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During a typically turgid disquisition about the ostensible “[[The bilaterality, or not, of the ISDA|bilaterality]]” of the {{isdama}}, the JC remarked rashly that despite ''looking like'' a bilateral, even-stevens, un-[[loansome]] sort of a thing, in practical fact most swaps are really 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 somewhat sidetracked the original article, so we have “[[Let’s take it offline|taken things offline]]” and started a whole new article where the JC can properly make a tit of himself without spoiling the other article.
To recap the background to that post:


So here goes: at least beyond the galaxy of inter-dealer arrangements, a ''swap is a synthetic loan''.
{{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''.
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.”}}


You could analyse an interest rate swap as off-setting fixed rate and floating rate loans. 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.  
''Fiddlesticks''. At least outside the inter-dealer community, and even then, frequently within it, this conventional wisdom is not true.  


“Aha, JC: quite so. But this implies, does it not, that the parties are ''not'' lending to each other? Do not the “loans” cancel out too?”
In the bigger picture, ''swaps are loans''.


Well, yes: but the difference is in how the two sides manage their respective positions. Beyond that cramped star system of inter-dealer relationships, there is a boundless universe where one party is a “dealer” and the other a “customer”. This is the great majority of all swap arrangements.  
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.


The difference between ''customer'' and ''dealer'' is not who is “long” and who “short” — one of the beauties of swap contracts is that customers can easily go long ''or'' short — nor on who pays fixed and who pays floating. 
''Swap dealers should not collateralise their customers.''


For the customer the object of transacting is to ''change'' its market exposure: to get into a positions it did not have before, or get out of one it did. This sounds obvious. But, being a bilateral contract, you might think it follows that the dealer is changing its position, too. But it is not. A dealer is there to provide exposure without taking any itself, and thereby to earn a commission. The dealer intends to say ''flat''.    
There. I said it.


==== Swaps are usually synthetic loans ====
JC is blessed in having charitable friends who forgive intellectual softness.  
But how does this make a swap into a “synthetic loan” from the dealer to the customer? Let’s take an example. The JC’s fictional hedge fund [[Hackthorn Capital Partners]] owns USD10m of [[Lexrifyly]], and wants to get into the fabulous new start-up [[Cryptöagle]]. It can do one of three things:


(i) sell [[Lexrifyly]] outright and buy [[Cryptöagle]];
“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.”


(ii) hold [[Lexrifyly]] and borrow to buy [[Cryptöagle]];
====Customers and dealers====
{{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.


(iii) hold [[Lexrifyly]] and get synthetic exposure to [[Cryptöagle]] via a swap.
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.  


For argument’s sake let’s say on the investment date, both [[Cryptöagle]] and [[Lexrifyly]] trade at USD1 per share, so the acquired and sold positions are each for 10m shares. Here are the positions:
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”. 
 
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.
 
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 do so the other way?”
 
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.
 
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.
 
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]]).
 
====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]].
 
Hackthorn can do one of three things:
 
{{Quote|{{divhelvetica|
(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]];
 
(iii) ''hold'' [[Lexrifyly]] and ''get synthetic exposure to'' [[Cryptöagle]] via an [[equity swap]] from its dealer, without, apparently borrowing any money.}}}}
 
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:


{{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.
Line 34: Line 68:
:''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.
Line 44: Line 77:


'''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''
}}}}
}}}}


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 existing portfolio, 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> 
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.  
 
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?
 
Generally not, because in providing these swap exposures to its customers, the dealer is not changing its own market position. It delta-hedges. At the same moment it puts on a swap, it executes an offsetting hedge. The customer ''buys'' an exposure: that is, starts ''without'' and ends up ''with'' a “position”; the dealer manufactures and then sells exposure: it starts ''without'' a position, takes an order, creates a position and then transfers it to the customer, leaving the dealer where it started, ''without'' a position. Hence, the expressions “[[sell side|sell-side]]” — the dealers — and “[[buy side|buy-side]]” — their customers.
 
Now, a swap is a principal obligation, so transferring exposure “''+x''” to a customer necessarily involves the dealer acquiring exposure “''-x''” — but that “''-x''” exposure corresponds to a “+''x''” exposure the dealer has already acquired by “[[Delta-hedging|delta hedging]]” in the market.<ref>The  dealer may need to borrow money to fund its hedge, but this is exactly what the customer’s floating rate pays for. This is “borrowing on the customer’s behalf”.</ref> It might do this by buying the underlying asset, of futures, or entering into a offsetting swap by which matches off its “long” exposure against another “short” exposure with another counterparty.   


Customer’s final position is ''+x''.    
This is a form of ''[[leverage]]''. ''As it would have'' ''in a loan.''


Dealer’s is ''(-x +x)'', or zero.  
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 would make on a loan.<ref>To keep it simple, I have ignored the scope for synthetic margin loan and rehypothecation.</ref> 


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.     
But, hang on: this is a bilateral arrangement, right, so isn’t the converse also 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? Is not a “short” swap position, for a dealer, exactly the same as a “long” swap position for a customer?


Hence, having collateral from each customer is important for the dealer. As long as each of the dealer’s other customers it providing it collateral, and the dealer is competently delta-hedging, being paid cash collateral by the dealer is far less important for the customer.   
No, because in providing these swap exposures to its customers, the dealer simultaneously [[Delta-hedging|delta-hedges]]. It does not change its own market position. The customer ''buys'' an exposure: that is, starts ''without'' and ends up ''with'' a “position”; the dealer manufactures and then ''sells'' an exposure: it starts ''without'' a position, takes an order, creates a position, transfers it to the customer and ends up where it started, ''without'' a position.   


Is that the sound of [[Lehman]] [[horcrux]]<nowiki/>es sparking up I hear?
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.


==== Fixed/floating swaps ====
==== Fixed/floating swaps ====
Line 74: Line 101:
:—{{buchstein}}, {{dsh}}
:—{{buchstein}}, {{dsh}}
}}
}}
But are [[synthetic equity swap]]s just an odd use case? Aren’t other, normal, swaps bilateral, and less “lendy” in nature? What about interest rate swaps? Surely ''paying'' a fixed rate while ''receiving'' a floating rate has none of the characteristics of borrowership and loanery about it?  
{{smallcaps|Ok; that’s a}} [[delta-one]] equity swap. But [[synthetic equity swap|synthetic prime brokerage]] is, surely, an unusual use case?
====Income implies principal====
 
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.<ref>Sure, you could sell a strip of coupons off your bond. Okay. But to do that, there first has to be a bond, and you have to buy it and ''cut it up''. Once you’ve done that, you have your disembodied interest cashflow, but you also have this weird, mutilated principal-only instrument ghosting around the market at a heavy discount to a fully-limbed equivalent, sort of like Weird Barbie or one of those intercised kids without a daemon in ''His Dark Materials''. </ref> Derivatives give us the mathematical tools to ''hypothetically'' isolate income streams from their principal and trade them as discrete instruments, but at some point, derivatives must intersect with real-world instruments, ''because that is what they are derived from''. For a customer to take on a derivative position, someone else in the linear chain of derivatives hedging its exposure must, at some point, buy a real-world hedge. And that must be financed. A rate with out principal is like a shadow without a boy.  
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 thing 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.”}}
 
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.
 
Do swaps change all that?
 
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”====
{{quote|
{{D|Derivative|/dɪˈrɪvətɪv/|n}}
FINANCE: (of a product) having a value ''deriving from'' an underlying variable asset. (''emphasis added'')}}
 
{{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.
 
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.  
 
And ''that principal'' ''must be financed''.


Okay, so since real-world income depends on an income-bearing asset in the real world, to get exposure to that income in a given “notional amount” you must make a principal investment in that amount. 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.  
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.  
====Derivatives as engines of hypothesis====
Swaps changed all that. It was only once the [[Children of the Woods|Children of the Forest]] wrought their wristy magic on the [[First Men]] in the dark thickets of [[Bretton Woods|Woods of Bretton]] that the ways of the [[Single agreement|Single Agreement]] came into common understanding. Only then were leaden, earth-bound notions of principal swept away; the swap market took wing upon the nuclear power of infinite leverage. Income flows could bust free of their leaden principal host and frolic in ISDA’s glittering starlight.


''But''. Income implies principal, remember. A swap can have disembodied fixed and floating rates only because, when they are set against each other, the principal investments to which they would normally be attached ''cancel each other out''. Make no mistake: those principal investments are there, but they are just ''assumed''. Taken as a given. The customer does not need to fund its payments independently; they come from its existing portfolio. But the dealer does. It is not changing its position. To flatten out its exposure to the customer, it must buy a hedge. That will require either explicit funding — if the dealer hedges with a physical asset — or implied funding, if the dealer hedges with a derivative. Somewhere along that chain, someone will buy a physical asset.
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 balancesheet)====
====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 debt instrument. Interest rate swaps are, in this sense, “synthetic ''fixed income'' prime brokerage”: a [[margin loan]] to buy a fixed income asset.


Consider the respective parties’ economic positions before and after trading. The customer does change its net position; the [[dealer]] does not. Swapping a fixed cashflow for a floating one is to ''keep'' the “asset” that funds that cashflow (which logically must be a “fixed-rate asset”), and to acquire a new floating-rate asset in the same principal amount. This is also the principal amount of the implied loan the customer must take out to acquire the floating-rate asset. That being the case, the principal of the floating-rate asset cancels out against the principal of the loan, and the customer left with just the floating rate cashflows, for which it must pay the fixed rate it has agreed. The customer’s position is the present value of the floating rate it has bought minus the present value of the fixed rate of its financing.
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.  


Without a loan, the customer would have to sell its whole fixed-rate asset and use the proceeds to buy a 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.
Without that implied loan, the customer would have to sell an asset to raise the proceeds to buy the floating-rate bond outright 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 certainly not borrowing anything. It is making a fully-funded long investment.


“But, but, but JC: can’t you see? If you pay someone 100 and they pay you the return of an instrument worth 100 and interest, you have loaned them interest?”
“But, but, but JC: can’t you see? If you pay someone 100 and they pay you the return of an instrument worth 100 and interest, ''you'' have loaned ''them'' the money?”


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''.
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 the floating-rate bond, to hedge itself.  It is flat. You have not, net, lent the dealer ''anything''.
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