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 08:56, 7 December 2023

1,364 bytes added , 7 December 2023

→‎On the case for one-way margin

Amwelladmin

Bureaucrats, Interface administrators, Administrators

82,892

edits

@@ Line 101: / Line 101: @@
 ==== On the case for one-way margin ====
-In recent years — ironically, just as the “dealer” vs “customer” dynamic has become more pronounced<ref>After the [[GFC]], bank proprietary trading fell away to almost nothing.</ref> — the global regulatory-industrial complex,<ref>This label is not just sardonic: there really is a cottage industry of of “regulatory change management professionals” who owe their last decade’s livelihood to ''accommodating'' quixotic regulatory initiatives like this. They are a powerful lobby with a direct interest in maintaining the rate of regulatory churn.</ref> still fighting last decade’s war, has forged rules which overlook this. Notably, the coordinated worldwide approach to bilateral [[regulatory margin]]. As swap positions move in and out of the market, swap counterparties must post each other the cash value of the net market movements each day. This is a little like closing positions out at the end of each day and settling up, with a key difference: you ''don’t'' close out your positions. The parties are still on risk.
+In recent years — ironically, just as the “dealer” vs “customer” dynamic has become more pronounced<ref>After the [[GFC]], bank proprietary trading fell away to almost nothing.</ref> — the global regulatory-industrial complex,<ref>This label is not just sardonic: there really is a cottage industry of of “regulatory change management professionals”, in-house and out, who owe their last decade’s livelihood to ''accommodating'' quixotic regulatory initiatives like this. They are a powerful lobby with a direct interest in maintaining the rate of regulatory churn.</ref> still fighting last decade’s war, has forged rules which overlook this. Notably, the coordinated worldwide approach to bilateral [[regulatory margin]]. As swap positions move in and out of the market, counterparties must post each other the cash value of the net market movements each day. This is a little like closing positions out at the end of each day and settling up, with a key difference: you ''don’t'' close out your positions. The valuations at which the parties exchange margin are guestimated. The parties stay on risk.
-Well — ''one'' of them is. The customer: the one who initiated the trade, to put itself into a market position of some sort. The other party, remember, is delta-hedged. It didn’t initiate the trade, but accommodated it, on the precise grounds that its market position would not change, and its credit position, against the customer, would be satisfactory.
+Well — ''one'' of them does — the customer: the one who initiated the trade, to put itself into a market position of some sort. The other party, remember, is delta-hedged. It didn’t initiate the trade, but accommodated it, on the precise grounds that its market position would not change, and its credit position, against the customer, would be satisfactory.
-Requiring margin from a customer who is net out-of-the-money makes sense: if the customer fails, the dealer’s corresponding hedges are defeated and it will be left with an open market exposure to all of the customer’s positions. This is exactly what the dealer wants to avoid. It is meant to be flat. So, daily [[variation margin]] mitigates the dealer’s market risk to date; [[initial margin]] covers it for the forward market risk while it closes out its hedge portfolio against the defaulted client. As long as the dealer is covered, market disruption is minimised, and the dealer’s own solvency — which, due to its interconnection with the rest of the market may well present a systemic risk — is not threatened.
+Requiring margin — even guestimated margin —from a ''customer'' who is net [[out-of-the-money]] makes sense: if the customer fails, the dealer’s corresponding hedges are defeated. It will be left with an open market exposure to all of the customer’s positions. From a systemic risk position, this is the last thing anyone wants: a dealer whose customer positions are all effectively hedged can’t go bust. So, daily [[variation margin]] ''to the dealer'' mitigates the dealer’s market risk to date; [[initial margin]] covers it for the forward market risk should it have to close out its hedge portfolio against the defaulting client.
-Requiring a dealer to post margin to its customer against the customer’s net in-the-money position makes no sense whatsoever:
+As long as the dealer is covered, market disruption is minimised, and the dealer’s own solvency — the deterioration of which, due to its interconnectedness with the rest of the market, may well present a systemic risk — is not threatened.
-First, customers are trading their capital, dealers are not. Dealers are [[delta-hedge]]d against every customer. They are not “the other side of the trade”. A dealer’s “position” against a given client being “under water” in itself does not change the dealer’s risk of insolvency.  Of course, dealers ''do'' present a risk of insolvency, and customers will have tolerate so much exposure to that risk, but the customer has other levers to manage that risk. They can close out their position, take profits and re-establish the position the new level, for one thing. That enables the dealer to close out its hedge, pass on the hedge gains and reset hedges and initial margin at the higher level. This is not the same has paying the mark-to-market of a unrealised swap. To be sure, customers might not ''like'' doing this — realising a taxable gain and having to stump up more [[initial margin]] when you re-establish the position blows, for sure — but none of these are good reasons for anyone but the customer concerned. Withholding variation margin on profitable positions giving customers the choice: keep your position open and your money with the dealer and live with its solvency risk, ''or book your gain and get your money back and start again — encourages prudent behaviour. If nothing else it incentivises customers to diversify their risk. And it does not automatically lever up the customer’s portfolio. For what do we think the customer will ''do'' with all that free cash [[VM]] its dealer keeps sending it?  If it was planning to just sit on it, wouldn’t just — ''leave it at the bank''?
+But requiring a ''dealer'' to post margin to its customer to cover the customer’s net in-the-money positions makes no sense whatsoever:
+First, customers — and here I mean buy-side market participants ''who do not themselves post systemic risk''<ref>There are different considerations for those who pose market risk, but these should be dealt with by equivalent capital regulation and limitations on leverage and so on: in a perfect world, buy-side entities would never get so big as to pose systemic risk.<> — there are trading on their capital, dealers are not.<ref>Dealers hold capital primarily against counterparty failure, remember, not market risk itself: absent counterparty failure they should have none.</ref> They are putting themselves in harm’s way. Part of the thrill of taking on risk is ''that you have risk''.
+Dealers are [[delta-hedge]]d against every customer. They are not “the other side of the trade”. A dealer’s “position” against a given client being “under water” in itself does not change the dealer’s risk of insolvency. Of course, dealers ''do'' present a risk of insolvency, and customers will tolerate so much exposure to that risk, but the customer has other levers to manage it. They can close out their position, take profits and re-establish the position at the new level, or with another dealer, for one thing. That enables the dealer to close out its hedge, pass on the hedge gains and reset hedges and initial margin at the higher level.<ref>A grave factor in [[Credit Suisse]]’s losses on [[Archegos]] was “margin erosion” caused by massive appreciation on its swap positions. While Credit Suisse was unusual in not using “dynamic margining” (which solves the “margin erosion” problem) to its [[synthetic equity derivatives]] book, “static” [[initial margin]] is the rule for other asset classes, and for [[regulatory IM]].</ref> This is not the same as paying out the [[mark-to-market]] of a unrealised swap.
+To be sure, customers might not ''like'' doing this — realising a taxable gain and having to stump up more [[initial margin]] when re-establishing positions blows, for sure — but none of these are good reasons for anyone but the customer concerned. Withholding [[variation margin]] on profitable positions gives customers the choice: you can ''either'' keep your position open, but your money with the dealer, avoid tax and live with the “dealer risk”, ''or'' book your gain and get your money back and start again — encourages prudent behaviour. If nothing else it incentivises customers to diversify their risk. And it does not automatically lever up the customer’s portfolio. For what do we think the customer will ''do'' with all that free cash [[VM]] its dealer keeps sending it?  If it was planning to just sit on it, wouldn’t just — ''leave it at the bank''?
 Secondly, [[dealer]]s and [[bank]]s are already capitalised and regulated for systemic risk.<ref>[[Broker/dealer]]s that are not deposit-taking banks are more lightly capitalised. But nor — for that very reason — can they hold customer assets and cash on their balance sheet, but must hold it on trust for customers with a client money bank that ''is'' capital regulated.</ref> There are already constraints on how they must operate, and how much capital they must hold against the contingency of portfolio losses. It holds this capital, in large part, to protect against the risks presented to it ''by its customers''. Customers like thinly capitalised, highly-levered investment funds.