When variation margin attacks: Difference between revisions

The conventional answer is, “because under a [[swap]], I now have [[credit exposure]] to you for that profit and, you know, [[Lehman]].” Yes, it is our old friend the Lehman [[horcrux]]. Let’s come back to that.

=== Deregulation and electronic trading ===

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]].

=== 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 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]].