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| Frights like this are quite energising, if you pick them up during the “four eyes check” at the conclusion of [[onboarding]].<ref>You won’t.</ref> Less so, when Briggs J catches them for you when handing down a judgment from the commercial division of the High Court.<ref>He will.</ref> | | Frights like this are quite energising, if you pick them up during the “four eyes check” at the conclusion of [[onboarding]].<ref>You won’t.</ref> Less so, when Briggs J catches them for you when handing down a judgment from the commercial division of the High Court.<ref>He will.</ref> |
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| ==== “BINO” — bilateral in name only ====
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| {{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]]”.
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| =====The arrival of the agents=====
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| Decentralised markets are not a stable equilibrium. <Ref>Sorry, cryptobros.</ref>
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| Whenever many people seek to manage their risk in a distributed community, the opportunity arises for well-connected professionals to ''intermediate'': to bring together buyers and sellers and take a commission. Swaps are, by nature, principal-to-principal contracts, but the principle is the same: a small class of intermediaries aggregate, anonymise and ''transfer'' risks around the market, but they don’t, as far as they can help it, ''take'' risks. They are in it for the facilitation fees, and a financing spread. Their economic exposure to their customers, therefore, resembles a lender’s to a borrower. Swap “dealers” are, effectively, ''providing finance''.
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| Realising this may change how you think about ISDA negotiation. It did for [[JC]]. We will develop this idea in future posts.
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| Because, except for a narrow class of [[inter-dealer]] swap relationships, all {{isdama}}s are dealer-customer [[relationship contracts]] and “bilateral” ''only in name'': [[swap dealer|dealers]] ''provide'' exposures to [[end user|customers]], who ''consume'' them. The customers are, economically, principals: they provide the impulse to trade; they elect when to exercise options, they decide when to terminate positions. The [[dealer]] is — economically, even if not legally — an agent: it hedges, calculates values and, as a part of the regulated financial system, is burdened with additional [[regulatory capital]] charges if it doesn’t get its [[close-out netting]] right.
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| But, as long as the customer stays solvent, ''the dealer is not on risk''.
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| This submerged asymmetry leads to two kinds of bother: first, as noted above, a bit of a squabble about ''labels''. A first-world problem no doubt, but, since [[swap dealer]]s set up their templates to assume ''they'' will be Party A and their customers Party B, when immovable object meets irresistible force it can spark an unseemly debate from which the [[dealer]] will quickly back down — ''the customer is always right'' — about who should be who. One of the meeker dealers on the street solved this problem by choosing to be “Party B” as standard. But this only confused customers who were unused to being “Party A”.
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| ====Why does it matter?====
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| {{smallcaps|What is in}} a name?
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| 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.
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| 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.
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| ''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.
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| That this method 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 letting or, God forbid, ''making'' them give it away.
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| And a customer who frets about its outsized exposure to a dealer has a ready solution: ''find another dealer''. 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.
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| By contrast, [[end user]]s are ''not'' regulated. They are often thinly capitalised funds, trading with leverage on someone else’s money. (Guess who’s? ''The [[dealer]]’s''.)
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| The real source of systemic [[dealer]] risk is the [[Second-order derivative|second-order risk]] presented to the dealer’s solvency by the dealer’s ''customers'' blowing up. This is a situation a [[dealer]] is more likely to get itself into if it has had to pay away wodges of [[regulatory margin]] to collateralise its customer’s unrealised gains, giving those customers, already betting with the broker’s money, even more of it. We have a separate essay on this: See ''[[when variation margin attacks]]''.
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| Might the market have gravitated this way were it not for our fiction of pretending this is a bilateral relationship?
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