Template:M intro isda Party A and Party B: Difference between revisions

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 a 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”.

Well, yes: but the difference is in how the two sides manage their respective positions. 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 swap arrangements.  

The difference between ''customer'' and ''dealer'' does not depend on who is “long” and who “short” — customers can be long ''or'' short — nor on who pays fixed and who pays floating.   

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''.    

But how does this make a swap into a “synthetic loan” from the dealer to the customer? Let’s take an example. The JC’s fictional hedge fund [[Hackthorn Capital Partners]] owns USD10m of [[Lexrifyly]], and wants to get into the fabulous new start-up [[Cryptöagle]]. It can do one of three things:

(i) sell [[Lexrifyly]] outright and buy [[Cryptöagle]];

(ii) hold [[Lexrifyly]] and borrow to buy [[Cryptöagle]];

(iii) hold [[Lexrifyly]] and get synthetic exposure to [[Cryptöagle]] via a swap.

For argument’s sake let’s say on the investment date, both [[Cryptöagle]] and [[Lexrifyly]] trade at USD1 per share, so the acquired and sold positions are each for 10m shares. Here are the positions:

:''Net position'': ''10m [[Cryptöagle]] shares + zero [[Lexrifyly]] + zero loan''

If it keeps its [[Lexrifyly]] and borrows, the position is as follows:

:''Sold: Zero.

:''Borrowed: USD10m.

:''Bought'': USD10m [[Cryptöagle]].

:''Net position'': ''10m [[Lexrifyly]] shares + 10m [[Cryptöagle]] shares - USD10m - accrued interest''

If it keeps its [[Lexrifyly]] and puts on a swap struck at USD10m, the position is as follows:

:''Net position'':  ''10m [[Lexrifyly]] shares + 10m [[Cryptöagle]] shares - USD10m - accrued interest''

Even though there is no physical loan, the investor’s payment profile is the same. It pays a floating rate, and has the USD10m notional value of the loan deducted from its pay-out. And 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 arrangement, right, so isn’t the converse true of the dealer? Isn’t the dealer, in a sense, “borrowing” by paying the total return of the asset to get “exposure” to the floating rate in the same way? Indeed, 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 customer ''buys'' an exposure: that is, starts ''without'' and ends up ''with'' a “position”; the dealer manufactures and then sells exposure: it starts ''without'' a position, takes an order, creates a position and then transfers it to the customer, leaving the dealer where it started, ''without'' a position. Hence, the expressions “[[sell side|sell-side]]” — the dealers — and “[[buy side|buy-side]]” — their customers.  

Now, a swap is a principal obligation, so transferring exposure “''+x''” to a customer necessarily involves the dealer acquiring exposure “''-x''” — but that “''-x''” exposure corresponds to a “+''x''” exposure the dealer has already acquired by “[[Delta-hedging|delta hedging]]” in the market.<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> 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.   

Customer’s final position is ''+x''.    

Dealer’s is ''(-x +x)'', or zero.  

Provided the [[dealer]] knows what it is about, its main risk in running a swap portfolio is not therefore market risk — it should not have any — but ''customer credit'' ''risk''. Should a customer fail, the dealer’s book is no longer matched: its delta-hedge is now an outright long or short position.     

Hence, having collateral from each customer is important for the dealer. As long as each of the dealer’s other customers it providing it collateral, and the dealer is competently delta-hedging, being paid cash collateral by the dealer is far less important for the customer. 

Is that the sound of [[Lehman]] [[horcrux]]<nowiki/>es sparking up I hear? 

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, forged rules which overlook this plain asymmetry. 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 guesstimates. The parties stay on risk.  

Well — ''one'' of them does — as per the above, the customer has risk; the dealer does not. The customer was the one who initiated the trade, to put itself into a market position of some sort. The dealer didn’t initiate the trade, but accommodated it in the expectation only of commission and on the explicit grounds that its market position would not change and the customer’s credit position would be satisfactory.

Requiring margin — even guesstimated margin —from a ''customer'' who is net [[out-of-the-money]] makes sense: if the customer fails, the dealer’s hedges are defeated and it will be have open market exposures to the customer’s positions. From the point of view of systemic risk, the last thing anyone wants is a dealer whose hedges fail. That is when it can go bust. So, daily [[variation margin]] ''to the dealer'' mitigates that risk to date; [[initial margin]] covers it for the future, should the dealer have to close out hedges against a defaulting client.  

As long as the dealer is covered, there will be minimal market disruption and the dealer’s own solvency is not threatened.  

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> — are the ones who are willingly putting themselves in harm’s way. They are taking on risk: that is what they are there for. Of course, dealers ''do'' present some risk of insolvency, and customers should only tolerate so much exposure to that risk, but the customer has other levers to manage it. They can close out their positions, take profits and re-establish their position at the current level, or with another dealer, for one thing. If they do that, the dealer can close out its hedge, pass on gains whilst being off risk, and then restrike its hedges and initial margin at the higher level if need be.<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 prime brokerage|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 the kumara, for sure — but none of these are good reasons for anyone but the customer. 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. This encourages prudent behaviour. If nothing else, it incentivises customers to diversify their risk across dealers.  

And it does not automatically lever up the customer’s portfolio. For what do we think a 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. Dealers hold this capital, in large part, to protect against the risks presented to them ''by customers''. Customers like thinly capitalised, highly-levered, investment funds. If no customer ever fails, nor will a delta-hedging dealer.  

That risk is amplified if dealers must pay away their own cash to reflecting their clients’ unrealised gains on a derivative portfolio ''already 70% financed by the dealer''. It’s just mad: “Hi. You already owe me 70% of the value of the stock you bought largely with my money, and you want ''me'' to pay you margin if the stock goes up?”

This is all the more mad if the dealer is hedging with a physical asset. ''No-one pays variation margin on gains on a physical asset''.<ref>Dealers can, and do, manage this by financing their physical portfolios. They would do this anyway, but variation margin requirements more or less oblige then to.</ref>

Now you might make the case, and some have,<ref>Notably Gerd Gigerenzer, who has tracked the expansion in length of the Basel accords against the persistent rate of bank failure.</ref> that capital regulation has been a bit of disaster, but one lot of crappy regulations is not a prescription for ''more'' crappy regulations. Even if, as in this case, the new regulations were also proposed by the Basel committee too.  

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.