Template:M intro isda a swap as a loan

While composing his turgid disquisition on the “bilaterality” of the ISDA Master Agreement, JC remarked that, despite looking like bilateral, even-stevens, un-loansome things swaps are, in fact, implied loans. Hotly justifying this stance side-tracked 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 — the classic loan has 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.

Swaps, so conventional wisdom would have it, are exchanges among peers. “It is,” cognoscenti are given to say, “an equal-opportunity, biblically righteous compact between equals. There is no lender or borrower to a swap: yes, the transaction may go in and out of the money but, as it does, each participant is an honest rival for the favour of the Lady Fortune, however capricious may she be.”

Fiddlesticks. At least outside the inter-dealer community, and even then, frequently within it, this conventional wisdom is not true.

In the bigger picture, swaps are loans.

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 it from their customers), 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.

JC is blessed in having charitable friends who forgive intellectual softness.

“Oh, well,” they are prone to say when the old boy goes off on one, “I suppose you could analyse an interest rate swap as a pair of off-setting loans. Yes, that seems strictly true. But, dear fellow, is it not rather to miss the point? Seeing each party lends to the other, and as notional principal flows in both directions at the same time, the loan, as you put it, cancels out. The parties to a swap are not really lending to each other, old thing.”

Customers and dealers

But this is not what JC means. When a dealer provides a swap to a customer, economically the dealer lends outright to the customer. The customer itself doesn’t get the money, but that doesn’t matter. The money goes on financing the hedge. Now, 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” — dealers — and “buy-side” — customers.

The difference between customer and dealer on a swap is not who is “long” and who “short” the swap exposure — one of the great swappist beauties of 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 is lending and who is borrowing.

The capital cost of changing your position

For a customer, the object of any Transaction is to change its overall market exposure: to get into a position it did not have before, or get out of one it did. But dealers do not do this. 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 change its position the other way?”

In the narrow confines of a specific ISDA Transaction — ignoring any hedging arrangements — perhaps. But the narrow Transaction is not the whole picture. In the wider context of the parties’ overall net risk positions, this does not happen. Customers invest: they take on risk. They change their positions. Dealers don’t.

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 this, but fundamentally, the 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.

Now: the thing about being net long, or net short, a financial exposure is that someone needs to acquire that exposure. Even if the exposure is an “unfunded” rate, or index, in the real world that rate only comes from making a capital investment in an underlying product. Someone has to commit capital to generate that return.

This is the same capital expenditure that a bank must make when extending a loan. The difference is only that the bank commits that capital to its hedging programme, rather than giving it directly to the customer (as it would in a margin loan).

Worked example

Imagine Hackthorn Capital Partners already holds USD10m of that redoubtable stalwart of legal thought-leadership Lexrifyly, and, it wants to acquire some long exposure to the JC’s fabulous new legaltech start-up, Cryptöagle.

Hackthorn can do one of three things:

(i) sell Lexrifyly and buy Cryptöagle — that is, make an outright long investment out of the proceeds of sale;

(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 from its dealer, without, apparently borrowing any money.

To make it easy, 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:

Sale
If it sells 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 Lexrifyly and borrows to buy Cryptöagle, 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 Lexrifyly and buys an equity swap from its dealer struck at USD10m, the position is as follows:

Sold: Zero.

Borrowed: Zero.

Swap outgoings: Floating rate on USD10m

Swap incomings: USD10m Cryptöagle - USD10m (being the strike price).

Net position: 10m Lexrifyly shares + 10m Cryptöagle shares - USD10m - accrued interest

Notice that the economics of the loan are identical to those of the swap. 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 change 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 thing to say here is that in the real universe of actual, non-derivative instruments, interest rate cashflows do not exist independently of an investment in principal. This is because an interest rate is, by definition, the income on a capital investment.

Oh, sure, you can 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 principal back into the market. Once you’ve done that, you have your disembodied interest cashflow, all right — but someone else has its dark inversion: this weird, mutilated, principal-only, zero-coupon instrument that trades 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 the principal you might not be able to see it any more, but it is still there.

“In the real world interest rates do not exist independently of principal investments. This is because an interest rate is, by definition, the income on a capital investment.”

Repeat: in the real world, interest rate cashflows depend on income-generating assets. It stands to reason. A rate without 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. This is not bitcoin, folks.

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 and the Way of the One Agreement passed into common understanding our leaden, earth-bound notions of “necessary principal” were swept away. Only then did the swap market take wing, upon the nuclear power of leverage. Income could flow, at last, unshackled of its leaden principal host, and was free to nudely frolic in ISDA’s glittering starlight.

The “synthetic” world is an alternative, magical realm. Normal rules of space-time do not apply. There are amulets, magic instruments and imaginary tools with which even ordinary mortals can do impossible things. As we have seen, we can isolate income from principal and trade them hypothetically, as discrete instruments.

But gravity is not banished; only postponed. At some point, this fantasia must alight on planet Earth and engage with real-world instruments, because that is what it is all derived from. Ultimately, somewhere, someone needs to construct each enchanting payoff from grubby, weighty, principal-laden corporate rights and obligations. Those rights and obligations are — on our mortal coil, must be — embedded in a scaly crust of principal.

And that principal must be financed.

So if you want to earn floating rate on a notional of a hundred bucks in the real world, you pony up a hundred bucks. That means selling an investment you already own: going off some other risk. If you don’t want to sell down another investment, you must borrow from someone.

If that someone is the dealer from whom you bought the floating rate note, consider the final cashflows: you pay a fixed rate on your loan; you finance that from the income generated by your asset portfolio, 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 debt instrument. 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.