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When variation margin attacks: Difference between revisions
When variation margin attacks (view source)
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:—Blackadder, Series 2: ''Potato''}} | :—Blackadder, Series 2: ''Potato''}} | ||
Any of the standard reference works<ref>Goldsmith, Armitage & Berlin, ''Teach Yourself Law'', Book IV; The Open University Criminology Course; The ''Perry Mason Book For Boys'', 1962, [[Aleebee|needless to say]].<ref> 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. | Any of the standard reference works<ref>Goldsmith, Armitage & Berlin, ''Teach Yourself Law'', Book IV; The Open University Criminology Course; The ''Perry Mason Book For Boys'', 1962, [[Aleebee|needless to say]].</ref> 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. | ||
==Back up, back up: banking, in the good old days== | ==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. | *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 | *Capital and regulation targeted prudent management of a bank’s balance sheet | ||
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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. | 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== | ==Enter the swaps== | ||
The history of swaps is interesting and fairly well-documented. It all started with a bright idea [[Salomon Brothers]] had to set off | The [[swap history|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 [[Set off|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. | |||