the starting value of the asset. If the customer wants to isolate its credit exposure from the dealer, it can take out a margin loan against a physical asset, just like a mortgage. Or it can take its profit, close out its trade and find out the terms on which the dealer will reset.

For several reasons:

Banks are Banks are not losing value on the customer positions: as per the above, they are delta-hedged. Banks have no market exposure unless their clients go bust.

Banks generally go bust because their clients go bust. They don’t go bust by themselves—I know, I know, Silicon Valley Bank did, but it is an honourable exception that proves the rule.

If we are worried about bank solvency, then forcing the bank to cash settle unrealised gains on derivatives portfolios is a bad idea.

“settling to market” every day with an important distinction: you don

Banks are independently capital regulated for solvency.

Swap counterparties are sophisticated professionals with the tools and resources to monitor credit exposure to their dealers and brokers. (We take it that understanding the financial weapons of mass destruction that these sophisticates truck in require more ninja wizardry than does weighing up the creditworthiness of a regulated financial institution).

It is a much better discipline for sophisticated counterparts to manage their credit exposure — spread it around, so to speak, than to require their banks to send hard cash out the door as collateral to clients with outsized exposures.

Every dollar these banks pay away reduces the capital buffer the bank has available for everyone else. It also provides the customer with free money on an unrealised mark-to-market position. This is like paying out while the roulette wheel is still spinning, in the expectation of where the ball might land. That is a loan: if the customer doubles down and loses, you don’t get your money back.

Daily mark to market moves are mainly noise. Yet this is what parties must collateralise against. A great deal of the back-and-forth of variation margin is accomodating noise . The signal emerges over a prolonged duration. Over the short run posted collateral can, as we know a system effect: if I double down on an illiquid position, it will tend to rise, and I will get more margin, and — this is the story of Archegos.

The increased systemic exposure of banks failing — which is what the margin regs were designed to address — is not caused by the banks themselves, but by their client exposures. Client exposures in turn are a function of client failures, which are in turn a function of leverage

Their failure shouldn't, typically, be a systemic risk unless their unusually size, interconnectedness or unintended system effects make them systematically important, in which case they should be regulated if they are systemically important, and made to hold capital, and (b) they have the market position and bargaining power to negotiate margin terms.

  1. They may trade contracts for difference and make spread bets with brokers, but these are standardised, smaller contracts.
  2. They are not.
  3. To keep it simple, I have ignored the scope for synthetic margin loan and rehypothecation.
  4. The dealer may need to borrow money to fund its hedge, but this is exactly what the customer’s floating rate pays for. This is “borrowing on the customer’s behalf”.
  5. After the GFC, bank proprietary trading fell away to almost nothing.
  6. This label is not just sardonic: there really is a cottage industry of of “regulatory change management professionals”, in-house and out, who owe their last decade’s livelihood to accommodating quixotic regulatory initiatives like this. They are a powerful lobby with a direct interest in maintaining the rate of regulatory churn.
  7. A grave factor in Credit Suisse’s losses on Archegos was “margin erosion” caused by massive appreciation on its swap positions. While Credit Suisse was unusual in not using “dynamic margining” (which solves the “margin erosion” problem) to its synthetic equity derivatives book, “static” initial margin is the rule for other asset classes, and for regulatory IM.
  8. Broker/dealers that are not deposit-taking banks are more lightly capitalised. But nor — for that very reason — can they hold customer assets and cash on their balance sheet, but must hold it on trust for customers with a client money bank that is capital regulated.
  9. Dealers can, and do, manage this by financing their physical portfolios. They would do this anyway, but variation margin requirements more or less oblige then to.
  10. Notably Gerd Gigerenzer, who has tracked the expansion in length of the Basel accords against the persistent rate of bank failure.