When variation margin attacks: Difference between revisions

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.

Up until the early 1980s, this was all quite well settled, but innovations in the market, technology and regulation began to change things.

==The times they are a-changing==

Unlike traditional banking activity, swaps were bilateral.  In one sense, ''both'' parties were lending to each other — hence they were not just parties, but “counterparties”.  In another sense, neither was: as long as you could [[Set-Off|offset]] the swapped loans at inception a swap trade was market neutral.<ref>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 [[Close-out netting|netting]], which isn’t wildly germane to this essay except to point out that [[Credit risk mitigation|credit mitigation]] for swaps by set-off, not security, and credit risk can swing around, depending on the market value of the underlying obligations.</ref>  

But a swap trade does not ''stay'' market neutral. Its [[mark-to-market]] value will change, and can swing around. Depending on how the cross-rates move, ''either'' party can be owed money. Hence the concept of “[[moneyness]]”: either party could be [[in-the-money]] or [[out-of-the-money]].