When variation margin attacks

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BLACKADDER: Look, there’s no need to panic. Someone in the crew will know how to steer this thing.
CAPTAIN RUM: The crew, milord? What crew?
BLACKADDER: I was under the impression that it was common maritime practice for a ship to have a crew.
CAPTAIN RUM: Opinion is divided on the subject.
BLACKADDER: Oh, really?
RUM: Yes. All the other captains say it is; I say it isn’t.
BLACKADDER: Oh, God; Mad as a brush.

—Blackadder, Series 2: Potato

Any of the standard reference works 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 loyal contrarian is going to run against what all the other captains will tell, you, let me set the scene with a story.

Once upon a time in America

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

In the months leading up to March 2021, Archegos Capital Management took synthetic positions on margin on a handful of comparatively illiquid stocks — ViacomCBS, Tencent Music, Baidu and Vipshop — in sizes that, across multiple prime brokers, were big enough to move the market sharply up. As the stocks appreciated, so did Archegos’ profit, and thus the net equity it held with its prime brokers. Archegos used that net equity to double down, buying the same stocks, pushing them up yet further. The higher they went, the thinner their trading volume, and the more of the market Archegos represented.

Now, hindsight is a wonderful thing, but really there was only one way this was ever going to turn out.

On 22 March, Archegos’ position in Viacom had a gross market value of US$5.1bn. In a cruel irony, Viacom interpreted this to mean market sentiment was so strong that it should take the opportunity to raise capital. Alas, no one was buying. Not even Archegos, since it was tapped out of equity with its prime brokers.

Viacom’s capital raising therefore failed, and all hell broke loose.

Now here is an interesting thing. Because Archegos gained their market exposure using swaps, by regulation, their brokers were obliged to pay the value of their net equity to them, every day, in the form of variation margin. To be sure, the broker usually pays VM into an account it runs for its client. There are withdrawal thresholds that apply to that account that takes into account required initial margin — oh, that’s another story altogether — but over those thresholds all the variation margin is the client’s money, available to be withdrawn on request.

This is completely normal in the world of latter-day derivatives: mandatory two-way exchange of variation margin was implemented by regulation in pretty much every major market in the name of reducing systemic risk — but all the same, it is utterly weird. It is like forced lending against asset appreciation. Imagine if your bank, by law, had to pay you the cash value of any increase in your home’s value over the life of your mortgage.

This is very different from cash margin lending. Had Archegos put the equivalent physical positions on, using margin loans, its brokers would not have had to advance it the cash value of its net equity. They may well have willingly done so, of course – that is how prime brokers make their money after all, but being able to lend money, and being obliged to lend money are quite different propositions on that special day when it seems the world is going to hell.

A dissonance

So there is this dissonance, between physical prime brokerage, where advancing cash against net equity is at the broker’s discretion — oh, sure, you have withdraw your equity at any time, but you have to take it in kind — and synthetic prime brokerage, where cash payment is required by regulation. It is inevitable for clients and their advisors to ask, “well, if I can withdraw my equity value in cash under a swap, why can’t I have it in cash for my physical portfolio under a margin loan?”

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” — call this the all other captains argument; or: “Well that just goes to show what a misconceived idea compulsory two-way variation margin is” — call this the Captain Redbeard Rum argument.

“Come on, JC: I know you are a cranky old bugger. But do you really mean to say you are going to swim against the tide of all that consensus?”

WHY NOT, my friends, WHY NOT?

Now, if someone would kindly hold my beer:

Banking, in the good old days

Remember when trusted intermediaries were a thing?

• Banks are these trusted intermediaries that make finance available to people who need it to run their businesses.
• Capital and regulation targeted prudent management of a bank’s balance sheet
• Client contracts were one-way affair: since banks were lending customers money, there were no material covenants going the other way. Businesses might provide collateral for their lending, in the form of plant and inventory, but did not collateralise in cash so much, seeing as that would be largely to defeat the purpose of borrowing in the first place.
• On the other side of the banks balance sheet were deposits. Again, no suggestion that the bank offered security for these: it compensates for the enhanced credit exposure over the risk-free rate with a spread over the base rate.
• Customers who considered them to be over-exposed to as single bank (in the shape of large deposits) simply diversified (or invested in non-cash assets).
• Note the role of banks here is not to take a proprietary position in the businesses to which they lent, or the investments which those businesses made, but to manage their credit exposure on their assets, ensure their deposits funded the business, and to make sure the margin between deposits and loans was enough to remain solvent.

Interbank relationships

There is, and always has been, a healthy interbank relationship, providing liquidity, custody, making markets, foreign exchange, hedging and providing each other short term funding to help manage their daily operations. These interbank relationships tend to be wide and many-faceted and the terms documenting them tended to be short to non-existent, and bilateral.

The overall vibe

The overall vibe of the financial system was of circumspect, self-imposed prudence: institutions, staffed by Captain Mainwarings provided stodgy, unflamboyant services to clients who were grateful to be offered them, and who would produce sureties for their investments.

The idea here is to set up an idea of a financial services industry with two types of participant: intermediaries and end users. We have waxed elsewhere about the countless ways enterprising individuals can contrive to interpose themselves into a process that oughtn’t to need that’’ much intermediating, but let us, for today’s outing, take it as we find it.

Intermediaries

There are various types of intermediary in the market: those that are part of the market infrastructure, like stock exchanges, clearing systems, securities depositories and so on; then those agents who earn only a commission from their involvement, and take no principal risk at all: cash brokers, investment managers, clearers, market-makers and intermediate brokers; and then there are those who do take principal risk, but only by lending to the end users, and again don’t participate in the upside or downside of the investments they are financing. In all cases the thing they have in common is that their financial interest is independent of the performance of the instruments in which they are dealing.

The interesting case is the swap dealer: being a counterparty to a derivative contract, a swap dealer is the other side of the trade to its customer and therefore, nominally, fully exposed to the underlier’s performance. However, swap dealers are generally delta-hedged and in many cases are prohibited by regulation from taking proprietary positions.

Intermediaries tend to be regulated and those that take on indebtedness are subject to stringent capital requirements designed precisely to minimise their risk of failure.

End users

End users are those market participants who do have skin in the game: they take all the benefits — less the fees, commissions and financing costs of their intermediaries — and absorb all the losses of their investments. They may be institutional (pension funds, investment funds, multinationals) or retail (private investors) and while the range of investment products they can invest in will depend on their sophistication and financial resources, they are not subject to any kind of prudential regulation. They can, and do, blow up. More speculative investment vehicles may be highly geared and quite likely to blow up.

Enter the swaps

The history of swaps is interesting and fairly well-documented. It all started in earnest 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 coupons on them, with an agreement to return the the same values of the respective currencies at maturity.

• Unlike usual banking activity this didn’t involve a bank lending to a customer. Both parties were lending to the other — hence not just parties, but “counterparties”. Day one, as long as you could really treat the opposing loans as setting off, neither party was really lending to the other. 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 netting, which isn’t wildly germane to this essay except to point out that credit mitigation for derivatives works in a very different way to loans: it works by set-off, not security, and it can swing around, depending on the market value of the underlying obligations.
• This is the other thing. Even if, at inception, it was a fair trade: I lend you Swissies and you lend me an equivalent amount of dollars at today’s exchange rate, should that exchange rate move — is inevitably it will — the respective values of the currencies to be returned at maturity (and the coupons due in the mean time) mean that the contract can quickly resemble indebtedness. Say CHF and USD were at parity when we struck our $10m swap. If CHF drops to 50% of the value of USD, then the counterparty paying dollars effectively owes $5m to the one paying CHF. If, tomorrow, CHF rallies 100% and USD drops 50%, tomorrow the indebtedness will be the other way around. Both therefore had significant contingent credit risk to the during the life of the transaction.

Roll forward twenty years and derivative trading had become a twenty billion dollar industry.

See also

• Variation margin

• Archegos
• Swap history