Template:M intro isda a swap as a loan: Difference between revisions

{{Quote|Whereas most finance contracts imply dominance and subservience between lenders who extract excruciating covenants and enjoy a preferred place in the borrower’s affections, on its Christmas card list and so on, swaps are unique in ''not being like that''.

So here goes: the JC’s position is that outside the inter-dealer community, this conventional wisdom is not meaningfully true. An “end user” swap ''is'', in fact, a synthetic loan from dealer to customer.

Industry veterans may look upon you slack-jawed if you say this. Being optimistic, they try to give you the benefit of the doubt for this flight of fancy.

“Oh, well, I suppose you could analyse an [[Interest rate swap mis-selling scandal|interest rate swap]] as a pair of off-setting fixed-rate and floating-rate loans. Yes, that seems strictly true. But it is rather to miss the point. Seeing as the same amount of principal in the same currency flows in both directions at the same time, the principal flows cancel each other out — they ‘net’ to zero. So, loans, sure. But two, going in opposite directions. This implies, does it not, that the parties are ''not'' lending to each other? The loans cancel out.”  

But this is not what the JC means.  

Now, far out in space, beyond the Oort cloud of the cramped star system 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 — a “customer”. This is the great majority of all swap arrangements.  

The difference between ''customer'' and ''dealer'' is not who is “long” and who “short” — one of the great [[Swappist Oath|swappist]] beauties is that customers can easily go long ''or'' short — nor on who pays “fixed” and who “floating”.   

The difference between customer and borrower is ''who is borrowing''.   

Hang on, though, JC: you yourself say a swap is a bilateral contract. How can that be so? Does it not follow that if the ''customer'' changes its position, the dealer must be doing so too?  

The dealer ''provides'' exposure without taking any itself. It thereby earns a commission. This is all the excitement the dealer wants. The dealer stays ''flat'' the customer’s market risk. It hedges that market risk away. Without no market risk, the dealer is left with only customer ''credit'' exposure. ''As it would have'' ''in a loan''. (Spoiler: the similarities don’t end there.)

Imagine the JC’s in-house [[hedge fund]], [[Hackthorn Capital Partners]] holds USD10m of that redoubtable stalwart of legal [[Thought leader|thought-leader]]<nowiki/>ship [[Lexrifyly]], and wants to get exposure to the fabulous new [[Legaltech startup conference|legaltech start-up]], [[Cryptöagle]].

Notice how similar the loan and the swap are. 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 exposure to [[Lexrifyly]], 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?  

 

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.    

Ok; that’s a delta-one equity swap. But is this kind of [[synthetic equity swap|synthetic prime brokerage]] just an odd use case? Aren’t “normal” swaps truly bilateral and less “lendy” in nature? How about interest rate swaps? Surely ''paying'' a fixed rate while ''receiving'' a floating rate has none of these same characteristics of borrowership and loanery about it?  

The first point to make here is that in the real universe of actual, non-synthetic investments, fixed or floating rate cashflows ''do not exist independently of a principal investment''. This is because they are necessarily ''income'' on a capital investment. When you put it like that, it is kind of obvious this must be true. 

Oh, sure, you could 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 have to 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 also have unleashed this weird, mutilated, principal-only instrument that flaps around the market at a heavy discount to a fully-limbed equivalent, sort of like Weird Barbie or one of those intercised kids with no daemon in ''His Dark Materials''.  

Repeat: in the real world, ''income cashflows only exist with an income-generating asset''. Stands to reason. A rate with out principal is like a shadow without a boy.  

Did swaps change all that?

If you want a [[floating rate]] on a notional of a hundred bucks, you pony up a hundred bucks and buy a floating-rate note. That means selling down an asset you already have. If you don’t want to do that, you can borrow the hundred bucks at a fixed rate from the dealer who is selling you the floating rate note, and bingo the principal on the note and your loan cancel out and you have an interest rate swap.  

 

One last way to look at this: an [[interest rate swap]] is a levered investment in a fixed income asset. A margin loan to buy a fixed income asset is, literally, a levered investment in that fixed income asset. The difference is the customer is taking a margin loan, the dealer is not.

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 acquire a new floating-rate asset in the same principal amount. Because that borrowing has the same principal amount as the 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 it has agreed.  

Without that implied loan, the customer would have to sell an asset to raise the proceeds to buy the floating-rate bond from the dealer. That is, pay the principal amount to the dealer, and acquire the interest and principal cashflows of a floating rate asset. Here the customer is not borrowing anything.

Quite so: but that is the nature of a floating-rate bond. It ''is'' a loan. But it is ''not a loan to the dealer''. It is a loan ''to the issuer of the floating-rate bond''. If the dealer is paying you the return of a floating-rate bond you may be assured it has used your money to buy a floating-rate bond, to hedge itself. You have not, net, lent the dealer ''anything''.