When variation margin attacks: Difference between revisions

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When variation margin attacks (view source)

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Swaps provide “unfunded” financial exposure to assets: you don’t own the assets, much less pay for them: you don’t have to put any money down up front at all.<ref>Besides any [[initial margin]] your counterparty required: see below.</ref> This is, economically, the same as betting.<ref>It is also the same as buying (or selling) insurance, with one difference: to be insured, you must suffer an insurable loss.</ref> Given the size of individual swap transactions — typically in the millions of dollars — your total notional exposure can quickly blow out of all proportion. The market hit upon two neat tricks to manage these risks: [[netting]] and [[credit support]].
Swaps provide “unfunded” financial exposure to assets: you don’t own the assets, much less pay for them: you don’t have to put any money down up front at all.<ref>Besides any [[initial margin]] your counterparty required: see below.</ref> This is, economically, the same as betting.<ref>It is also the same as buying (or selling) insurance, with one difference: to be insured, you must suffer an insurable loss.</ref> Given the size of individual swap transactions — typically in the millions of dollars — your total notional exposure can quickly blow out of all proportion. The market hit upon two neat tricks to manage these risks: [[netting]] and [[credit support]].


==== Netting ====
We are not really concerned with netting here — the [[JC]] has plenty to say on that topic [[Close-out netting|elsewhere]] — so let’s quickly deal with it: just as you could offset the [[present value]] of the opposing legs of each swap to calculate a positive or negative [[mark-to-market]] value for that swap, so too could you offset positive and negative [[mark-to-market]] values for different swaps to arrive at a single net exposure for your whole {{isdama}}. This idea — [[close-out netting]] — was a stroke of genius, and the brave commandos of {{icds}} encoded this “[[single agreement]]” concept into the {{1987ma}} and its successors.  
We are not really concerned with netting here — the [[JC]] has plenty to say on that topic [[Close-out netting|elsewhere]] — so let’s quickly deal with it: just as you could offset the [[present value]] of the opposing legs of each swap to calculate a positive or negative [[mark-to-market]] value for that swap, so too could you offset positive and negative [[mark-to-market]] values for different swaps to arrive at a single net exposure for your whole {{isdama}}. This idea — [[close-out netting]] — was a stroke of genius, and the brave commandos of {{icds}} encoded this “[[single agreement]]” concept into the {{1987ma}} and its successors.  


But even with netting, counterparties to a swap relationship could still have large, volatile exposures to each other. The highly levered nature of swap transactions meant that one’s total net exposure could swing wildly in a single day, and could flip [[In-the-money|in]] or [[out-of-the-money]] quite suddenly.
==== Credit support ====
But even with netting, the highly [[Leverage|levered]] nature of swap transactions meant that one’s overall net exposure could swing around wildly.


A solution arrived a decade or so after swap trading started in earnest. In 1994 ISDA released a “[[credit support annex]]” to the {{isdama}} under which, the parties could require [[initial margin]], and also exchange variation margin reflecting the prevailing exposure under the agreement. This is all rather complicated and fiddly<ref>See our [[CSA Anatomy]], for as much detail as any one person could want.</ref> but the gist of it was that either side could calculate its net exposure on a day and require the other side to post credit support — usually in the form of bonds or liquid securities — to it to hold as collateral for that exposure.
A solution arrived a decade or so after swap trading started in earnest. In 1994 ISDA released a “[[credit support annex]]” to the {{isdama}} under which the parties could exchange “credit support” to each other to offset their prevailing exposures to each other. This is all rather complicated and fiddly<ref>See our [[CSA Anatomy]], for as much detail as any one person could want.</ref> but the gist of it was that you could calculate your net [[exposure]] to your counterparty on any day and, if it was over an agreed threshold, you could require your counterparty “post” cash, bonds or liquid securities to you as collateral for that exposure. If the exposure swung back, the counterparty could require you to return those assets tomorrow. Rinse and repeat.


The benefits of credit support accrued largely to to bank counterparties who, over this period, were subject to increasingly stringent and detailed rules about how much capital they were required to hold against trading exposures to their customers.  
Like the {{Isdama}}, the [[CSA]] is a bilateral document: it assumes the parties are equal, arm’s-length counterparties and that each can post to the other. In the early days, [[Swap dealer|swap dealers]] often adjusted their CSAs so that only the customer posted credit support. Over this period, the [[Basel Accords]] published increasingly stringent and detailed rules<ref>Basel I was 30 pages. Basel II, published June 2006 (whoops!) was 347 pages. Basel III, as of September 2021, is 1626 pages.</ref> about how much capital banks should hold against their trading exposures to their customers. If at first customers were less bothered about the creditworthiness of their swap dealers,<ref>To be sure, sophisticated investment managers were already requiring their dealers post [[variation margin]] by the the start of the new millennium.</ref> this all changed, fast, during the 2008 financial crisis in which every major dealer had at least a near-death experience, if not an actual one.


By and large, at least in the early days of credit support, customers were not so concerned with the creditworthiness of their swap dealers — this was dealt with by “prudential regulation” of the financial services institutions — so many credit support arrangements were one way only car that is to say the customer posting credit support to the dealer and not vice versa.<ref>this was by no means a universal rule, and more sophisticated real money counterparties were requiring variation margin by the the start of the new millennium</ref>
Suddenly the dealers, themselves, were a source of systemic risk. The regulatory reform machine moved into overdrive; the era of unregulated derivatives was over. Regulators the world over began requiring all swap counterparties to collect [[variation margin]] on all common forms of swap contract: bilateral, daily, and in [[Cash|''cash'']].


The idea that light touch prudential regulation was enough to absorb systemic risk in the financial system evaporated forever during the 2008 financial crisis in which every major dealer had at least a near-death experience if not an actual one.
===== Remember the good old days =====
Now remember that old distinction between intermediary and customer. Intermediaries are meant to be well-capitalised; they don’t have a dog in the fight: their interest is just in collecting their commission. Their customers take the market risks.


A couple of ironies: firstly, the excessive leverage in bank balance sheets was partly driven by capital treatment provided to collect right swaps. In any event, the error of unregulated derivatives was over. A raft of new regulations came in including global regulations requiring compulsory posting of variation margin on all the most common forms of swap contract.
Swap dealers ''look'' like they are taking market risks, but they are not. Post Volcker, they are not ''allowed'' to. Swap dealers are passing on the return of their hedging activity to their customers, and collecting commissions and interest on financing.<ref>We have in mind [[Synthetic equity swap|synthetic equity derivatives]] here. This may be less clearly the case in other asset classes, but it is still (post Volcker) broadly true for all of them.</ref>


A number of things changed, even for those dealers with existing variation margin arrangements: the new arrangements were required to be bilateral, daily, and settled in cash.  
You can, and physical [[prime brokerage]] customers do, achieve exactly the same effect with a margin loan: the customer buys shares on margin; the [[prime broker]] holds the shares as collateral for the loan. If the shares decline in value, the broker may call for more margin. If the shares rise in value, the customer generates increased equity with the broker, but is not automatically entitled to the cash value of that equity. There is no variation margin, as such.


The theory of the game here is that existing derivative exposures are effectively settled to market in cash daily, limiting counterparty exposure. But no allowance was made for the distinction between dealer and customer.
The prime broker may ''agree'' to lend more against that equity — that is the business it is in, after all — but it is not ''obliged'' to. The customer cannot force the broker to lend against the equity. As long as it leaves enough equity in the account the customer may withdraw excess equity, but only by taking the shares it owns. Withdrawing ''shares'' from a prime brokerage account doesn’t fundamentally change ones debtor/creditor relationship. Withdrawing cash ''against'' shares assuredly does.
 
Let's just stepped back into the world of margin lending to compare these new derivatives arrangements with traditional relationship between a bank and its customer. A customer who buys a security on margin pleasures that security to its prime broker as collateral for its loan repayment liability. If that security appreciates this generates a net equity position with the broker, but does not automatically entitle the customer to further borrowing against that asset. To be sure, the customer may withdraw its equity, but only by taking possession of the shares it has bought. Removing excess shares from the prime brokers account does not fundamentally change the debtor/creditor relationship between broker and customer. It is also true that the prime broker does not have a beneficial interest in the asset and the customer’s asset should be excluded from the brokers’ insolvency estate in the case of its bankruptcy.  


The nature of a synthetic swap position is different in that regard: any positive equity is an unsecured claim against the prime broker. However, traditionally, this credit risk would have been managed by reliance on prudential regulation rather than funded credit mitigation.
The nature of a synthetic swap position is different in that regard: any positive equity is an unsecured claim against the prime broker. However, traditionally, this credit risk would have been managed by reliance on prudential regulation rather than funded credit mitigation.
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