Template:M intro isda a swap as a loan

During a typically turgid disquisition about the ostensible “bilaterality” of the ISDA Master Agreement, the JC remarked rashly that despite looking like a bilateral, even-stevens, un-loansome sort of a thing, in practical fact most swaps are implied financing arrangements.

Hotly justifying this stance sidetracked the original article, so we have “taken things offline” and started a whole new article where the JC can properly make a tit of himself without spoiling the a perfectly pointless ululation about Party A and Party B.

To recap the background to that post:

Whereas most finance contracts imply dominance and subservience between lenders who extract excruciating covenants and enjoy a preferred place in the borrower’s affections, on its Christmas card list and so on, swaps are unique in not being like that.

“A swap contract is an exchange among peers. It is an equal-opportunity, biblically righteous compact between equals. There is no lender or borrower: each participant is an honest rival for the favour of the Lady Fortune, however capricious may she be.”

So here goes: the JC’s position is that outside the inter-dealer community, this conventional wisdom is not meaningfully true. An “end user” swap is, in fact, a synthetic loan from dealer to customer.

Industry veterans may look upon you slack-jawed if you say this. Being optimistic, they try to give you the benefit of the doubt for this flight of fancy.

“Oh, well, I suppose you could analyse an interest rate swap as a pair of off-setting fixed-rate and floating-rate loans. Yes, that seems strictly true. But it is rather to miss the point. 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. So, loans, sure. But two, going in opposite directions. This implies, does it not, that the parties are not lending to each other? The loans cancel out.”

Customers and dealers

But this is not what the JC means.

Now, far out in space, beyond the Oort cloud of the cramped star system of inter-dealer relationships, there is a boundless universe of end user swaps. Here, one party is a “dealer” and the other — the end user — a “customer”. This is the great majority of all swap arrangements.

The difference between customer and dealer is not who is “long” and who “short” — one of the great swappist beauties is that customers can easily go long or short — nor on who pays “fixed” and who “floating”.

The difference between customer and borrower is who is borrowing.

For a customer the object of any transaction is to change its overall market exposure: to leg into positions it did not have before, or leg out of ones it did. This sounds obvious enough. But dealers do not. They say flat.

Hang on, though, JC: you yourself say a swap is a bilateral contract. How can that be so? Does it not follow that if the customer changes its position, the dealer must be doing so too?

Well, no.

The dealer provides exposure without taking any itself. It thereby earns a commission. This is all the excitement the dealer wants. The dealer stays flat the customer’s market risk. It hedges that market risk away. Without no market risk, the dealer is left with only customer credit exposure. As it would have in a loan. (Spoiler: the similarities don’t end there.)

Ok: but how does that fleeting resemblance turn a bilateral swap into a “synthetic loan” from the dealer to the customer?

Imagine the JC’s in-house hedge fund, Hackthorn Capital Partners holds USD10m of that redoubtable stalwart of legal thought-leadership Lexrifyly, and wants to get exposure to the fabulous new legaltech start-up, Cryptöagle.

It can do one of three things:

(i) sell Lexrifyly and buy Cryptöagle — this is an outright long investment;

(ii) hold Lexrifyly and borrow to buy Cryptöagle — this is a financed investment;

(iii) hold Lexrifyly and get exposure to Cryptöagle via a swap — conventionally, not a financed investment. (But...)

For ease of argument, let’s say on the investment date, both Cryptöagle and Lexrifyly trade at USD1 per share, so both positions are 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

Notice how similar the loan and the swap are. 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 exposure to Lexrifyly, 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.

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?

No, because in providing these swap exposures to its customers, the dealer simultaneously delta-hedges. It does not changing its own market position. The customer buys an exposure: that is, starts without and ends up with a “position”; the dealer manufactures and then sells an exposure: it starts without a position, takes an order, creates a position, transfers it to the customer and ends up where it started, without a position.

Hence, the expressions “sell-side” — the dealers — and “buy-side” — their customers.

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.

Fixed/floating swaps

Nuncle: ’Tis none so mincey as a Farrington chop
And nowt so loansome as a fixed rate swap.

—Büchstein, Die Schweizer Heulsuse

Ok; that’s a delta-one equity swap. But is this kind of synthetic prime brokerage just an odd use case? Aren’t “normal” swaps truly bilateral and less “lendy” in nature? How about interest rate swaps? Surely paying a fixed rate while receiving a floating rate has none of these same characteristics of borrowership and loanery about it?

Income implies principal

The first point to make here is that in the real universe of actual, non-synthetic investments, fixed or floating rate cashflows do not exist independently of a principal investment. This is because they are necessarily income on a capital investment. When you put it like that, it is kind of obvious this must be true.

Oh, sure, you could sell a strip of coupons off a bond. Okay. But to do that, there must first be a bond, and you have to buy it, cut it up and sell the stripped bond back into the market. Once you’ve done that, you have your disembodied interest cashflow all right, but you also have unleashed this weird, mutilated, principal-only instrument that flaps around the market at a heavy discount to a fully-limbed equivalent, sort of like Weird Barbie or one of those intercised kids with no daemon in His Dark Materials.

Repeat: in the real world, income cashflows only exist with an income-generating asset. Stands to reason. A rate with out principal is like a shadow without a boy.

Derivatives as engines of hypothesis

Did swaps change all that?

It was only once the Children of the Forest wrought their wristy magic on the First Men in the dark thickets of Woods of Bretton that the ways of the Single Agreement came into common understanding. Only then were leaden, earth-bound notions of principal swept away; the swap market took wing upon the nuclear power of infinite leverage. Income flows could bust free of their leaden principal host and frolic in ISDA’s glittering starlight.

In this synthetic world we have the mathematical tools to hypothetically isolate income from the assets which generate it, and trade the income streams as discrete instruments, but at some point, they must intersect with real-world instruments, because that is what they are derived from. For a customer to take on a derivative position, someone else, somewhere in the linear chain of financial instruments hedging that exposure must, at some point, buy a real-world hedge. Including its principal. And that must be financed.

If you want a floating rate on a notional of a hundred bucks, you pony up a hundred bucks and buy a floating-rate note. That means selling down an asset you already have. If you don’t want to do that, you can borrow the hundred bucks at a fixed rate from the dealer who is selling you the floating rate note, and bingo the principal on the note and your loan cancel out and you have an interest rate swap.

Interest rate swaps are, in this sense, “synthetic fixed income prime brokerage”.

Leverage is a state of mind (or balance-sheet)

One last way to look at this: an interest rate swap is a levered investment in a fixed income asset. A margin loan to buy a fixed income asset is, literally, a levered investment in that fixed income asset. The difference is the customer is taking a margin loan, the dealer is not.

We can see this by considering the parties’ respective economic positions before and after trading. The customer changes its net position; the dealer does not. Swapping a fixed cashflow for a floating one is to keep the “asset” funding that fixed cashflow, and to borrow the funds required to acquire a new floating-rate asset in the same principal amount. Because that borrowing has the same principal amount as the floating-rate asset, the principal amounts cancel out, and the customer left with just the floating rate cashflow, for which it must pay the fixed rate it has agreed.

Without that implied loan, the customer would have to sell an asset to raise the proceeds to buy the floating-rate bond from the dealer. That is, pay the principal amount to the dealer, and acquire the interest and principal cashflows of a floating rate asset. Here the customer is not borrowing anything.

“But, but, but JC: can’t you see? If you pay someone 100 and they pay you the return of an instrument worth 100 and interest, you have loaned them the money?”

Quite so: but that is the nature of a floating-rate bond. It is a loan. But it is not a loan to the dealer. It is a loan to the issuer of the floating-rate bond. If the dealer is paying you the return of a floating-rate bond you may be assured it has used your money to buy a floating-rate bond, to hedge itself. You have not, net, lent the dealer anything.