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{{ | {{drop|[[a swap as a loan|D]]|uring a typically}} [[The bilaterality, or not, of the ISDA|turgid disquisition]] about the “bilaterality” of the {{isdama}}, JC remarked that, despite ''looking like'' bilateral, even-stevens, un-[[loansome]] things, in fact swaps are ''implied financing arrangements''. | ||
Hotly justifying this stance sidetracked the original article, so | Hotly justifying this stance sidetracked the original article, so JC “[[Let’s take it offline|took things offline]]” and started a whole new article on the topic. Here it is. | ||
To recap the background to that post: | To recap the background to that post: | ||
{{Quote| | {{Quote|{{drop|W|hereas most}} finance contracts imply dominance and subservience — a ''lender'' who extracts excruciating covenants, takes mortgages, sharpens knives and so on, and a ''borrower'' whose mortal soul is traduced, suffers repeated indignities but who must yet feign affection through gritted teeth and deep resentment — swaps are ''not like that''. | ||
“A swap | “A swap 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.”}} | ||
[[Jolly Contrarian|JC]]’s says that, outside the inter-dealer community, this conventional wisdom is not true. | |||
Industry veterans may look upon | An “end user” swap ''is'', in fact, a “synthetic” loan from [[dealer]] to [[customer]]. To the extent regulations require dealers to ''post'' [[variation margin]] outright against their own swap exposures, (rather than simply calling for from their customers to cover customer exposures), ''the regulations make the financial system ''less'' stable, ''more'' risky, ''more'' leveraged, and ''more'' prone to the market calamities that fueled the global financial crisis. | ||
{{quote| | |||
''Bilateral variation margin is a category error. Swap dealers should not collateralise their customers.''}} | |||
There. I said it. | |||
Industry veterans may look upon JC slack-jawed as he says this. Regulators certainly will. Being optimistic, they might try to give JC the benefit of the doubt for this flight of fancy, while thinking “''has the old bugger finally lost his marbles''?” | |||
JC is blessed in that his friends are inclined to charity. “Oh, well, I suppose you ''could'' analyse an [[Interest rate swap mis-selling scandal|interest rate swap]] as a pair of off-setting loans,” they are prone to say. “Yes, that seems strictly true. But, dear fellow, it is rather to miss the point, isn’t it? Seeing as the same amount of principal in the same currency flows in both directions at the same time, the principal cancels out. | |||
The parties to a swap are not ''really'' lending to each other, old thing.” | |||
====Customers and dealers==== | ====Customers and dealers==== | ||
{{ | {{drop|B|ut this is}} not what the JC means. He means to say that when a dealer provides a swap to a customer, economically, the dealer lends, outright, to the customer. One way. | ||
Now, far out in space, beyond the Oort cloud | Now, far out in space, beyond the cramped Oort cloud 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” — is a “customer”. These are the great majority of all swap arrangements in the known universe. Hence, the expressions “[[sell side|sell-side]]” — the dealers — and “[[buy side|buy-side]]” — their customers. | ||
The difference between ''customer'' and ''dealer'' is not who is “long” and who “short” — one of the great [[Swappist Oath|swappist]] beauties is that customers can go long ''or'' short, as they please — nor on who pays “fixed” and who “floating”. | The difference between ''customer'' and ''dealer'' on a swap is not who is “long” and who “short” — one of the great [[Swappist Oath|swappist]] beauties under the ISDA framework is that customers can go long ''or'' short, as they please — nor on who pays “fixed” and who “floating”. | ||
The difference between customer and borrower is ''who, economically, is borrowing''. | The difference between customer and borrower is ''who, economically, is borrowing''. | ||
For a ''customer'' the object of any | For a ''customer'' the object of any {{isdaprov|Transaction}} is to ''change its overall market exposure'': to get into positions it did not have before, or get out of ones it did. | ||
This sounds obvious enough. But dealers do ''not''. Dealers stay ''flat''. | |||
“Hang on, though, JC: | “Hang on, though, JC: if a swap is bilateral, how ''can'' that be so? Does it not follow that if the ''customer'' changes its position one way, the dealer must dp so the other way?” | ||
In the narrow confines of the specific {{isdama}} perhaps. But in the wider context of the parties overall net positions, ''no''. | |||
The dealer | The dealer “provides” exposure by sourcing it in the market, delta-hedging it, and charging its customer a [[commission]]. There are all kinds of enterprising and funding-efficient ways it can do so, but fundamentally, a dealer stays market-neutral. The customer’s credit risk for the life of the trade, is all the excitement the dealer wants. As long as its market side hedges work, the only market risk the dealer takes comes about if the customer fails. That is to say, the dealer has customer ''credit'' exposure for as long as the customer stays in its risk position. The customer decides when to exit: as long as it is not solvent the dealer is committed to staying in. If the customer wants to exit, the dealer will make a price. | ||
''As it would have'' ''in a loan''. | ''As it would have'' ''in a loan''. | ||
Ok: but how does that fleeting resemblance turn an obviously bilateral swap into a “synthetic loan”? | Ok: but how does that fleeting resemblance turn an obviously bilateral swap into a “synthetic loan”? | ||
Revision as of 18:45, 1 April 2024
During a typically turgid disquisition about the “bilaterality” of the ISDA Master Agreement, JC remarked that, despite looking like bilateral, even-stevens, un-loansome things, in fact swaps are implied financing arrangements.
Hotly justifying this stance sidetracked the original article, so JC “took things offline” and started a whole new article on the topic. Here it is.
To recap the background to that post:
Whereas most finance contracts imply dominance and subservience — a lender who extracts excruciating covenants, takes mortgages, sharpens knives and so on, and a borrower whose mortal soul is traduced, suffers repeated indignities but who must yet feign affection through gritted teeth and deep resentment — swaps are not like that.
“A swap 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.”
JC’s says that, outside the inter-dealer community, this conventional wisdom is not true.
An “end user” swap is, in fact, a “synthetic” loan from dealer to customer. To the extent regulations require dealers to post variation margin outright against their own swap exposures, (rather than simply calling for from their customers to cover customer exposures), the regulations make the financial system less stable, more risky, more leveraged, and more prone to the market calamities that fueled the global financial crisis.
Bilateral variation margin is a category error. Swap dealers should not collateralise their customers.
There. I said it.
Industry veterans may look upon JC slack-jawed as he says this. Regulators certainly will. Being optimistic, they might try to give JC the benefit of the doubt for this flight of fancy, while thinking “has the old bugger finally lost his marbles?”
JC is blessed in that his friends are inclined to charity. “Oh, well, I suppose you could analyse an interest rate swap as a pair of off-setting loans,” they are prone to say. “Yes, that seems strictly true. But, dear fellow, it is rather to miss the point, isn’t it? Seeing as the same amount of principal in the same currency flows in both directions at the same time, the principal cancels out.
The parties to a swap are not really lending to each other, old thing.”
Customers and dealers
But this is not what the JC means. He means to say that when a dealer provides a swap to a customer, economically, the dealer lends, outright, to the customer. One way.
Now, far out in space, beyond the cramped Oort cloud 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” — is a “customer”. These are the great majority of all swap arrangements in the known universe. Hence, the expressions “sell-side” — the dealers — and “buy-side” — their customers.
The difference between customer and dealer on a swap is not who is “long” and who “short” — one of the great swappist beauties under the ISDA framework is that customers can go long or short, as they please — nor on who pays “fixed” and who “floating”.
The difference between customer and borrower is who, economically, is borrowing.
For a customer the object of any Transaction is to change its overall market exposure: to get into positions it did not have before, or get out of ones it did.
This sounds obvious enough. But dealers do not. Dealers stay flat.
“Hang on, though, JC: if a swap is bilateral, how can that be so? Does it not follow that if the customer changes its position one way, the dealer must dp so the other way?”
In the narrow confines of the specific ISDA Master Agreement perhaps. But in the wider context of the parties overall net positions, no.
The dealer “provides” exposure by sourcing it in the market, delta-hedging it, and charging its customer a commission. There are all kinds of enterprising and funding-efficient ways it can do so, but fundamentally, a dealer stays market-neutral. The customer’s credit risk for the life of the trade, is all the excitement the dealer wants. As long as its market side hedges work, the only market risk the dealer takes comes about if the customer fails. That is to say, the dealer has customer credit exposure for as long as the customer stays in its risk position. The customer decides when to exit: as long as it is not solvent the dealer is committed to staying in. If the customer wants to exit, the dealer will make a price.
As it would have in a loan.
Ok: but how does that fleeting resemblance turn an obviously bilateral swap into a “synthetic loan”?
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 JC’s fabulous new legaltech start-up, Cryptöagle.
It can do one of three things:
(i) sell Lexrifyly and buy Cryptöagle — that is, make an outright long investment;
(ii) hold Lexrifyly and borrow to buy Cryptöagle — that is, take a margin loan;
(iii) hold Lexrifyly and get synthetic exposure to Cryptöagle via an equity swap — that is, 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 economics of 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. As it would have in a loan.
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 would make on a loan.[1]
But, hang on: this is a bilateral arrangement, right, so isn’t the converse also 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? 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 chang 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.
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.[2]
Ok; that’s a delta-one equity swap. But synthetic prime brokerage is, surely, an unusual use case?
Aren’t “normal” swaps truly bilateral? How about a good old fashioned interest rate swap? Surely paying a fixed rate, and receiving a floating rate, has none of these same characteristics of borrowership about it?
The first point to make here is that in the real universe of actual, non-derivative instruments, fixed or floating rate cashflows do not exist independently of principal investments. (This is just as true of dividends on equities, of course). This is because a cashflow is necessarily income on a capital investment.
Oh, sure, you could detach and sell a strip of coupons off a bond: okay. But to do that, there must first be a bond, and you must 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 are left with this weird, mutilated, principal-only, zero-coupon instrument that you must sell into the market at a heavy discount to its fully-limbed equivalent. It will exist, but unhappily: like Weird Barbie or one of those intercised children with no daemon in His Dark Materials. Once you have sold it you might not be able to see the principal investment any more, but it is still there.
Repeat: in the real world, income cashflows depend on an income-generating asset. Stands to reason. A rate with out principal is like a shadow without a boy.
Do swaps change all that? No: because at some point, swaps must be based in the reality from which they are derived.
Derivatives as “engines of hypothesis”
Derivative
/dɪˈrɪvətɪv/ (n.)
FINANCE: (of a product) having a value deriving from an underlying variable asset. (emphasis added)
When the Children of the Forest wrought their wristy magic on the First Men, the Way of the One Agreement passed into common understanding. Only then were our leaden, earth-bound notions of “necessary principal” swept away.
Only then did the swap market take wing, upon the nuclear power of infinite leverage. Income could flow, at last, broken free of its leaden principal host, and could nudely frolic in ISDA’s glittering starlight.
The synthetic world is an alternative, magical realm. In it, there are imaginary tools with which we can do impossible things. Hypothetically, we can isolate income from principal and trade them as discrete instruments. Normal rules of spacetime do not apply.
But gravity is not banished; only postponed. At some point, our swappist fantasia must alight on planet Earth and engage with real-world instruments, because that is what it is all derived from. Ultimately, somewhere down the chain, someone needs to construct each enchanting payoff from grubby, real old-fashioned, corporate rights and obligations. Those rights and obligations will come with principal attached. And that must be financed.
If you want to earn floating rate on a notional of a hundred bucks, in the real world you pony up a hundred bucks and buy a floating-rate note. Ponying up cash means selling an investment you already own:[3] going off some other risk. If you don’t want to sell down that asset, you must borrow a hundred bucks from someone. If it is the dealer who is selling you the floating rate note, then consider the final cashflows: you pay a fixed rate out of the income generated by your assets, the principal on the note you’ve bought cancels out against the principal of your loan and bingo: you have an interest rate swap.
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. Interest rate swaps are, in this sense, “synthetic fixed income prime brokerage”: a margin loan to buy a fixed income asset.
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 buy the new floating-rate asset. Because that borrowing has the same principal amount as the purchased 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 cashflow 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 outright 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 certainly not borrowing anything. It is making a fully-funded long investment.
“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 the floating-rate bond, to hedge itself. It is flat. You have not, net, lent the dealer anything.