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===Bilaterality=== | ===Bilaterality=== | ||
{{smallcaps|A belief in}} even-handedness gripped the ones whose [[deep magic]] forged the runes of that ancient [[First Swap]]. Not just a two-sided structure — most private contractual arrangements have that — but a ''symmetrical'' one, lacking the dominance and subservience that traditional finance contracts imply. | {{smallcaps|A belief in}} even-handedness gripped the ones whose [[deep magic]] forged the runes of that ancient [[First Swap]]. Not just a two-sided structure — most private contractual arrangements have that — but a ''symmetrical'' one, lacking the dominance and subservience that traditional finance contracts imply. There is not necessarily a large, institutional “have” indulging a small commercial “have-not” with favours of loaned money or extended credit, for which privilege it extracts excruciating [[covenant]]s, gives not a jot in return, and enjoys a preferred place amongst the [[customer]]’s many scrapping creditors. | ||
[[Swaps]], as the [[First Men]] saw them, would not be like that. Not ''necessarily''. | |||
“A swap | “A swap shall be an exchange among peers: an equal-opportunity sort of thing; righteous in that, under its auspices, one is neither lender nor borrower, but simply an honest rival for the favour of the Lady Fortune, however capricious may she be.” | ||
“Thus, those who swap things are not master and servant, but equals. ''Rivals''. Let us call them ‘Counterparties’.” | “Thus, those who ''swap'' things are not master and servant, but equals. ''Rivals''. Let us call them ‘Counterparties’.” | ||
And, to be sure, swaps ''are'' different from | This imagines swaps in that pure, innocent, bubble-gum-cards-in-the-playground way. “I have two Emerson Fittipaldis, you have two Mario Andrettis, we can increase the net happiness of the world by swapping so we both have one of each.” | ||
In the playground there are no brokers or dealers of bubble gum cards to intermediate, make markets and provide liquidity, let alone a trusted central clearer. It is a peer-to-peer, decentralised marketplace.<ref>Oh, wait. Hang on. There ''was''. It was Peason Minor in 3B. That made a two-way market in foopballers, F1 drivers and Top Trumps military planes and supercars. That guy was incredible. Wonder what he’s doing now. [''CIO at GSAM — Ed.''] Okay so most metaphors don’t bear close examination.</ref> | |||
And, to be sure, swaps ''are'' different from [[loan]]s and [[cash equities|brokerage arrangements]]. They start off “at market”, where all is square. Either party may be long or short, fixed or floating: at the moment the trade is struck, the world infused with glorious possibility. | |||
One fellow’s fortunes may rise or fall relative to the other’s and, as a result, she may ''owe'' (in the vernacular, be “[[out-of-the-money]]”) or ''be owed'' (“[[in-the-money]]”). | One fellow’s fortunes may rise or fall relative to the other’s and, as a result, she may ''owe'' (in the vernacular, be “[[out-of-the-money]]”) or ''be owed'' (“[[in-the-money]]”). | ||
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==== “BINO” — bilateral in name only ==== | ==== “BINO” — bilateral in name only ==== | ||
{{Smallcaps|But there is}} a better objection: for all our protestations to the contrary, the ISDA is not ''really'' a symmetrical contract of equals. It ''is'' usually, a [[financing contract]], in economic effect, even if not in [[formal]] structure. Where one party is an [[end user|customer]] gaining exposure to a market risk, and the other is a market professional [[dealer]] providing [[Delta hedge|delta-hedged]] exposure to that risk, a swap is a sort of “[[synthetic loan]]”. | {{Smallcaps|But there is}} a better objection: for all our protestations to the contrary, the ISDA is not ''really'' a symmetrical contract of equals. It ''is'' usually, a [[financing contract]], in economic effect, even if not in [[formal]] structure. Where one party is an [[end user|customer]] gaining exposure to a market risk, and the other is a market professional [[dealer]] providing [[Delta hedge|delta-hedged]] exposure to that risk, a swap is a sort of “[[synthetic loan]]”. | ||
=====The arrival of the agents===== | |||
Decentralised markets are not a stable equilibrium. <Ref>Sorry, cryptobros.</ref> Whenever one allocates large amounts of risk to a distributed community the opportunity arises for professional introducers to intermediate. To locate buyers and sellers and put them together. Swaps are no different. The swap is by nature a principal-to-principal contract, but the principle is the same: this class of intermediaries sleeve, aggregate and anonymise risk, but they don’t, as far as they can help it, take it. They are there for the ''commission''. Their economic exposure to their customers resembles a lender’s to its borrowers. They are, effectively, ''providing finance''. | |||
Realising this may change how you think about ISDA negotiation. It did for the [[JC]]. So profound did this thought seem that it grew and grew and now there is a [[A swap as a loan|whole new article about it]]. | Realising this may change how you think about ISDA negotiation. It did for the [[JC]]. So profound did this thought seem that it grew and grew and now there is a [[A swap as a loan|whole new article about it]]. | ||
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{{smallcaps|What is in}} a name? | {{smallcaps|What is in}} a name? | ||
This may be to draw a long bow, but you could | This may be to draw a long bow, but you could, and the JC does, make the case that over-emphasising ''formal' bilaterality, and ignoring ''substantive'' asymmetry, has led the regulatory dance into the wrong corner of the dancefloor. | ||
The logic is this: this is a contract of equals. Each poses an equal, but offsetting, risk to the other. Therefore credit concern cuts both ways, so any regulatory impositions should — ''must'' — also apply both ways. | The logic is this: this is a contract of equals. Each poses an equal, but offsetting, risk to the other. Therefore credit concern cuts both ways, so any regulatory impositions should — ''must'' — also apply both ways. | ||
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And so we have seen: [[swap dealer]]s have to post [[Regulatory initial margin|regulatory initial]] and [[Variation margin|variation margin]] to their customers, just the same way their customers must post it to them. | And so we have seen: [[swap dealer]]s have to post [[Regulatory initial margin|regulatory initial]] and [[Variation margin|variation margin]] to their customers, just the same way their customers must post it to them. | ||
''But this is nuts''. Swap dealers are | ''But this is nuts''. Swap dealers are capitalised financial institutions providing a service for a fixed commission. When dealing, they don’t take on outright market positions. They must hold [[regulatory capital]] against their dealing activity. That this means of managing systemic risk hasn’t always ''worked'' fabulously well is not the point: the principle is sensible: ensure financial institutions are sound by obliging them to ''hold on'' to money, rather than making them give it away. | ||
And a customer who frets about its outsized exposure to a dealer has a ready solution: ''move its business away''. Diversifying the portfolio encourages competition in the market and introduces a healthy redundancy.<ref>In “[[Normal Accidents: Living with High-Risk Technologies|normal accidents]]” terminology financial markets are [[Tight coupling|tightly-coupled]], [[Complexity|non-linear]] systems where “slack” loosens that coupling and reduces the risk of catastrophic failure.</ref> Overall, encouraging customers to limit their outright exposure to dealers enhances the market’s overall resilience. | And a customer who frets about its outsized exposure to a dealer has a ready solution: ''move its business away''. Diversifying the portfolio encourages competition in the market and introduces a healthy redundancy.<ref>In “[[Normal Accidents: Living with High-Risk Technologies|normal accidents]]” terminology financial markets are [[Tight coupling|tightly-coupled]], [[Complexity|non-linear]] systems where “slack” loosens that coupling and reduces the risk of catastrophic failure.</ref> Overall, encouraging customers to limit their outright exposure to dealers enhances the market’s overall resilience. | ||
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Obliging dealers to [[Variation margin|cash-collateralise]] customers’ open positions creates the ''opposite'' incentives. Customers are encouraged not to diversify their risk, but to concentrate it, with the [[dealer]]s offering the most aggressive margin rates. And the dealer market is competitive to the point of being paranoid, as we learned from [[Archegos]]. Dealers will cut their required margins to the bone, thereby increasing their risk of loss. | Obliging dealers to [[Variation margin|cash-collateralise]] customers’ open positions creates the ''opposite'' incentives. Customers are encouraged not to diversify their risk, but to concentrate it, with the [[dealer]]s offering the most aggressive margin rates. And the dealer market is competitive to the point of being paranoid, as we learned from [[Archegos]]. Dealers will cut their required margins to the bone, thereby increasing their risk of loss. | ||
By contrast, [[end user]]s are not regulated. They are often thinly capitalised funds, trading with leverage on someone else’s money: guess | By contrast, [[end user]]s are ''not'' regulated. They are often thinly capitalised funds, trading with leverage on someone else’s money: guess whose’s? ''The [[dealer]]''. | ||
The real source of systemic [[dealer]] risk is the [[Second-order derivative|second-order risk]] presented by the dealer’s ''customers'' blowing up. | The real source of systemic [[dealer]] risk is the [[Second-order derivative|second-order risk]] presented by the dealer’s ''customers'' blowing up. | ||