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


As long as the dealer is covered, there will be minimal market disruption and the dealer’s own solvency is not threatened.  
As long as the dealer is covered, there will be minimal market disruption and the dealer’s own solvency is not threatened.  
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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.  
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''?
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.  
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?”
That risk is amplified if dealers must pay away their own cash to reflecting their customers’ 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>
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>
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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.
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.


===Voluntary margin===
==== Other dumb use cases ====
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 lending|margin lenders]] and physical prime brokers do every day of the week.  
And leaving aside the risk consequences of bilateral variation margin, don’t forget the ''operational hassle'' it presents. The financial system is complicated enough without gobs of cash flying to and fro just to offset changing risk positions on principal contracts. All other things being equal, it would be better not to post margin than to post it.  
 
If we accept for a minute dealers shouldn’t have to margin customers without good reason, we notice a class of transactions in which customers presents ''no'' risk to the system at all but, because of the bilaterality of margin regulations, they are obliged to receive, and then return, daily margin anyway. These are fully-paid option contracts. Here, the customer pays its premium up front. Anything it can be liable for, it pays at inception. Thereafter, worst case, the option expires out-of-the-money and the customer gets nothing.  


But this lending is discretionary, and dealers can apply whatever [[haircut]]<nowiki/>s, credit terms and diversification criteria they choose. Regulatory VM must be paid in full and in cash. Imagine if retail banks were ''forced'' to pay out to mortgage customers the value of unrealised gains on their properties! 
But if the option trades into the money, the dealer is obliged to pay variation margin to the customer.


“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.” 
Not only is this counterproductive to the interests of systemic stability, as per the above, but it also means the customer has to get involved with margining and cash management, because it will have to post this excess margin back to the dealer if the position moves back the other way. This is operational faff for no good reason.


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%). A house is a levered play. A customer might technically “own” the house, but only in a very contingent sense: if it cannot keep up its mortgage payments, it will not own the house much longer.  
===Voluntary margin===
Now, none of this stops a dealer recognising the “equity” in a customer’s unrealised [[mark-to-market]] gains and lending against it. This is what [[Margin lending|margin lenders]] and physical prime brokers do every day of the week. But this kind of lending is ''discretionary''. Dealers don’t have to do it, and if they do, they can apply whatever [[haircut]]<nowiki/>s, credit terms and diversification criteria they like.


The same is true of a derivative exposure. It is, as above, 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 optimises its funding and to earns a commission on the opening and closing of the trade. It lends 70% of the initial value of the asset. If the customer wants to isolate its dealer credit exposure, 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.
As a customer’s unrealised profit increases in value, you would expect the dealer’s lending appetite to diminish. But regulatory VM rules ''force'' the dealer to lend in full, and in cash. Imagine if retail banks were forced to cash collateralise mortgage customers the value of unrealised gains on their properties!


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).
“But, but, but, JC: there is a difference. A mortgage customer ''owns'' her house. She has no credit exposure to the bank for the house. If the bank fails, the customer keeps the house. With a swap, the dealer owns the hedge. If it fails, the customer would lose everything.” 


It is a ''much'' better discipline for financial sophisticates to manage their dealer credit exposure — spread it around, so to speak — than to require their dealers to send them hard cash so they can double down with individual dealers.  
All this is true. But, equally, the customer’s personal capital outlay for that house — her real investment — is small. A house is a levered play. A customer might technically “own” her house, but only in the very contingent sense that she keeps up her mortgage payments. ''She only owns the house as long as the bank gets its money''.  


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.  
The same is true of an equity swap. It is, as above, an implied loan. The customer puts down initial margin — economically equivalent to a deposit — and gets a levered return on the whole asset. The dealer earns only its commission on the opening and closing of the trade and, because it is funding its own hedge, takes a funding rate from the customer. Economically, the dealer has lent 70% of the initial value of the asset. If the customer wants to isolate its exposure to the dealer for its equity, it can take out a margin loan against a physical asset, just like a mortgage. Or it could close out its trade, take its profit and restrike par with the dealer.


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 ''accommodating 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]].
[[Buy-side]] counterparties are, [[Q.E.D.]], sophisticated professionals.<ref>They don’t get through onboarding if they are not. Sophistication is a condition to entry to the game.</ref> They have the tools, resources and skills to monitor their dealers’ credit standing. It is a ''much'' better discipline for them to prudently manage their own dealer credit exposure than to have dealers send them hard cash so they don’t have to. 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.


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
Every dollar of margin a dealer pays to one customer reduces the capital it has available for everyone else. Dealer margin is a preference to that creditor over others. Daily [[mark-to-market]] moves are ''mainly'' ''noise''. Signal emerges only over time. A great deal of the back-and-forth of variation margin is, therefore, ''accommodating noise''. The signal only 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]].


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.
The systemic risk caused by interconnected financial institutions failing — which is what the margin regs were designed to address — is not caused by the banks themselves, but by their customer exposures. Dealer risk is a function of customer failures, which in turn are a function of leverage. Paying variation margin to customers invites more leverage.
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