Margin excess
|
Hedge Funds & Prime Brokerage Anatomy™
|
Margin excess[3] is potential margin: any amount standing to a customer’s account with a prime broker over and above the minimum margin that the prime broker requires the customer to hold against its liabilities. Margin excess may be in the form of unrealised profit from live transactions, variation margin on swap positions credited to the customer’s account, or excess assets the customer has paid for but holds with the prime broker as custodian.
The prime broker holds or controls it — possession is nine-tenths of the law — but, as long as it stays as “margin excess” — see below — must give it back to the customer on request.
As long as you have a margin excess, you shouldn’t need to make a margin call — a margin adjustment will do.
While the PB holds margin excess it is subject to all the usual security arrangements; the only difference is that the customer is not obliged to let the PB hold it, as such; but customers habitually do, because it is convenient — they have to hold it somewhere, so why not with the good old prime broker? — and because it tends to make their prime brokers feel better about things. And as long as the prime broker has the right to adjust margin at any time, it is justified in feeling quite good about it. If the prime broker must give even a brief notice period before adjusting, then things are quite a bit more fraught.
“As long as it stays as margin excess”
The reality about just when a customer may ask for its margin excess back — “whenever it likes”, in the normal run of things — can startle a complacent risk officer, but what a startled risk officer can then do, should it not terribly like the idea of giving the margin excess back — is to immediately reclassify it as required margin by means of a margin adjustment.
Careful, though: all this, however, is quickly undermined — as those at Credit Suisse in charge of risking The Client Who Shall Not Be Named would tell you, if any of them were left — if there is any notice period before a margin adjustment takes effect, or if there is a margin lock-up.
Is margin excess “as good as” initial margin?
Yes — and no. This is the subtitle to that grand Shakespeareian tragedy of our times, The Merchant of Menace.
As a starting proposition, excess customer cash you hold, and that you may, at a (commercially reasonable) whim, declare instantly to be initial margin is, in legal theory, near enough the same as initial margin. If a client should ask you for it, you can, on the spot, recharacterise it and refuse. But this changes should there be any notice period between your pronouncement that it is initial margin, and it formally becoming, under the terms of your contract, initial margin. Because in this windy period a customer may, as TCWMNBN did, demand that you pay it back.
Secondly, bear in mind the human aspects at play, as so saucily expounded in the CS Report on Archegos.
Let us coin a maxim:
“Before an apocalypse becomes an apocalypse, it doesn’t look like an apocalypse.”
Risk-free, twenty-twenty hindsight is by definition not available to those who must make the decisions that lead to it. Only later does the reactor core melt down. Only later does the market crash. Beforehand, no-one knew or — at least until it was too late, even believed — that things would turn out like this. Q.E.D.
Why did people do what they did when it was so obviously stupid looking back at it? Well, As Sidney Dekker puts it in his excellent The Field Guide to Human Error Investigations:
“Forks in the road stand out so clearly to you, looking back. But when inside the tunnel, when looking forward and being pushed ahead by unfolding events, these forks were shrouded in the uncertainty and complexity of many possible options and demands; they were surrounded by time constraints and other pressures.”
Ergo, the decision calculus then was nowhere near as obvious as it appears now, as an object in the rear-view mirror: if it had been, the catastrophe would not have happened.
And it is one thing to have a right to pull your trigger, it is quite another to be prepared to use it. Especially if you don’t know how this all will play out.
After the event, all that remains is is a smoking hulk and twisted wreckage strewn across the landscape and it could not be more obvious that there was only ever one option.
Before it, there were twenty million dollars of annual revenues at stake.
Few individuals will blow up a significant business relationship without diffusing responsibility through some kind of institutional escalation. But that takes time. And escalations are fraught: to recommend affronting a platinum client is to invite a shellacking from someone a long way further up the tree than you.
Now: if these are the options, and our valiant risk manager doesn’t yet have that twenty-twenty hindsight of what might come about tomorrow, is it any wonder she’ll be tempted to do nothing?
Before an apocalypse becomes an apocalypse, it doesn’t look like an apocalypse.
See also
References
- ↑ But see the vexed topic of margin lock-up, which significantly constrains the PB’s flexibility.
- ↑ Archegos had a three day notice period, which interposed some rather gristly squeaky-bum time between your adjustment and it going live, which the Credit Suisse risk team weren’t willing to endure.
- ↑ Not to be confused with excess margin, which occurs in the exchange-traded derivatives world, and is the margin your futures and options clearing broker requires over and above margin required by exchanges.