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== Risk management under the ISDA == | == Risk management under the ISDA == | ||
It did not take long for folks to realise that these new swap things presented a whole new class of risks.<ref name="fwmd"/> | 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: you don’t have to put any money down up front at all.<ref>Besides any [[initial margin]] your counterparty required: see below.</ref> This is, economically, the same as betting.<ref>It is also the same as buying (or selling) insurance, with one difference: to be insured, you must suffer an insurable loss.</ref> Given the size of individual swap transactions — typically in the millions of dollars — your total notional exposure can quickly blow out of all proportion. The market hit upon two neat tricks to manage these risks: [[netting]] and [[credit support]]. | |||
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 swap 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 swaps 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. | |||
The solution | But even with netting, counterparties to a swap relationship could still have large, volatile exposures to each other. The highly levered nature of swap transactions meant that one’s total net exposure could swing wildly in a single day, and could flip [[In-the-money|in]] or [[out-of-the-money]] quite suddenly. | ||
A solution arrived a decade or so after swap trading started in earnest. In 1994 ISDA released a “[[credit support annex]]” to the {{isdama}} under which, the parties could require [[initial margin]], and also exchange variation margin reflecting the prevailing exposure under the agreement. 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 was that either side could calculate its net exposure on a day and require the other side to post credit support — usually in the form of bonds or liquid securities — to it to hold as collateral for that exposure. | |||
The benefits of credit support accrued largely to to bank counterparties who, over this period, were subject to increasingly stringent and detailed rules about how much capital they were required to hold against trading exposures to their customers. | The benefits of credit support accrued largely to to bank counterparties who, over this period, were subject to increasingly stringent and detailed rules about how much capital they were required to hold against trading exposures to their customers. |