Template:M intro isda Party A and Party B: Difference between revisions

We should not let ourselves forget: beyond the cramped star system of inter-dealer relationships, there is a boundless universe where one party is a “dealer” and the other a “customer”. This is the great preponderance of all ISDA arrangements. The ''customer'' and a ''dealer'' roles are different. The difference does not depend on who is “long” and who “short”, or who is the fixed rate payer and who is the floating rate payer. Hence the expressions “[[sell side|sell-side]]” — the dealers, who sell exposure — and “[[buy side|buy-side]]” — their customers, who buy it.  

For the buy-side, the object of trading a swap, or making any investment, is to ''change'' its market exposure: to get into a positions it did not have before. This sounds obvious. But, being a bilateral contract, its corollary ought to be that the sell side ought to be changing its position, too. But it is not. A dealer “sells” a swap to earn a commission ''without'' changing its market exposure.   

Now, a swap is a principal obligation, so being a party to one necessarily changes the dealer’s market exposure, so the dealer must then “[[Delta-hedging|delta hedge]]” that position away, by taking on an equal and offsetting position in the same asset somewhere else: by buying the underlying asset, or matching off its exposure under “long” position against another exposure under a “short” position in the same underlier.  

There are plenty of ways to delta hedge, but the basic economic principle is this: on the asset side of the swap the equity leg) the dealer has not changed its market position. It has not, over all, made an investment. It has not borrowed anything.    

But how does this make a swap into a synthetic loan? It is best illustrated by comparing a swap with an actual loan. Take this scenario:

[[Hackthorn Capital Partners]] owns USD10m of AUM. It wishes to buy USD10m of [[Cryptöagle]]. It can either: ''sell'' its existing AUM and use the proceeds to buy Cryptöagle, or ''keep'' its existing portfolio and borrow USD10m.

If it sells its existing portfolio outright, the position is as follows:

:Sold: USD10m.

:Borrowed: Zero.

:Amount owed: Zero.

:Bought: 10m Cryptöagle @ USD1 per share.

:Amount due: [[total return swap|total return]] on 10m Cryptöagle.

If it keeps its existing portfolio and borrows, the position is as follows:

:Sold: Zero.

:Borrowed: USD10m.

:Amount owed: floating rate on USD10m.

:Bought 10m of Cryptöagle @ USD1 per share.

:Amount due: [[total return swap|total return]] on 10m existing portfolio and 10m Cryptöagle.}}}}

{{Quote|{{divhelvetica|During loan, Hackthorn pays floating rate on USD10m and is exposed to the market price of Cryptöagle. <br>

On termination of the loan Hackthorn sells Cryptöagle. If sale proceeds exceed loan repayment, Hackthorn repays the loan and keeps the difference. If sale proceeds are less than loan repayment, Hackthorn must finance the shortfall from its existing portfolio, thereby booking a loss.<br>

Therefore, Hackthorn’s net exposure is ''USD10m - Cryptöagle spot price''.

During swap, Hackthorn pays floating rate on USD10m and dealer pays total return on Cryptöagle. On termination, if the swap termination amount is negative, Hackthorn pays it to dealer. If it is positive, dealer pays Hackthorn. <br>

The swap termination payment is ''USD10m - Cryptöagle spot price''.

Like a loan, the equity swap gives Hackthorn exposure to [[Cryptöagle]] whilst keeping its existing portfolio, which Hackthorn uses to fund cashflows on its new capital asset. This is a form of ''[[leverage]]''. 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 lender would make.<ref>To keep it simple, I have ignored the scope for synthetic margin loan and rehypothecation.</ref>

But, hang on: this is a bilateral swap arrangement, so isn’t the same also true of the dealer? Isn’t the dealer paying a rate to get exposure to the synthetic cashflow of an asset — the floating rate — in the same way, so is, in a sense “borrowing” by paying its total return? Is not a “short” equity derivative, for a dealer, exactly the same as a “long” equity derivative for a customer?

Generally not, because in providing these swap exposures to its customers, the dealer is not changing its own market position. It delta-hedges. At the same moment it puts on a swap, it executes an offsetting hedge. The dealer’s net position on its derivative book will generally be flat. You don’t need to borrow money to take no position.<ref>The  dealer may need to borrow money to fund its hedge, but this is exactly what the customer’s floating rate pays for. This is “borrowing on the customer’s behalf”.</ref>

This makes a lot of sense in one direction — customer to dealer — but none whatsoever in the other. Customers should absolutely cash settle the net losing value of their positions to their dealers (and more). Dealers absolutely should not post “losing values” on customer positions to their customers. For several reasons:

Banks are capitalised and regulated for systemic risk

 

Banks generally go bust because their clients go bust. They don’t go bust by themselves—I know, I know, Silicon Valley Bank did, but it is an honourable exception that proves the rule.

 

If we are worried about bank solvency, then forcing the bank to cash settle unrealised gains on derivatives portfolios is a bad idea.