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, 5 December 2023→Voluntary margin
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===Voluntary margin=== | ===Voluntary margin=== | ||
No-one of this stops the dealer recognising the “equity” in a | No-one of this stops the dealer recognising the “equity” in a customer’s unrealised [[mark-to-market]] gains and extending credit — increasing lines — against it. This is what margin lenders and cash prime brokers do every day of the week. | ||
But this lending is discretionary, and dealers can apply the haircuts, credit terms and diversification criteria as they see fit. The dealer can decide where and when to draw its lines. | |||
Imagine if lending banks were ''forced'' to pay mortgage customers the value of unrealised gains on their house prices. Imagine how much worse the global financial crisis would have been then. | |||
“But, but, but, JC: there is a difference. Where a house is concerned, the customer owns the house. It has no credit exposure to the bank for the house. If the bank fails, the customer keeps its house. With a swap, the customer would lose everything. All this is true. But, equally the customer’s personal capital outlays for that house — its real investment — is 20% (at the time of the GFC it might have been closer to 0%). This is a levered play. | |||
The same is true of a derivative exposure. It is an implied loan. The customer puts down its initial margin — economically equivalent to a deposit — and gets the return of the whole asset. The bank’s interest is to optimise its funding and to earn a commission on the opening and closing of the trade. It agrees to lend 70 percent of the starting value of the asset. If the customer wants to isolate its credit exposure from the dealer, it can take out a margin loan against a physical asset, just like a mortgage. Or it can take its profit, close out its trade and find out the terms on which the dealer will reset. | |||
For several reasons: | For several reasons: | ||
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If we are worried about bank solvency, then forcing the bank to cash settle unrealised gains on derivatives portfolios is a bad idea. | If we are worried about bank solvency, then forcing the bank to cash settle unrealised gains on derivatives portfolios is a bad idea. | ||
“settling to market” every day with an important distinction: you | “settling to market” every day with an important distinction: you don | ||
Banks are independently capital regulated for solvency. | Banks are independently capital regulated for solvency. | ||
Swap counterparties are sophisticated professionals with the tools and resources to monitor credit exposure to their brokers. (We take it that the [[financial weapons of mass destruction]] that these sophisticates truck in require more | Swap counterparties are sophisticated professionals with the tools and resources to monitor credit exposure to their dealers and brokers. (We take it that understanding the [[financial weapons of mass destruction]] that these sophisticates truck in require more ninja wizardry than does weighing up the creditworthiness of a regulated financial institution). | ||
It is a much better discipline for sophisticated counterparts to manage their credit exposure — spread it around, so to speak, than to require their banks to send hard cash out the door as collateral to clients with outsized exposures. | It is a much better discipline for sophisticated counterparts to manage their credit exposure — spread it around, so to speak, than to require their banks to send hard cash out the door as collateral to clients with outsized exposures. | ||
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Every dollar these banks pay away reduces the capital buffer the bank has available for everyone else. It also provides the customer with free money on an unrealised [[mark-to-market]] position. This is like paying out while the roulette wheel is still spinning, in the expectation of where the ball might land. That is a loan: if the customer doubles down and loses, you don’t get your money back. | Every dollar these banks pay away reduces the capital buffer the bank has available for everyone else. It also provides the customer with free money on an unrealised [[mark-to-market]] position. This is like paying out while the roulette wheel is still spinning, in the expectation of where the ball might land. That is a loan: if the customer doubles down and loses, you don’t get your money back. | ||
Daily mark to market moves are mainly noise. Yet this is what | Daily mark to market moves are mainly ''noise''. Yet this is what parties must collateralise against. A great deal of the back-and-forth of variation margin is accomodating noise | ||
. The signal emerges over a prolonged duration. Over the short run posted collateral can, as we know a system effect: if I double down on an illiquid position, it will tend to rise, and I will get more margin, and — this is the story of [[Archegos]]. | |||
The increased systemic exposure of banks failing — which is what the margin regs were designed to address — is not caused by the banks themselves, but by their client exposures. Client exposures in turn are a function of client failures, which are in turn a function of leverage | The increased systemic exposure of banks failing — which is what the margin regs were designed to address — is not caused by the banks themselves, but by their client exposures. Client exposures in turn are a function of client failures, which are in turn a function of leverage | ||
Their failure shouldn't, typically, be a systemic risk unless their unusually size, interconnectedness or unintended system effects ''make'' them systematically important, in which case they should be regulated if they are systemically important, and made to hold capital, and (b) they have the market position and bargaining power to negotiate margin terms. | Their failure shouldn't, typically, be a systemic risk unless their unusually size, interconnectedness or unintended system effects ''make'' them systematically important, in which case they should be regulated if they are systemically important, and made to hold capital, and (b) they have the market position and bargaining power to negotiate margin terms. | ||