When variation margin attacks: Difference between revisions

Any of the standard reference works<ref>Goldsmith, Armitage & Berlin, ''Teach Yourself Law'', Book IV; The Open University Criminology Course, Part I; 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. Since, like Captain Redbeard Rum, your correspondent is going to run against the conventional wisdom, let us set the scene with a story.

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

Intermediaries come in many shapes and sizes: market infrastructure — [[Exchange|stock exchange]]s, [[clearing system]]s, securities depositories and so on; those 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> — [[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 their customers, and generally don’t participate in the upside<ref>Nor, for the most part, down-side, barring “gap losses” where, due to portfolio losses, the customer is insolvent and cannot repay its loan.</ref> of the investments they are financing: [[Bank|banks]].

All of these intermediaries have one thing in common: their remuneration does not depend on how their customer’s investments perform, until they perform ''so'' badly they cause the customer’s bankruptcy. Intermediaries do not have [[Skin in the Game: Hidden Asymmetries in Daily Life - Book Review|skin in the game]]. They are not supposed to lose ''any'' money, let alone billions of dollars of the stuff.

In any weather, until the early 1980s, you were either a ''customer'' or an ''intermediary'' and the above was all quite well settled.  

But innovations in the market, technology and regulation began to change things.

[[File:Noel.png|right|frameless]]

Everyone else recognised this to be a cool idea, and before you know it, swaps trading was a trillion dollar industry. Okay; this took twenty years, but in the geological history of finance from the time of Hammurabi, a couple of decades is the blink of an eye.  

Swaps challenged all that: now ''either'' party could be creditor or debtor. It was hard to know who to regulate. Who needed protecting from whom? Did they ''both'' have to be regulated? Or ''neither''? For the first couple of decades, the answer was basically “neither”.<ref name="fwmd">Hence widespread allusions to the wild west, [[Locust|locusts]], [[Black swan|black swans]], casino banking, [[financial weapons of mass destruction]] and so on.</ref>

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.

== Risk management under the ISDA ==

At about the same time computer-based trading was revolutionising the financial markets, the madcap spirit of 1980s free-love ''laissez-faire'' delivered their radical deregulation. It is not unreasonable to suppose these conditions contributed to an explosion in the market for swaps during the 1980s.<ref>These three forces combined to create a mammoth. [http://faculty.citadel.edu/silver/IF/MBA_course/Chap9_Swap_Evolution.pdf Citadel] estimates USD interest rate swaps volumes went from from zero in 1981 to over half a billion dollars by 1987. </ref>

It did not take long for folks to realise that these new [[swap]] things presented a whole new class of risks.<ref name="fwmd"/> Swaps provide “unfunded” financial exposure to assets: you don’t own the assets, much less pay for them: the idea of exchanging notional amounts fell away and, besides initial margin, you didn’t have to put any money down at all. Given the size of individual swap transactions — typically in the millions of dollars — it didn’t take many transactions before total notional exposures were collossal. Practitioners in the market hit upon two neat tricks to manage these risks: [[netting]] and [[credit support]].

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 transaction 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 swap transactions with the same customer 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. Giving effect to netting contracts, and attaining the capital relief they promise is now a multi-million-dollar industry of weaponised [[tedium]].  

But even with netting, the [[Leverage|levered]] nature of swap transactions means that overall net exposures can still swing around wildly.

The regulatory reform machine moved into overdrive; the era of unregulated derivatives was over. Regulators the world over began requiring ''all'' swap counterparties, prudentially regulated or not, to provide [[variation margin]] on all common forms of swap contract: bilateral, daily, and in [[Cash|''cash'']].

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 [[commission]]. Their customers take the market risks.

Swap dealers ''look'' like they are taking market risks, but generally they are not. Post Volcker, in most cases they are not ''allowed'' to. [[Swap dealer]]<nowiki/>s pass on their returns of their trading activity to their customers, in return for [[Commission|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> Furthermore, [[dealer]]<nowiki/>s are somewhat at the mercy of their customers: having put positions on, their rights to terminate are legally and [[Commercial imperative|commercially]] circumscribed. By contrast, customers can terminate at any time — it’s their investment — and for any reason, including vague nervousness about their dealer’s solvency.

You can, and physical [[prime brokerage]] customers do, achieve exactly the same effect with a [[Margin lending|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.

For this is ''exactly'' what bilateral variation margin does. Capital is the measure of “unallocated cash” available to meet the claims of general creditors. Cash being fungible, ''any'' cash on the balance sheet counts towards the capital ratio. A counterparty with an uncollateralised paper gain of $100m against a dealer still has a claim to that $100m: it can close out at any time, and even if the dealer fails first ''it still has a claim on that amount from the dealer’s capital reserves''. It is just lining up with other creditors who also have claims.

And leaving aside the risk consequences of bilateral variation margin, don’t forget the ''operational hassle'' it presents. The financial system is complicated enough without gobs of cash flying to and fro just to offset changing risk positions on principal contracts. All other things being equal, it would be better not to post margin than to post it.  

Not only is this counterproductive to the interests of systemic stability, as per the above, but it also means the customer has to get involved with margining and cash management, because it will have to post this excess margin back to the dealer if the position moves back the other way. This is operational faff for no good reason.

Now, none of this stops a dealer recognising the “equity” in a customer’s unrealised [[mark-to-market]] gains and lending against it. This is what [[Margin lending|margin lenders]] and physical prime brokers do, every day of the week. But this kind of lending is, as lending should be, ''discretionary''. Dealers don’t have to accept the new trade, and if they do, they can impose whatever [[haircut]]s, credit terms, diversification criteria and other conditions they like. A customer who diesn’t like the terms can take its business elsewhere. This, as the [[Archegos]] situation illustrated, is plenty compulsion enough.