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{{drop|[[a swap as a loan|D]]|uring a typically}} [[The bilaterality, or not, of the ISDA|turgid disquisition]] about the “bilaterality” of the {{isdama}}, JC remarked that, despite ''looking like'' bilateral, even-stevens, un-[[loansome]] things, in fact swaps are ''implied financing arrangements''.
{{drop|[[a swap as a loan|W]]|hile composing}} his [[The bilaterality, or not, of the ISDA|turgid disquisition]] on the “bilaterality” of the {{isdama}}, JC remarked that, despite ''looking like'' bilateral, even-stevens, un-[[loansome]] things swaps are, in fact, ''implied loans''. Hotly justifying this stance side-tracked the original article, so JC  “[[Let’s take it offline|took things offline]]” and started a whole new article on the topic. Here it is.
 
Hotly justifying this stance sidetracked the original article, so JC  “[[Let’s take it offline|took things offline]]” and started a whole new article on the topic. Here it is.


To recap the background to that post:
To recap the background to that post:


{{Quote|{{drop|W|hereas most}} finance contracts imply dominance and subservience — a ''lender'' who extracts excruciating covenants, takes mortgages, sharpens knives and so on, and a ''borrower'' whose mortal soul is traduced, suffers repeated indignities but who must yet feign affection through gritted teeth and deep resentment — swaps are ''not like that''.
{{Quote|{{drop|W|hereas most}} finance contracts imply dominance and subservience — the classic loan has a ''lender'' who extracts excruciating covenants, takes mortgages, sharpens knives and so on, and a ''borrower'' whose mortal soul is traduced, suffers repeated indignities but who must yet feign affection through gritted teeth and deep resentment — swaps are ''not like that''.
   
   
“A swap is an exchange ''among peers''. It is an equal-opportunity, biblically righteous compact between equals. There is no lender or borrower: each participant is an honest rival for the favour of the Lady Fortune, however capricious may she be.”}}
Swaps, so conventional wisdom would have it, are exchanges ''among peers''. “It is,” cognoscenti are given to say, “an equal-opportunity, biblically righteous compact ''between equals''. There is no lender or borrower to a swap: yes, the transaction may go in and out of the money but, as it does, each participant is an honest rival for the favour of the Lady Fortune, however capricious may she be.”}}
 
''Fiddlesticks''. At least outside the inter-dealer community, and even then, frequently within it, this conventional wisdom is not true.


[[Jolly Contrarian|JC]]’s says that, outside the inter-dealer community, this conventional wisdom is not true.  
In the bigger picture, ''swaps are loans''.


An “end user” swap ''is'', in fact, a “synthetic” loan from [[dealer]] to [[customer]]. To the extent regulations require dealers to ''post'' [[variation margin]] outright against their own swap exposures, (rather than simply calling for from their customers to cover customer exposures), the regulations make the financial system ''less'' stable, ''more'' risky, ''more'' leveraged, and ''more'' prone to the market calamities that fueled the global financial crisis.
An “end user” swap ''is'', in fact, a “synthetic” loan from [[dealer]] to [[customer]]. To the extent regulations require dealers to ''post'' [[variation margin]] outright against their own swap exposures (rather than simply calling for it from their customers), the regulations make the financial system ''less'' stable, ''more'' risky, ''more'' leveraged, and ''more'' prone to the market calamities that fueled the global financial crisis. Bilateral variation margin is a category error.


{{quote|
''Swap dealers should not collateralise their customers.''
Bilateral variation margin is a category error. ''Swap dealers should not collateralise their customers.''}}


There. I said it.
There. I said it.


Industry veterans may look upon JC slack-jawed as he says this. Regulators certainly will. Being optimistic, they might try to give JC the benefit of the doubt for this flight of fancy, while thinking “''has the old bugger finally lost his marbles''?”
JC is blessed in having charitable friends who forgive intellectual softness.  
 
JC is blessed in that his friends are inclined to charity. “Oh, well, I suppose you ''could'' analyse an [[Interest rate swap mis-selling scandal|interest rate swap]] as a pair of off-setting loans,” they are prone to say. “Yes, that seems strictly true. But, dear fellow, it is rather to miss the point, isn’t it? Seeing as the same amount of principal in the same currency flows in both directions at the same time, the principal cancels out.  


The parties to a swap are not ''really'' lending to each other, old thing.”  
“Oh, well,” they are prone to say when the old boy goes off on one, “I suppose you ''could'' analyse an [[Interest rate swap mis-selling scandal|interest rate swap]] as a pair of off-setting loans. Yes, that seems strictly true. But, dear fellow, is it not rather to miss the point? Seeing each party lends to the other, and as notional principal flows in both directions at the same time, the loan, as you put it, cancels out. The parties to a swap are not ''really'' lending to each other, old thing.”  


====Customers and dealers====
====Customers and dealers====
{{drop|B|ut this is}} not what the JC means. He means to say that when a dealer provides a swap to a customer, economically, the dealer lends, outright, to the customer. One way.  
{{drop|B|ut this is}} not what the JC means. When a dealer provides a swap to a customer, economically, the dealer lends, outright, to the customer. One way. The customer doesn’t get the money, but that doesn’t matter. The money goes on financing the hedge.
 
Now, far out in space, beyond the cramped Oort cloud of inter-dealer relationships, there is a boundless universe of “end user” swaps. Here, one party is a “dealer” and the other — the “end user” — is a “customer”. These are the great majority of all swap arrangements in the known universe. Hence, the expressions “[[sell side|sell-side]]” — the dealers — and “[[buy side|buy-side]]” — their customers.  


The difference between ''customer'' and ''dealer'' on a swap is not who is “long” and who “short” — one of the great [[Swappist Oath|swappist]] beauties under the ISDA framework is that customers can go long ''or'' short, as they please — nor on who pays “fixed” and who “floating”.  
Now there is a boundless universe of “end user” swaps. Here, one party is a “dealer” and the other — the “end user” — is a “customer”. These are the great majority of all swap arrangements in the known universe. Hence, the expressions “[[sell side|sell-side]]” — the dealers — and “[[buy side|buy-side]]” — their customers.  


The difference between customer and borrower is ''who, economically, is borrowing''.
The difference between ''customer'' and ''dealer'' on a swap is not who is “long” and who “short” the swap exposure — one of the great [[Swappist Oath|swappist]] beauties of the ISDA framework is that customers can go long ''or'' short, as they please — nor on who pays “fixed” and who “floating”.  


For a ''customer'' the object of any {{isdaprov|Transaction}} is to ''change its overall market exposure'': to get into positions it did not have before, or get out of ones it did.  
The difference between customer and borrower is ''who is lending and who is borrowing''. 
====The capital cost of changing your position====
{{drop|F|or a customer}}, the object of any {{isdaprov|Transaction}} is to ''change its overall market exposure'': to get into a position it did not have before, or get out of one it did.  


This sounds obvious enough. But dealers do ''not''. Dealers stay ''flat''.  
But dealers do ''not'' do this. Dealers stay ''flat''.  


“Hang on, though, JC: if a swap is bilateral, how ''can'' that be so? Does it not follow that if the ''customer'' changes its position one way, the dealer must dp so the other way?”  
“Hang on, though, JC: if a swap is bilateral, how ''can'' that be so? Does it not follow that if the ''customer'' changes its position one way, the dealer must do so the other way?”  


In the narrow confines of the specific {{isdama}} perhaps. But in the wider context of the parties overall net positions, ''no''.  
In the narrow confines of a specific {{isdaprov|Transaction}} perhaps. But the narrow Transaction is not the whole picture. In the wider context of the parties overall net risk positions, this does not happen. Customers change their positions


The dealer “provides” exposure by sourcing it in the market, delta-hedging it, and charging its customer a [[commission]]. There are all kinds of enterprising and funding-efficient ways it can do so, but fundamentally, a dealer stays market-neutral. The customer’s credit risk for the life of the trade, is all the excitement the dealer wants. As long as its market side hedges work, the only market risk the dealer takes comes about if the customer fails. That is to say, the dealer has customer ''credit'' exposure for as long as the customer stays in its risk position. The customer decides when to exit: as long as it is not solvent the dealer is committed to staying in. If the customer wants to exit, the dealer will make a price.  
The dealer “provides” exposure by sourcing it in the market, delta-hedging it, and charging its customer a [[commission]]. There are all kinds of enterprising and funding-efficient ways it can do so, but fundamentally, a dealer stays market-neutral. The customer’s credit risk for the life of the trade, is all the excitement the dealer wants. As long as its market side hedges work, the only market risk the dealer takes comes about if the customer fails. That is to say, the dealer has customer ''credit'' exposure for as long as the customer stays in its risk position. The customer decides when to exit: as long as it is not solvent the dealer is committed to staying in. If the customer wants to exit, the dealer will make a price.  
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Aren’t “''normal''” swaps truly bilateral? How about a good old fashioned [[interest rate swap]]? Surely ''paying'' a [[fixed rate]], and ''receiving'' a [[floating rate]], has none of these same characteristics of borrowership about it?  
Aren’t “''normal''” swaps truly bilateral? How about a good old fashioned [[interest rate swap]]? Surely ''paying'' a [[fixed rate]], and ''receiving'' a [[floating rate]], has none of these same characteristics of borrowership about it?  


The first point to make here is that in the real universe of actual, non-[[derivative]] instruments, fixed or floating rate cashflows ''do not exist independently of principal investments''. (This is just as true of [[dividend]]<nowiki/>s on equities, of course). This is because a cashflow is necessarily ''income'' on a capital investment.
The first ting to say here is that in the real universe of actual, non-[[derivative]] instruments, interest rate cashflows ''do not exist independently of an investment in principal''.<ref>This is just as true of [[dividend]]<nowiki/>s on equities, of course.</ref> This is because an interest rate is, by definition, the ''income'' on a capital investment.
 
Oh, sure, you can detach and sell a strip of [[coupon]]<nowiki/>s off a [[Debt security|bond]]: okay. But to do that, there must first ''be'' a bond, and you must buy it, cut it up and sell the stripped bond principal back into the market. Once you’ve done that, you have your disembodied interest cashflow, all right — but someone else has its dark inversion: this weird, mutilated, principal-only, [[Zero-coupon bond|zero-coupon]] instrument that trades at a heavy discount to its fully-limbed equivalent. It will exist, but unhappily: like Weird Barbie or one of those intercised children with no daemon in ''His Dark Materials''. Once you have sold the principal you might not be able to ''see'' it any more, ''but it is still there''.
 
{{Quote|{{drop|“I|n the real world}} interest rates do not exist independently of principal investments. This is because an interest rate is, by definition, the income on a capital investment.”}}


Oh, sure, you could detach and sell a strip of [[coupon]]<nowiki/>s off a [[Debt security|bond]]: okay. But to do that, there must first ''be'' a bond, and you must buy it, cut it up and sell the stripped bond back into the market. Once you’ve done that, you have your disembodied interest cashflow, all right — but you are left with this weird, mutilated, principal-only, [[Zero-coupon bond|zero-coupon]] instrument that you must sell into the market at a heavy discount to its fully-limbed equivalent. It will exist, but unhappily: like Weird Barbie or one of those intercised children with no daemon in ''His Dark Materials''. Once you have sold it you might not be able to ''see'' the principal investment any more, ''but it is still there''.
Repeat: in the real world, ''interest rate cashflows depend on income-generating assets''. It stands to reason. A rate without principal is like a shadow without a boy.  


Repeat: in the real world, ''income cashflows depend on an income-generating asset''. Stands to reason. A rate with out principal is like a shadow without a boy.
Do swaps change all that?


Do swaps change all that? No: because at some point, swaps must be ''based in the reality from which they are derived''.
No: because at some point, swaps must be ''based in the reality from which they are derived''. This is not bitcoin, folks.
====Derivatives as “engines of hypothesis”====
====Derivatives as “engines of hypothesis”====
{{quote|
{{quote|
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FINANCE: (of a product) having a value ''deriving from'' an underlying variable asset. (''emphasis added'')}}
FINANCE: (of a product) having a value ''deriving from'' an underlying variable asset. (''emphasis added'')}}


{{smallcaps|When the}} [[Children of the Woods|Children of the Forest]] wrought their wristy magic on the [[First Men]], the [[Single agreement|Way of the One Agreement]] passed into common understanding. Only then were our leaden, earth-bound notions of “necessary principal” swept away.  
{{Drop|W|hen the [[Children of the Forest|Children]]}} [[Children of the Woods|of the Forest]] wrought their wristy magic on the [[First Men]] and the [[Single agreement|Way of the One Agreement]] passed into common understanding our leaden, earth-bound notions of “necessary principal” were swept away. Only then did the swap market take wing, upon the nuclear power of [[leverage]]. Income could flow, at last, unshackled of its leaden ''principal'' host, and was free to nudely frolic in ISDA’s glittering starlight.
 
The “synthetic” world is an alternative, magical realm. Normal rules of [[space-time]] do not apply. There are amulets, magic instruments and imaginary tools with which even ordinary mortals can do impossible things. As we have seen, we can isolate income from [[principal]] and trade them hypothetically, as discrete instruments.  


Only then did the swap market take wing, upon the nuclear power of infinite [[leverage]]. Income could flow, at last, broken free of its leaden ''principal'' host, and could nudely frolic in ISDA’s glittering starlight.
But gravity is not banished; only ''postponed''. At some point, this fantasia must alight on planet Earth and engage with real-world instruments, ''because that is what it is all derived from''. Ultimately, somewhere, someone needs to construct each enchanting payoff from grubby, weighty, principal-laden corporate rights and obligations. Those rights and obligations are — on our mortal coil, must be — embedded in a scaly crust of principal.  


The synthetic world is an alternative, magical realm. In it, there are imaginary tools with which we can do impossible things. ''Hypothetically'', we can isolate [[income]] from [[principal]] and trade them as discrete instruments. Normal rules of spacetime do not apply.
And ''that principal'' ''must be financed''.


But gravity is not banished; only ''postponed''. At some point, our swappist fantasia must alight on planet Earth and engage with real-world instruments, ''because that is what it is all derived from''. Ultimately, somewhere down the chain, someone needs to construct each enchanting payoff from grubby, real old-fashioned, corporate rights and obligations. Those rights and obligations will come with principal attached. And ''that'' must be financed.  
So if you want to earn [[floating rate]] on a notional of a hundred bucks in the real world, you pony up a hundred bucks. That means selling an investment you already own:<ref>Even free cash deposited with the bank is an investment: it is a loan to the bank.</ref> going off some other risk. If you don’t want to sell down another investment, you must ''borrow'' from someone.  


If you want to earn [[floating rate]] on a notional of a hundred bucks, in the real world you pony up a hundred bucks and buy a floating-rate note. Ponying up cash means selling an investment you already own:<ref>Even free cash deposited with the bank is an investment: it is a loan to the bank.</ref> going off some other risk. If you don’t want to sell down that asset, you must ''borrow'' a hundred bucks from someone. If it is the [[dealer]] who is selling you the [[floating rate note]], then consider the final cashflows: you ''pay'' a fixed rate out of the income generated by your assets, the principal on the note you’ve bought cancels out against the principal of your loan and bingo: ''you have an interest rate swap''.
If that someone is the [[dealer]] from whom you bought the [[floating rate note]], consider the final cashflows: you ''pay'' a fixed rate on your loan; you finance that from the income generated by your asset portfolio, the principal on the note you’ve bought cancels out against the principal of your loan and bingo: ''you have an interest rate swap''.


====Leverage is a state of mind (or balance-sheet)====
====Leverage is a state of mind (or balance-sheet)====
{{smallcaps|One last way}} to look at this: an interest rate swap is a levered investment in a fixed income asset. Interest rate swaps are, in this sense, “synthetic ''fixed income'' prime brokerage”: a [[margin loan]] to buy a fixed income asset.
{{smallcaps|One last way}} to look at this: an interest rate swap is a levered investment in a debt instrument. Interest rate swaps are, in this sense, “synthetic ''fixed income'' prime brokerage”: a [[margin loan]] to buy a fixed income asset.


We can see this by considering the parties’ respective economic positions before and after trading. The customer changes its net position; the [[dealer]] does not. Swapping a fixed cashflow for a floating one is to ''keep'' the “asset” funding that fixed cashflow, and to borrow the funds required to buy the new floating-rate asset. Because that borrowing has the same principal amount as the purchased floating-rate asset, the principal amounts cancel out, and the customer left with just the floating rate cashflow, for which it must pay the fixed rate cashflow it has agreed.  
We can see this by considering the parties’ respective economic positions before and after trading. The customer changes its net position; the [[dealer]] does not. Swapping a fixed cashflow for a floating one is to ''keep'' the “asset” funding that fixed cashflow, and to borrow the funds required to buy the new floating-rate asset. Because that borrowing has the same principal amount as the purchased floating-rate asset, the principal amounts cancel out, and the customer left with just the floating rate cashflow, for which it must pay the fixed rate cashflow it has agreed.  
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