When variation margin attacks: Difference between revisions

Had Archegos put the equivalent ''physical'' positions on, using [[margin loan]]s, its brokers would ''not'' have ''had'' to advance it the cash value of its [[net equity]]. They may well have ''willingly'' done so, of course –  that is how [[prime broker]]s make their money after all, but being ''able'' to lend money, and being ''obliged'' to lend money are quite different propositions on that special day when it seems the world is going to hell.<ref>It is fair to note that — with the possible exception of the vampire squid — [[Archegos]]’s brokers did ''not'' believe the world was going to hell, at least not until it was far too late. But the principle remains.</ref>  

So there is this [[dissonance]], between [[Cash prime brokerage|''physical'' prime brokerage]], where lending money against [[net equity]] is at the prime broker’s discretion — oh, sure, you may withdraw your [[net equity]] at any time, but you have to take it [[Payment in kind|in kind]]<ref>Withdrawing [[net equity]] in the form of the [[shares]] themselves, rather than their [[cash]] value, has a very different effect on the [[prime broker]]’s risk profile. It makes the client’s portfolio ''less'' volatile; withdrawing [[cash]] makes it ''more'' volatile.</ref> — and [[Synthetic prime brokerage|''synthetic'' prime brokerage]], where cash payment of that value of that net equity — in the swaps world, known as “[[variation margin]]” — is required by regulation.  

 

On its face, this is a fair question, to which the answer is either: “Huh. I hadn’t thought of that. Yes, I suppose you are right” — call this the “all other captains” argument; or: “Well that just goes to show what a misconceived idea compulsory two-way variation margin is” — call this the “Redbeard Rum” argument.

 

We prefer the Redbeard Rum argument.

WHY NOT, my friends, WHY NOT? Now, if someone would kindly hold my beer:  

In the good old days — in the time of the [[Children of the Forest]], before the [[First Men]] — the overall vibe of the financial system was circumspect, self-imposed ''[[prudence]]'': musty institutions, staffed by Captain Mainwaring-types, providing stodgy, unflamboyant loan facilities and broking services to clients who were grateful to be offered them, and who would produce whatever sureties their banks required as a condition to doing business.   

We had a financial services industry with two types of participant: ''intermediaries'' and ''customers''. We have waxed [[Look, I tried|elsewhere]] about the countless ways businesses can contrive to interpose themselves into a process that oughtn’t to need ''that'' much intermediating, but let us, for today’s outing, take it as we find it.

There are various types of intermediary in the market: those that comprise market infrastructure: [[Exchange|stock exchange]]s, [[clearing system]]s, securities depositories and so on; those [[Agent|agents]] who earn only a [[commission]] from their involvement, and take no [[principal]] risk<ref>I include here “[[quasi-agent]]” roles that are conducted on a [[riskless principal]], but (absent insolvency) are economically neutral: thse participants are remunerated by [[commission]] or fixed [[mark-up]] and do not have “[[Skin in the Game: Hidden Asymmetries in Daily Life - Book Review|skin in the game]]”.</ref> at all: [[Cash brokerage|cash broker]]<nowiki/>s, [[Investment manager|investment managers]], [[Clearing broker|clearer]]<nowiki/>s, [[Market-maker|market-makers]] and [[Intermediate broker|intermediate brokers]]; and those who ''do'' take principal risk, but only by lending to customers, and don’t participate in the upside or downside<ref>Barring through “gap loss” where, due to portfolio losses, the customer is insolvent and cannot repay its loan.</ref> of the investments they are financing: [[Bank|banks]].  

In all cases the thing these intermediaries have in common is that their financial return is not linked the performance of the instruments in which they are dealing. They do not have skin in the game.

Customer contracts with intermediaries were a one-way affair: since intermediaries were incurring costs and taking on risks to provide their services for a relatively paltry return — lending money, handling brokerage orders and so on — legal covenants went one way only. The idea was not for intermediaries to lose colossal amounts of money.  

Customers are those who ''do'' have skin in the game: they take all the benefits — less the fees, commissions and financing costs of their intermediaries — and absorb all the losses of their investments. They may be institutional (pension funds, investment funds, multinationals) or retail (private investors) and while the range of investment products they can invest in will depend on their sophistication and financial resources, they are not subject to any kind of prudential regulation. They can, and do, blow up.  

 

More speculative investment vehicles may be highly [[Vega|geared]] and quite ''likely'' to blow up.