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When variation margin attacks: Difference between revisions
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Now here is an interesting thing. Because [[Archegos]] gained their market exposure using [[Equity derivatives|swaps]], ''by regulation'', their brokers were ''obliged'' to pay out their realised gains<ref>For [[prime broker]]<nowiki/>s charging “[[dynamic margin]]” this was partly offset by the effect of increased [[initial margin]] required on the inflated value of the position in question; for those charging only a [[static margin]] amount, there was not even that fig-leaf. </ref> or “[[net equity]]”, every day, in cash, in the form of [[variation margin]]. To be sure, the broker usually pays [[VM]] into a bank account it runs for its client. There are withdrawal thresholds that apply to that account that takes into account required [[initial margin]] — oh, that’s another story altogether — but over those thresholds all the variation margin is the client’s money, available to be withdrawn on request. | Now here is an interesting thing. Because [[Archegos]] gained their market exposure using [[Equity derivatives|swaps]], ''by regulation'', their brokers were ''obliged'' to pay out their realised gains<ref>For [[prime broker]]<nowiki/>s charging “[[dynamic margin]]” this was partly offset by the effect of increased [[initial margin]] required on the inflated value of the position in question; for those charging only a [[static margin]] amount, there was not even that fig-leaf. </ref> or “[[net equity]]”, every day, in cash, in the form of [[variation margin]]. To be sure, the broker usually pays [[VM]] into a bank account it runs for its client. There are withdrawal thresholds that apply to that account that takes into account required [[initial margin]] — oh, that’s another story altogether — but over those thresholds all the variation margin is the client’s money, available to be withdrawn on request. | ||
This is completely normal in the world of latter-day derivatives: mandatory two-way exchange of [[variation margin]] was implemented by regulation in pretty much every major market ''in the name of reducing systemic risk'' — but all the same, in the context of [[Archegos]], it does look weird. It is like ''forced'' | This is completely normal in the world of latter-day [[Derivative|derivatives]]: mandatory two-way exchange of [[variation margin]] was implemented by regulation in pretty much every major market ''in the name of reducing systemic risk'' — but all the same, in the context of [[Archegos]], it does look weird. It is like ''forced'' [[swap dealer]]<nowiki/>s to extend additional lending against asset appreciation, regardless of the likelihood that the asset might then ''de''preciate again. Imagine if your bank, by law, had to pay you the cash value of any increase in your home’s value over the life of your mortgage. | ||
Had Archegos put the equivalent ''physical'' positions on, using [[margin loan]]s, its [[prime broker]]<nowiki/>s would ''not'' have ''had'' to advance it the cash value of its [[net equity]]. | Had Archegos put the equivalent ''physical'' positions on, using [[margin loan]]s, its [[prime broker]]<nowiki/>s would ''not'' have ''had'' to advance it the cash value of its [[net equity]]. Now to be sure they may well have ''willingly'' done so, of course – lending on margin 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 whole 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> And the more precipitately a position has gone ''up'', the more likely it is to come precipitately ''down'' again. | ||
=== A dissonance === | === A dissonance === | ||
So there is this [[dissonance]], between [[Cash prime brokerage|''physical'' prime brokerage]], where lending money against [[net equity]] is at the prime | 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> or liquidate your position, if you want it in cash — 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. | ||
That’s worth dwelling on: if you liquidate your position, sure you get all your cash, but you go ''off risk''. If the market tanks the next day, happy days all round. You’ve closed out your stake and taken your money off the table. With [[variation margin]], you get to keep your stake ''and'' take your money off the table. | |||
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 | Since this is required ''by [[Regulatory margin|co-ordinated world-wide regulation]]'' for swaps, it doesn’t take great imagination to read across to physical positions since they are, to all intents and purposes, economically identical. “Hang on a minute,” clients and their [[Buy-side legal eagle|advisors]] will say, “if you have to pay out my cash equity value under a swap, why can’t I have it for an equivalent physical position?” | ||
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. Here you go!” — call this the “all other captains” argument; or: “Well that just goes to show what a misconceived idea compulsory two-way [[variation margin]] is. There’s no way on earth I’m automatically paying out your equity in cash” — call this the “Redbeard Rum” argument. | |||
The [[JC]] prefers the Redbeard Rum argument. | The [[JC]] prefers the Redbeard Rum argument. | ||
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“Come on, [[JC]]: I know you are a cranky old bugger. But do you really mean to say you are going to swim against the tide of all that consensus?” | “Come on, [[JC]]: I know you are a cranky old bugger. But do you really mean to say you are going to swim against the tide of all that consensus?” | ||
Allow the cranky old fellow to launch his languid socio-historical explanation, and please indulge him, by pretending he would not instantly be cut off, mid-sentence, like so: “all right then: if you won’t give me cash for my physical longs, I’ll just put them on swap.” | |||
==Banking, in the good old days== | ==Banking, in the good old days== | ||
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 being allowed to do business. | 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 being allowed to do business. | ||
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==== Intermediaries, redux ==== | ==== Intermediaries, redux ==== | ||
So, the clarity about who was an intermediary broke down a little. Swaps did not necessarily need an intermediary at all, though in practice these days there usually is one: the very first swap, between IBM and the World Bank, was between two customers, or “[[end-user]]<nowiki/>s”, in that each took principal risk to the transaction. And there is an entire realm of swap trades ''between'' intermediaries, where neither side is a “customer” as such. | So, the clarity about who was an intermediary broke down a little. Swaps did not necessarily need an intermediary at all, though in practice these days there usually is one: the very first swap, between IBM and the World Bank, was between two customers, or “[[end-user]]<nowiki/>s”, in that each took principal risk to the transaction. And there is an entire realm of swap trades ''between'' intermediaries, where neither side is a “customer” as such. | ||
But the huge preponderance of swap volume is between an [[intermediary]] — a “[[swap dealer]]” — on one side and a [[customer]] — on the other. | But the huge preponderance of swap volume is between an [[intermediary]] — a “[[swap dealer]]” — on one side and a [[customer]] — on the other. | ||