When variation margin attacks

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.

The Devil’s Advocate™ →Go uptown In which the curmudgeonly old sod puts the world to rights. Index — Click ᐅ to expand: The Devil’s Advocate Tell me more Sign up for our newsletter — or just get in touch: for ½ a weekly 🍺 you get to consult JC. Ask about it here.

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

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

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, VM is typically paid into an account with the broker, and net equity takes initial margin into account — initial margin is another story altogether — that cash balance, over required initial margin, is available to be drawn down on request.

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 done so, of course – but the right to gracefully decline is a powerful thing. While lending on margin against net equity is how prime brokers make their money, there are times when you might want to pull in the horns. Especially if — as, per the chart — your client’s positions in thinly traded stocks have rallied enormously against the rest of the market. What goes up must come down; what goes up quickly tends to come down even more quickly.

Even in the

But anyway, we are getting ahead of ourselves.

Back up, back up: 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 vibes were of prudence: clients would produce non-cash surety, but banks would lend based on the overall understanding of a customer’s position, lending would be broadly proportionate.

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

• Archegos