82,892
edits
Template:M intro isda Party A and Party B: Difference between revisions
Template:M intro isda Party A and Party B (view source)
Revision as of 22:25, 4 December 2023
, 4 December 2023no edit summary
Amwelladmin (talk | contribs) Tags: Mobile edit Mobile web edit |
Amwelladmin (talk | contribs) No edit summary |
||
| Line 34: | Line 34: | ||
But there is a better objection: for all our automatic protestations to the contrary, the ISDA is not ''really'' a bilateral contract, and it ''is'' often financing contract, in economic effect even if not in formal structure. Where there is a customer gaining exposure to a risk and a dealer providing delta-hedged exposure to that risk, a swap is a sort of “synthetic loan”. | But there is a better objection: for all our automatic protestations to the contrary, the ISDA is not ''really'' a bilateral contract, and it ''is'' often financing contract, in economic effect even if not in formal structure. Where there is a customer gaining exposure to a risk and a dealer providing delta-hedged exposure to that risk, a swap is a sort of “synthetic loan”. | ||
You could analyse an interest rate swap as off-setting fixed rate and floating rate loans. Seeing as the same amount of principal in the same currency flows in both directions at the same time, the principal flows cancel each other out — they “net” to zero. | |||
“Aha, JC: quite so. But this implies, does it not, that the parties are ''not'' lending to each other?” | |||
The difference is in how the two sides manage their respective positions. | |||
We should not let ourselves forget: beyond the cramped star system of inter-dealer relationships, there is a boundless universe where one party is a “dealer” and the other a “customer”. This is the great majority of all ISDA arrangements. | |||
Provided the dealer knows what it is about, its main risk in running a swap portfolio not market risk — | The roles of ''customer'' and ''dealer'' are different. The difference does not depend on who is “long” and who “short”, nor on who pays the fixed rate and who pays the floating. Hence, the expressions “[[sell side|sell-side]]” — the dealers, who ''sell'' exposure — and “[[buy side|buy-side]]” — their customers, who ''buy'' it. | ||
For the customer the object of transacting is to ''change'' its market exposure: to get into a positions it did not have before, or get out of one it did. This sounds obvious. But, being a bilateral contract, you might think it follows that the dealer is changing its position, too. But it is not. A dealer is there to provide exposure without taking any itself, and thereby to earn a commission. The dealer intends to say ''flat''. | |||
Now, a swap is a principal obligation, so entering into one necessarily does changes the dealer’s exposure — but the dealer must then “[[Delta-hedging|delta hedge]]” its position away, executing an offsetting position somewhere else. It might do this by buying the underlying asset, of futures, or entering into a offsetting swap by which matches off its “long” exposure against another “short” exposure with another counterparty. | |||
There are plenty of ways to [[delta hedge]], but the basic economic principle is that the dealer has not changed its market position. It has not, over all, made an investment. It has not borrowed anything. | |||
Provided the [[dealer]] knows what it is about, its main risk in running a swap portfolio is not therefore market risk — it should not really have any — but ''customer credit'' risk. Should a customer fail, the dealer’s book is no longer matched: its hedge is now an outright position. | |||
Hence, having adequate collateral from each customer, to cover the risk that it fails, is very important. | |||
==== Swaps are usually synthetic loans ==== | ==== Swaps are usually synthetic loans ==== | ||
But how does this make a swap into a | But how does this make a swap into a “synthetic loan”? Compare a swap with an actual loan: | ||
{{Quote|{{divhelvetica| | {{Quote|{{divhelvetica| | ||
| Line 67: | Line 77: | ||
Note the cashflows in the loan scenario: | Note the cashflows in the loan scenario: | ||
{{Quote|{{divhelvetica|During loan, Hackthorn pays floating rate on USD10m and is exposed to the market price of Cryptöagle. | {{Quote|{{divhelvetica| | ||
On termination | During the loan, Hackthorn pays a floating rate on USD10m and is exposed to the market price of [[Cryptöagle]]. | ||
On termination, Hackthorn sells [[Cryptöagle]] to repay the loan. If sale proceeds exceed the loan repayment, Hackthorn keeps the difference. If they don’t, Hackthorn must fund the shortfall from its portfolio and book a loss. | |||
Hackthorn’s net exposure is therefore: ''USD10m - Cryptöagle spot price''. | |||
}}}} | }}}} | ||
| Line 81: | Line 94: | ||
Like a loan, the equity swap gives Hackthorn exposure to [[Cryptöagle]] whilst keeping its existing portfolio, which Hackthorn uses to fund cashflows on its new capital asset. This is a form of ''[[leverage]]''. The floating rate Hackthorn pays is ''implied funding''. The dealer will only accept this if it is satisfied Hackthorn has enough capital to finance its swap payments and settle any differences at termination. This is the same risk calculation a bank lender would make.<ref>To keep it simple, I have ignored the scope for synthetic margin loan and rehypothecation.</ref> | Like a loan, the equity swap gives Hackthorn exposure to [[Cryptöagle]] whilst keeping its existing portfolio, which Hackthorn uses to fund cashflows on its new capital asset. This is a form of ''[[leverage]]''. The floating rate Hackthorn pays is ''implied funding''. The dealer will only accept this if it is satisfied Hackthorn has enough capital to finance its swap payments and settle any differences at termination. This is the same risk calculation a bank lender would make.<ref>To keep it simple, I have ignored the scope for synthetic margin loan and rehypothecation.</ref> | ||
But, hang on: this is a bilateral | But, hang on: this is a bilateral arrangement, so isn’t the converse true of the dealer? | ||
Isn’t the dealer paying the cashflow of the asset to get exposure to the floating rate in the same way? Isn’t it, in a sense, “borrowing” by paying a total return? Or look at it this way: is not a “short” swap position, for a dealer, exactly the same as a “long” swap position for a customer? | |||
Generally not, because in providing these swap exposures to its customers, the dealer is not changing its own market position. It delta-hedges. At the same moment it puts on a swap, it executes an offsetting hedge. The dealer’s net position on its derivative book will generally be flat. You don’t need to borrow money to take no position.<ref>The dealer may need to borrow money to fund its hedge, but this is exactly what the customer’s floating rate pays for. This is “borrowing on the customer’s behalf”.</ref> | Generally not, because in providing these swap exposures to its customers, the dealer is not changing its own market position. It delta-hedges. At the same moment it puts on a swap, it executes an offsetting hedge. The dealer’s net position on its derivative book will generally be flat. You don’t need to borrow money to take no position.<ref>The dealer may need to borrow money to fund its hedge, but this is exactly what the customer’s floating rate pays for. This is “borrowing on the customer’s behalf”.</ref> | ||
| Line 106: | Line 121: | ||
===Voluntary margin=== | ===Voluntary margin=== | ||
No-one of this stops the dealer recognising the “equity” in a customer ’s u realised MTM and extending credit — increasing lines— against it. This is what cash prime brokers do every day of the week. But it is discretionary. The dealer can decide where and when to draw its lines. | No-one of this stops the dealer recognising the “equity” in a customer ’s u realised MTM and extending credit — increasing lines— against it. This is what cash prime brokers do every day of the week. But it is discretionary. The dealer can decide where and when to draw its lines. | ||
For several reasons: | For several reasons: | ||