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{{drop|[[a swap as a loan|W]]|hile composing}} his [[The bilaterality, or not, of the ISDA|turgid disquisition]] on the “bilaterality” of the {{isdama}}, 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  “[[Let’s take it offline|took things offline]]” and started a whole new article on the topic. Here it is.
{{quote|
People come out from their jobs, most of which are meaningless to them, and they watch me jump 20 cars, and maybe get splattered. It means something to them. They jump right alongside of me. They take the bars in their hands and for one split second, they’re all daredevils. I am the last gladiator in the new Rome. I go into the arena and I compete against destruction and I win. And next week, I go out there and I do it again. And this time, civilisation being what it is, and all, we have very little choice about our life. The only thing really left us is a choice about our death. And mine will be ''glorious''.
:—{{plainlink|https://youtu.be/zIZXGXE1aF8|''Evel Kneivel'' (1971)}}, on jumping the Grand Canyon
}}
{{drop|[[a swap as a loan|I]]|n}} his [[The bilaterality, or not, of the ISDA|leaden exposition]] on the “bilaterality” of the {{isdama}}, JC remarked that, despite ''looking'' like a bilateral, unfunded instrument, a swap is, in reality, an ''implied loan''.  
 
This throwaway comment prompted explosions of indignance from friends, colleagues and people who JC greatly respects so he decided to double down on it. Look, if you are going to go down in an attempt, it might as well be at the Grand Canyon. So, here goes.


To recap the background to that post:
To recap the background to that post:


{{Quote|{{drop|W|hereas 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''.
{{Quote|{{drop|W|hereas most}} finance contracts imply dominance of one party and subservience of the other — a loan, for example, has a ''lender'' who takes mortgages, sharpens knives and extracts excruciating covenants the way a dentist does teeth and a ''borrower'' whose mortal soul is traduced with the indignities of indebtedness 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.”}}
Swaps, so conventional wisdom would have it, are ''exchanges among peers''. “A swap is,” cognoscenti are given to say, “an equal-opportunity, biblically righteous compact ''between equals''. Yes, the Transaction may go in and out of the money but it swings either way. As it does, each participant is an honest rival for Lady Fortune’s favour, 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''.
That is the theory. But JC says, at least beyond the limited class of inter-dealer swap transactions, and even then, often within it, ''fiddlesticks''. 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.
An “end user” swap ''is'', in fact, a “synthetic” loan from a [[dealer]] to [[customer]]. <ref>Where regulations require dealers to ''post'' [[variation margin]] outright against their own [[out-of-the-money]] swap exposures (rather than simply calling for it when their customers are [[ouit-of-the-money]]), 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.''
''Swap dealers should not collateralise their customers.''


There. I said it.
There. I said it.</ref>


JC is blessed in having charitable friends who forgive intellectual softness.  
JC is blessed with 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 mis-selling scandal|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.”  
“Oh, well,” they are prone to say when the old boy goes off on one, “I suppose you ''could'' analyse an [[Interest rate swap mis-selling scandal|interest rate swap]] as a pair of off-setting loans. Yes, that seems strictly true. But 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.”  


But this is not what JC means. When a dealer provides a swap to a customer, even after taking into account the “offsetting loans” of this traditional theory, economically the dealer is ''still'' lending outright to the customer. The dealer doesn’t actually disburse any money to the customer, but that doesn’t matter: the dealer applies the loan proceeds instead in financing its hedge on the customer’s behalf.
====Customers and dealers====
====Customers and dealers====
{{drop|B|ut 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|sell-side]]” — dealers — and “[[buy side|buy-side]]” — customers.
{{drop|N|ow there is}} a boundless universe of “[[end user]]” swap {{isdaprov|Transaction}}s. Here, one party is a “dealer” and the other — the “end user” — is a “customer”. Hence, the expressions “[[sell side|sell-side]]” — dealers — and “[[buy side|buy-side]]” — customers. These are the great majority of all swap arrangements in the known cosmos.
 
So what, in a bilateral arrangement, determines who is “dealer” and who is “customer”? It is not who is “long” and who “short” the swap exposure — one of the great [[Swappist Oath|swappist]] beauties of the ISDA framework is that customers can go long ''or'' short, as they please. Nor is it who pays “fixed” and who pays “floating”. Rather it is who is “on risk” and who is “flat”. Customers want to change their net economic exposure. Dealers do not.  


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 Oath|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 argument JC will mount for the remainder of this piece is this:
{{quote|To change one’s economic exposure to any financial instrument involves ''capital investment''. An investor must either make that capital investment itself from its own funds or it must borrow the money from someone else. In a swap, that “someone else” is the ''dealer''. The way a dealer “makes that capital investment” is by ''hedging''.}}
 
Therefore, the economic difference between the ''customer'' and ''dealer'' in a swap Transaction is that ''the dealer is lending and the customer is borrowing''.   
====The capital cost of changing your position====
====The capital cost of changing your position====
{{drop|F|or a customer}}, the object of any {{isdaprov|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''.  
{{drop|F|or a customer}}, the object of any {{isdaprov|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''.  
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“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?”  
“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 {{isdaprov|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.  
In the narrow confines of a specific ISDA {{isdaprov|Transaction}} — ignoring any hedging arrangements — this is so. But the narrow {{isdaprov|Transaction}} is not the whole picture. There ''are'' hedging arrangements. In the wider context of the parties’ overall net risk positions, customers ''invest'': they take on risk. They change their positions. Dealers don’t. Their interest is only in commission. They do not have a market position.<ref>To be sure, [[dealer|dealers]] may have an “[[axe|trading axe]]”, as they delta-hedge across their whole derivatives trading book. But — especially since the [[global financial crisis]], and in large part before it, this axe is largely aimed at flattening the risk in their trading book and optimising their financing costs of all that hedging.</ref>


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.  
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. ''More'', actually.  As long as the dealer’s market-side hedges work, the only market risk the dealer takes arises 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. As long as the customer remains solvent, it chooses when to exit. The dealer is (morally) committed to staying in.<ref>Not legally, necessarily: there may well be regulatory capital reasons that a dealer must have a termination right on say 30 or 60 days’ notice — these give negotiation teams the thrill of arguing about the gilding of a lilly — but do not expect a dealer ever to exercise those rights, short of a market meltdown that threatens its own existence.</ref> If the customer wants to exit before a stated term, even where it has no legal right to do so, it is an odd swap dealer indeed who will make a price.<ref>Swap break costs are easy enough to calculate.</ref>


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.  
Now: the thing about being net long, or net short, a financial exposure is that someone needs to acquire that exposure. Even if it is an “unfunded” derivative like a rate or index, in the real world one can only achieve that rate or index return by making an actual capital investment in the underlying products that generate that rate or index. Even if it is not the investor, ''someone'' has to ''commit capital'' to generate that return. That someone is the dealer.


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|margin loan]]).
This is the same capital expenditure that a bank must make when extending a loan. The difference is only that a bank commits that capital directly to its customer, wheras a swap dealer commits it to its own hedging programme and then charges the financing cost of that capital to the customer.
 
This is the fundamental difference, for example, between an [[equity swap|delta-one equity swap]] and a [[Margin loan|margin loan]]. This is why equity swaps are also called “[[synthetic prime brokerage|''synthetic'' prime brokerage]]”.


====Worked example====
====Worked example====
Imagine [[Hackthorn Capital Partners]] already holds USD10m of that redoubtable stalwart of legal [[Thought leader|thought-leader]]ship [[Lexrifyly]], and, it wants to acquire some long exposure to the JC’s fabulous new [[Legaltech startup conference|legaltech start-up]], [[Cryptöagle]].
Imagine [[Hackthorn Capital Partners]] holds USD10m shares of [[Lexrifyly|Lexrifyly, Inc.]] and wants to gain exposure to [[Cryptöagle|Cryptöagle, GmbH]]. Hackthorn is fully invested and has no spare cash.


Hackthorn can do one of three things:  
Hackthorn can do one of three things:  
Line 50: Line 62:
(iii) ''hold'' [[Lexrifyly]] and ''get synthetic exposure to'' [[Cryptöagle]] via an [[equity swap]] from its dealer, without, apparently borrowing any money.}}}}
(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.  
To make it easy, let’s say the quantity and strike price for each is 10m shares at USD1, and the market value (MV) for [[Lexrifyly]] is USD1.2 and for [[Cryptöagle]] is USD1.4. Let’s say the investment period was 1 year and interest accrued at 1% per annum.


Here are the positions:
Here are the positions:
Line 56: Line 68:
{{Quote|{{divhelvetica|
{{Quote|{{divhelvetica|
'''Sale'''<br>
'''Sale'''<br>
If it sells [[Lexrifyly]] outright, the position is as follows:
If it sells [[Lexrifyly]] outright and buys [[Cryptöagle]] outright:
:''Sold: USD10m [[Lexrifyly]].
:''Sold: USD10m [[Lexrifyly]] @ USD1.
:''Borrowed'': Zero.
:''Borrowed'': 0.
:''Amount owed'': Zero.
:''Bought'': 10m [[Cryptöagle]] @ USD1.
:''Bought'': 10m [[Cryptöagle]].
:''Current MV of  [[Cryptöagle]]: USD1.4.
:''Net position'': ''10m [[Cryptöagle]] shares + zero [[Lexrifyly]] + zero loan''
----
:''MV(10m [[Cryptöagle]])'' equals '''USD14m'''
 


'''Loan'''<br>
'''Loan'''<br>
If it keeps [[Lexrifyly]] and borrows to buy [[Cryptöagle]], the position is as follows:
If it keeps [[Lexrifyly]] and borrows to buy [[Cryptöagle]]:
:''Sold: Zero.
:''Held: USD10m [[Lexrifyly]].
:''Borrowed: USD10m.
:''Borrowed: USD10m.
:''Bought'': USD10m [[Cryptöagle]].
:''Bought'': USD10m [[Cryptöagle]] @ USD1.
:''Net position'':  ''10m [[Lexrifyly]] shares + 10m [[Cryptöagle]] shares - USD10m - accrued interest''
----
:''MV(10m [[Lexrifyly]]) + MV(10m [[Cryptöagle]]) - USD10m and accrued interest'' equals:
----
:USD12m + USD14m - USD10.1m equals '''USD15.9m'''
 


'''Swap'''<br>
'''Swap'''<br>
If it keeps [[Lexrifyly]] and buys an equity swap from its dealer struck at USD10m, the position is as follows:
If it keeps [[Lexrifyly]] and buys a swap on [[Cryptöagle]] struck at USD1:
:''Sold: Zero.
:''Held: USD10m [[Lexrifyly]].
:''Borrowed: Zero.
:''Borrowed: Zero.
:''Swap outgoings'': Floating rate on USD10m
:''Swap outgoings'': Interest on USD10m
:''Swap incomings'': USD10m [[Cryptöagle]] - USD10m (being the strike price).
:''Swap incomings'': (MV([[Cryptöagle]] - Strike) * 10m)  
:''Net position'':  ''10m [[Lexrifyly]] shares + 10m [[Cryptöagle]] shares - USD10m - accrued interest''
----
}}}}
:''MV(10m [[Lexrifyly]]) + ((MV([[Cryptöagle]] - Strike) * 10m) - accrued interest on USD10m''
----
:USD12m + USD4m - USD100,000 equals  '''USD15.9m'''}}}}


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.  
The economics of the loan and the swap are ''identical''. The investor’s payment profile and return 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 the investor exposure to [[Cryptöagle]] whilst keeping its exposure to [[Lexrifyly]], which it uses to fund cashflows on its new capital asset.  


This is a form of ''[[leverage]]''. ''As it would have'' ''in a loan.''  
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.<ref>To keep it simple, I have ignored the scope for synthetic margin loan and rehypothecation.</ref>  
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. (To keep it simple, I have ignored the scope for synthetic margin loan and rehypothecation.)  


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?  
But, hang on: this is a bilateral arrangement, right, so isn’t the converse also true for 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-hedging|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.   
No, because in providing these swap exposures whether long or short, the dealer simultaneously [[Delta-hedging|delta-hedges]]. It does not change its 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, buys a hedge, and then sells an offsetting position to the customer, ending up where it started, flat, and ''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.  
Provided the [[dealer]] knows what it is about, its main risk in running a swap portfolio is not market risk — it should not have any — but ''customer credit'' ''risk''. The moment a customer fails, the dealer’s book is no longer hedged: what was a delta-hedge is now an outright long or short position. when the reason your customer has blown up is that its highly levered investment in the same segment of thinly traded illiquid stocks has just gapped downwards, this is enough of a risk to be a real bummer, as those involved in the [[Archegos]] omnishambles will tell you.


==== Fixed/floating swaps ====
==== Fixed/floating swaps ====

Revision as of 11:15, 19 July 2024

People come out from their jobs, most of which are meaningless to them, and they watch me jump 20 cars, and maybe get splattered. It means something to them. They jump right alongside of me. They take the bars in their hands and for one split second, they’re all daredevils. I am the last gladiator in the new Rome. I go into the arena and I compete against destruction and I win. And next week, I go out there and I do it again. And this time, civilisation being what it is, and all, we have very little choice about our life. The only thing really left us is a choice about our death. And mine will be glorious.

—Evel Kneivel (1971), on jumping the Grand Canyon

In his leaden exposition on the “bilaterality” of the ISDA Master Agreement, JC remarked that, despite looking like a bilateral, unfunded instrument, a swap is, in reality, an implied loan.

This throwaway comment prompted explosions of indignance from friends, colleagues and people who JC greatly respects so he decided to double down on it. Look, if you are going to go down in an attempt, it might as well be at the Grand Canyon. So, here goes.

To recap the background to that post:

Whereas most finance contracts imply dominance of one party and subservience of the other — a loan, for example, has a lender who takes mortgages, sharpens knives and extracts excruciating covenants the way a dentist does teeth and a borrower whose mortal soul is traduced with the indignities of indebtedness 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. “A swap is,” cognoscenti are given to say, “an equal-opportunity, biblically righteous compact between equals. Yes, the Transaction may go in and out of the money but it swings either way. As it does, each participant is an honest rival for Lady Fortune’s favour, however capricious may she be.”

That is the theory. But JC says, at least beyond the limited class of inter-dealer swap transactions, and even then, often within it, fiddlesticks. This conventional wisdom is not true. In the bigger picture, swaps are loans.

An “end user” swap is, in fact, a “synthetic” loan from a dealer to customer. [1]

JC is blessed with 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 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.”

But this is not what JC means. When a dealer provides a swap to a customer, even after taking into account the “offsetting loans” of this traditional theory, economically the dealer is still lending outright to the customer. The dealer doesn’t actually disburse any money to the customer, but that doesn’t matter: the dealer applies the loan proceeds instead in financing its hedge on the customer’s behalf.

Customers and dealers

Now there is a boundless universe of “end user” swap Transactions. Here, one party is a “dealer” and the other — the “end user” — is a “customer”. Hence, the expressions “sell-side” — dealers — and “buy-side” — customers. These are the great majority of all swap arrangements in the known cosmos.

So what, in a bilateral arrangement, determines who is “dealer” and who is “customer”? It 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 is it who pays “fixed” and who pays “floating”. Rather it is who is “on risk” and who is “flat”. Customers want to change their net economic exposure. Dealers do not.

The argument JC will mount for the remainder of this piece is this:

To change one’s economic exposure to any financial instrument involves capital investment. An investor must either make that capital investment itself from its own funds or it must borrow the money from someone else. In a swap, that “someone else” is the dealer. The way a dealer “makes that capital investment” is by hedging.

Therefore, the economic difference between the customer and dealer in a swap Transaction is that the dealer is lending and the customer 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 — this is so. But the narrow Transaction is not the whole picture. There are hedging arrangements. In the wider context of the parties’ overall net risk positions, customers invest: they take on risk. They change their positions. Dealers don’t. Their interest is only in commission. They do not have a market position.[2]

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. More, actually. As long as the dealer’s market-side hedges work, the only market risk the dealer takes arises 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. As long as the customer remains solvent, it chooses when to exit. The dealer is (morally) committed to staying in.[3] If the customer wants to exit before a stated term, even where it has no legal right to do so, it is an odd swap dealer indeed who will make a price.[4]

Now: the thing about being net long, or net short, a financial exposure is that someone needs to acquire that exposure. Even if it is an “unfunded” derivative like a rate or index, in the real world one can only achieve that rate or index return by making an actual capital investment in the underlying products that generate that rate or index. Even if it is not the investor, someone has to commit capital to generate that return. That someone is the dealer.

This is the same capital expenditure that a bank must make when extending a loan. The difference is only that a bank commits that capital directly to its customer, wheras a swap dealer commits it to its own hedging programme and then charges the financing cost of that capital to the customer.

This is the fundamental difference, for example, between an delta-one equity swap and a margin loan. This is why equity swaps are also called “synthetic prime brokerage”.

Worked example

Imagine Hackthorn Capital Partners holds USD10m shares of Lexrifyly, Inc. and wants to gain exposure to Cryptöagle, GmbH. Hackthorn is fully invested and has no spare cash.

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 the quantity and strike price for each is 10m shares at USD1, and the market value (MV) for Lexrifyly is USD1.2 and for Cryptöagle is USD1.4. Let’s say the investment period was 1 year and interest accrued at 1% per annum.

Here are the positions:

Sale
If it sells Lexrifyly outright and buys Cryptöagle outright:

Sold: USD10m Lexrifyly @ USD1.
Borrowed: 0.
Bought: 10m Cryptöagle @ USD1.
Current MV of Cryptöagle: USD1.4.
MV(10m Cryptöagle) equals USD14m


Loan
If it keeps Lexrifyly and borrows to buy Cryptöagle:

Held: USD10m Lexrifyly.
Borrowed: USD10m.
Bought: USD10m Cryptöagle @ USD1.
MV(10m Lexrifyly) + MV(10m Cryptöagle) - USD10m and accrued interest equals:
USD12m + USD14m - USD10.1m equals USD15.9m


Swap
If it keeps Lexrifyly and buys a swap on Cryptöagle struck at USD1:

Held: USD10m Lexrifyly.
Borrowed: Zero.
Swap outgoings: Interest on USD10m
Swap incomings: (MV(Cryptöagle - Strike) * 10m)
MV(10m Lexrifyly) + ((MV(Cryptöagle - Strike) * 10m) - accrued interest on USD10m
USD12m + USD4m - USD100,000 equals USD15.9m

The economics of the loan and the swap are identical. The investor’s payment profile and return 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 the investor exposure to Cryptöagle whilst keeping its exposure to Lexrifyly, which it 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. (To keep it simple, I have ignored the scope for synthetic margin loan and rehypothecation.)

But, hang on: this is a bilateral arrangement, right, so isn’t the converse also true for 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 whether long or short, the dealer simultaneously delta-hedges. It does not change its 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, buys a hedge, and then sells an offsetting position to the customer, ending up where it started, flat, and without a position.

Provided the dealer knows what it is about, its main risk in running a swap portfolio is not market risk — it should not have any — but customer credit risk. The moment a customer fails, the dealer’s book is no longer hedged: what was a delta-hedge is now an outright long or short position. when the reason your customer has blown up is that its highly levered investment in the same segment of thinly traded illiquid stocks has just gapped downwards, this is enough of a risk to be a real bummer, as those involved in the Archegos omnishambles will tell you.

Fixed/floating swaps

Nuncle: ’Tis none so mincey as a Farrington chop
And nowt so loansome as a fixed rate swap.[5]

—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.[6] 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:[7] 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.

  1. ↑ Where regulations require dealers to post variation margin outright against their own out-of-the-money swap exposures (rather than simply calling for it when their customers are ouit-of-the-money), 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.
  2. ↑ To be sure, dealers may have an “trading axe”, as they delta-hedge across their whole derivatives trading book. But — especially since the global financial crisis, and in large part before it, this axe is largely aimed at flattening the risk in their trading book and optimising their financing costs of all that hedging.
  3. ↑ Not legally, necessarily: there may well be regulatory capital reasons that a dealer must have a termination right on say 30 or 60 days’ notice — these give negotiation teams the thrill of arguing about the gilding of a lilly — but do not expect a dealer ever to exercise those rights, short of a market meltdown that threatens its own existence.
  4. ↑ Swap break costs are easy enough to calculate.
  5. ↑ Are you loansome tonight?
  6. ↑ This is just as true of dividends on equities, of course.
  7. ↑ Even free cash deposited with the bank is an investment: it is a loan to the bank.
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