Template:M intro isda a swap as a loan

During a typically turgid disquisition about the ostensible “bilaterality” of the ISDA Master Agreement, the JC remarked rashly that despite looking like a bilateral, even-stevens, un-loansome sort of a thing, in practical fact most swaps are implied financing arrangements.

Hotly justifying this stance somewhat sidetracked the original article, so we have “taken things offline” and started a whole new article where the JC can properly make a tit of himself without spoiling the other article.

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

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.

“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?”

The difference between customers and dealers

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.

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 “floating”.

For the customer the object of transacting is to change its overall market exposure: to get into positions it did not have before, or get out of ones it did. This sounds obvious.

Being a bilateral contract, is it not so that the dealer is changing its overall market position, too? No. The dealer provides exposure without taking any itself, and thereby earns a commission. This is all the dealer intends to do. The dealer intends to say flat. The dealer hedges its market risk away.

But how does that turn a bilateral swap into a “synthetic loan” from the dealer to the customer?

Let’s take an example. Imagine the JC’s in-house 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;

(ii) hold Lexrifyly and borrow to buy Cryptöagle;

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

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:

Outright sale
If it sells its Lexrifyly outright, the position is as follows:

Sold: USD10m Lexrifyly.

Borrowed: Zero.

Amount owed: Zero.

Bought: 10m Cryptöagle.

Net position: 10m Cryptöagle shares + zero Lexrifyly + zero loan

Loan
If it keeps its Lexrifyly and borrows, the position is as follows:

Sold: Zero.

Borrowed: USD10m.

Bought: USD10m Cryptöagle.

Net position: 10m Lexrifyly shares + 10m Cryptöagle shares - USD10m - accrued interest

Swap
If it keeps its Lexrifyly and puts on a swap struck at USD10m, the position is as follows:

Sold: Zero.

Borrowed: Zero.

Swap outgoings: Floating rate on USD10m

Swap incomings: USD10m Cryptöagle - USD10m.

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.

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” — the dealers — and “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” in the market. 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.

Dealer’s is (-x +x), or zero.

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.

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.

Is that the sound of Lehman horcruxes sparking up I hear?

Fixed/floating swaps

Nuncle: ’Tis none so mincey as a Farrington chop
And nowt so loansome as a fixed rate swap.

—Büchstein, Die Schweizer Heulsuse

But are synthetic equity swaps 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?

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. 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.

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.

Derivatives as engines of hypothesis

Swaps changed all that. It was only once the Children of the Forest wrought their wristy magic on the First Men in the dark thickets of Woods of Bretton that the ways of the 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.

Leverage is a state of mind (or balancesheet)

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.

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.

“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?”

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.