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Template:M intro isda a swap as a loan (view source)

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[[Jolly Contrarian|JC]]’s says that, outside the inter-dealer community, this conventional wisdom is not true.  
[[Jolly Contrarian|JC]]’s says that, outside the inter-dealer community, this conventional wisdom is not true.  


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 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.


{{quote|
{{quote|
''Bilateral variation margin is a category error. 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.
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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.  


''As it would have'' ''in a loan''.
Now: the thing about being net long, or net short, a financial exposure is that someone needs to acquire that exposure. Even if the exposure is an “unfunded” rate, or index, in the real world that rate only comes from making a capital investment in an underlying product. Someone has to ''commit capital'' to generate that return.  


Ok: but how does that fleeting resemblance turn an obviously bilateral swap into a “synthetic loan”?
This is the same capital expenditure that a bank must make when extending a loan. The difference is only that the bank commits that capital to its hedging programme, rather than giving it directly to the customer (as it would in a [[Margin loan|margin loan]]).


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 JC’s fabulous new [[Legaltech startup conference|legaltech start-up]], [[Cryptöagle]].
====Worked example====
Imagine [[Hackthorn Capital Partners]] already holds USD10m of that redoubtable stalwart of legal [[Thought leader|thought-leader]]ship [[Lexrifyly]], and, it wants to acquire some long exposure to the JC’s fabulous new [[Legaltech startup conference|legaltech start-up]], [[Cryptöagle]].


It can do one of three things:  
Hackthorn can do one of three things:  


{{Quote|{{divhelvetica|
{{Quote|{{divhelvetica|
(i) ''sell'' [[Lexrifyly]] and ''buy'' [[Cryptöagle]] — that is, make an outright long investment;
(i) ''sell'' [[Lexrifyly]] and ''buy'' [[Cryptöagle]] — that is, make an outright long investment out of the proceeds of sale;


(ii) ''hold'' [[Lexrifyly]] and ''borrow'' to buy [[Cryptöagle]] — that is, take a margin loan;
(ii) ''hold'' [[Lexrifyly]] and ''borrow'' to buy [[Cryptöagle]] — that is, take a [[margin loan]];


(iii) ''hold'' [[Lexrifyly]] and ''get synthetic exposure to'' [[Cryptöagle]] via an equity swap — that is, conventionally, ''not'' a financed investment. (''But...'')}}}}
(iii) ''hold'' [[Lexrifyly]] and ''get synthetic exposure to'' [[Cryptöagle]] via an [[equity swap]] from its dealer, without, apparently borrowing any money.}}}}


For ease of argument, let’s say on the investment date, both [[Cryptöagle]] and [[Lexrifyly]] trade at USD1 per share, so both positions are for 10m shares.  
To make it easy, let’s say on the investment date, both [[Cryptöagle]] and [[Lexrifyly]] trade at USD1 per share, so both positions are for 10m shares.  


Here are the positions:
Here are the positions:


{{Quote|{{divhelvetica|
{{Quote|{{divhelvetica|
'''Outright sale'''<br>
'''Sale'''<br>
If it sells its [[Lexrifyly]] outright, the position is as follows:
If it sells [[Lexrifyly]] outright, the position is as follows:
:''Sold: USD10m [[Lexrifyly]].
:''Sold: USD10m [[Lexrifyly]].
:''Borrowed'': Zero.
:''Borrowed'': Zero.
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:''Bought'': 10m [[Cryptöagle]].
:''Bought'': 10m [[Cryptöagle]].
:''Net position'': ''10m [[Cryptöagle]] shares + zero [[Lexrifyly]] + zero loan''
:''Net position'': ''10m [[Cryptöagle]] shares + zero [[Lexrifyly]] + zero loan''


'''Loan'''<br>
'''Loan'''<br>
If it keeps its [[Lexrifyly]] and borrows, the position is as follows:
If it keeps [[Lexrifyly]] and borrows to buy [[Cryptöagle]], the position is as follows:
:''Sold: Zero.
:''Sold: Zero.
:''Borrowed: USD10m.
:''Borrowed: USD10m.
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'''Swap'''<br>
'''Swap'''<br>
If it keeps its [[Lexrifyly]] and puts on a swap struck at USD10m, the position is as follows:
If it keeps [[Lexrifyly]] and buys an equity swap from its dealer struck at USD10m, the position is as follows:
:''Sold: Zero.
:''Sold: Zero.
:''Borrowed: Zero.
:''Borrowed: Zero.
:''Swap outgoings'': Floating rate on USD10m
:''Swap outgoings'': Floating rate on USD10m
:''Swap incomings'': USD10m [[Cryptöagle]] - USD10m.
:''Swap incomings'': USD10m [[Cryptöagle]] - USD10m (being the strike price).
:''Net position'':  ''10m [[Lexrifyly]] shares + 10m [[Cryptöagle]] shares - USD10m - accrued interest''
:''Net position'':  ''10m [[Lexrifyly]] shares + 10m [[Cryptöagle]] shares - USD10m - accrued interest''
}}}}
}}}}


Notice how similar the economics of 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.  
Notice that the economics of the loan are identical to those of the swap. 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]]''. ''As it would have'' ''in a loan.''  
This is a form of ''[[leverage]]''. ''As it would have'' ''in a loan.''  
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