Static and dynamic margin

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Synthetic Prime Brokerage Anatomy™

Synthetic prime brokerage is documented under the 2002 ISDA Equity Derivatives Definitions, so read this anatomy in conjunction with our wider Equity Derivatives Anatomy. See also our Prime Brokerage Anatomy.

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A technique that achieved some notoriety in the aftermath of the Archegos meltdown, but in the good old innocent days of TRS, especially before compulsory variation margin, was really rather run-of-the-mill.

Where you have a “bulletTRS, being a delta-one equity derivative with a specified termination date, usually one or two years from inception, Initial margin would be calculated based on the notional value of the swap at inception and the estimated life of the trade and the expected volatility during that period.

Once set, the broker could not change initial margin, unless there were pre-agreed Equity Notional Resets. Unless and until reset, the initial margin would be calculated on that initial strike price, and would not adjust to reflect the changing value of the underlier. This means, as the swap value went up, the relative value of the initial margin as a proprtion of that value, went down. The CS Report on Archegos termed this effect, rather artfully we think, as “margin erosion”.

In a nutshell: 15% initial margin at 100 is the same as 7.5% initial margin when the underlier appreciates to 200.

Now, you might say, but the customer is making money! Why should it have to pay more initial margin where its trades are in-the-money? Surely there is now a buffer not of fifteen, but one hundred and fifteen before the broker is facing a loss!

Well, because of the offsetting impact of variation margin paid out to the customer. If a position appreciates by 100%, the broker must pay out, in cash, the value of that gain as variation margin. If you view an equity swap as “a margin loan done with derivatives”, the broker took in 15 on day 1, used 85 of its own money to buy 100 of the stock as a hedge, and has now paid out another hundred to the client. So the economics of the margin loan are now: loaned 185, received margin 15.

Dynamic margin and the rise of the synthetic equity swap

Increasingly, it seemed delta-one equity swap clients were not really looking for fixed term exposures: any fixed term is arbitrary if what you are trying to do is replicate a margin loan with a physical holding of the stock, that you can sell, or not sell, whenever it pleases you. Hence was born the synthetic equity swap — sometimes known as a “portfolio master confirmation”, a “portfolio swap annex”, a “PRT”, an “SES”, or some other confection like that — which presumed the client would hold the position indefinitely, and thus allowed the broker to reassess its margin at any time, and also reference the initial margin to the prevailing Final Price, not the Initial Price — hence dynamic margin, and not static margin. Dynamic margin automatically adjusts the dollar value of required initial margin to a fixed portion of the value of the position without uncomfortable calls to the client to explain why.

See also