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 — 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 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. Furthermore, to the extent dealers are obliged to post two-way variation margin, regulators have made a category error in not realising this.

Industry veterans may look upon you slack-jawed if you say this. Regulators certainly will. Being optimistic, they try to give you the benefit of the doubt for this flight of fancy, while thinking “has the old bugger finally lost his marbles?”

The 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 flows cancel each other out. So, loans, sure. But two loans, going in opposite directions. They cancel each other 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, economically, a dealer lends, outright, to a customer. One way.

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” — is a “customer”. This is 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 is not who is “long” and who “short” — one of the great 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 borrower is who, economically, 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 one way, the dealer must be doing so the other way?”

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 hedges the market risk of the customer’s trade — which, yes, is the opposite to the customer’s position — away. Without no market risk, the dealer has 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 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.

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 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.

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 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.

Derivatives as engines of hypothesis

Do swaps change all that? No: because at some point, swaps must be based in the reality from which they are derived.

Derivative
/dɪˈrɪvətɪv/ (n.)
FINANCE: (of a product) having a value deriving from an underlying variable asset.

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 necessary principal swept away. Only then did the swap market take wing, upon the nuclear power of infinite leverage.

Income flows could, at last, 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 those 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 sell down that asset, you can borrow the hundred bucks at a fixed rate from the dealer who is selling you the floating rate note, pay that fixed rate out of your assets, and bingo: the principal on the note you’ve bought cancels out against your loan and 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.