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When variation margin attacks: Difference between revisions
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{{archegos capsule}} | {{archegos capsule}} | ||
===The curious regulation of [[variation margin]]=== | ===The curious regulation of [[variation margin]]=== | ||
Now here is an interesting thing. Because [[Archegos]] gained their market exposure using [[Equity derivatives|swaps]], ''by regulation'', their brokers were ''obliged'' to pay the value of | Now here is an interesting thing. Because [[Archegos]] gained their market exposure using [[Equity derivatives|swaps]], ''by regulation'', their brokers were ''obliged'' to pay out their realised gains<ref>For [[prime broker]]<nowiki/>s charging “[[dynamic margin]]” this was partly offset by the effect of increased [[initial margin]] required on the inflated value of the position in question; for those charging only a [[static margin]] amount, there was not even that fig-leaf. </ref> or “[[net equity]]”, every day, in cash, in the form of [[variation margin]]. To be sure, the broker usually pays [[VM]] into a bank account it runs for its client. There are withdrawal thresholds that apply to that account that takes into account required [[initial margin]] — oh, that’s another story altogether — but over those thresholds all the variation margin is the client’s money, available to be withdrawn on request. | ||
This is completely normal in the world of latter-day derivatives: mandatory two-way exchange of [[variation margin]] was implemented by regulation in pretty much every major market ''in the name of reducing systemic risk'' — but all the same, it | This is completely normal in the world of latter-day derivatives: mandatory two-way exchange of [[variation margin]] was implemented by regulation in pretty much every major market ''in the name of reducing systemic risk'' — but all the same, in the context of [[Archegos]], it does look weird. It is like ''forced'' brokers to extend additional lending against assets appreciation, regardless of the likelihood that the asset might then ''de''preciate again. Imagine if your bank, by law, had to pay you the cash value of any increase in your home’s value over the life of your mortgage. | ||
Had Archegos put the equivalent ''physical'' positions on, using [[margin loan]]s, its | Had Archegos put the equivalent ''physical'' positions on, using [[margin loan]]s, its [[prime broker]]<nowiki/>s would ''not'' have ''had'' to advance it the cash value of its [[net equity]]. They may well have ''willingly'' done so, of course – that is how [[prime broker]]s make their money after all — but being ''able'' to lend money, and being ''obliged'' to lend money are quite different propositions on that special day when it seems the whole world is going to hell.<ref>It is fair to note that — with the possible exception of the vampire squid — [[Archegos]]’s brokers did ''not'' believe the world was going to hell, at least not until it was far too late. But the principle remains.</ref> | ||
=== A dissonance === | === A dissonance === | ||
So there is this [[dissonance]], between [[Cash prime brokerage|''physical'' prime brokerage]], where lending money against [[net equity]] is at the prime broker’s discretion — oh, sure, you may withdraw your [[net equity]] at any time, but you have to take it [[Payment in kind|in kind]]<ref>Withdrawing [[net equity]] in the form of the [[shares]] themselves, rather than their [[cash]] value, has a very different effect on the [[prime broker]]’s risk profile. It makes the client’s portfolio ''less'' volatile; withdrawing [[cash]] makes it ''more'' volatile.</ref> — and [[Synthetic prime brokerage|''synthetic'' prime brokerage]], where cash payment of that value of that net equity — in the swaps world, known as “[[variation margin]]” — is required by regulation. | So there is this [[dissonance]], between [[Cash prime brokerage|''physical'' prime brokerage]], where lending money against [[net equity]] is at the prime broker’s discretion — oh, sure, you may withdraw your [[net equity]] at any time, but you have to take it [[Payment in kind|in kind]]<ref>Withdrawing [[net equity]] in the form of the [[shares]] themselves, rather than their [[cash]] value, has a very different effect on the [[prime broker]]’s risk profile. It makes the client’s portfolio ''less'' volatile; withdrawing [[cash]] makes it ''more'' volatile.</ref> — and [[Synthetic prime brokerage|''synthetic'' prime brokerage]], where cash payment of that value of that net equity — in the swaps world, known as “[[variation margin]]” — is required by regulation. | ||
It is inevitable for clients and their [[Buy-side legal eagle|advisors]] to ask, “well, if you have to pay me equity value in cash under a swap, why can’t I have it in cash for my physical portfolio under a margin loan?” | It is inevitable for clients and their [[Buy-side legal eagle|advisors]] to ask, “well, if you have to pay me equity value in cash under a swap, why can’t I have it in cash for my physical portfolio under a [[margin loan]]?” | ||
On its face, this is a fair question, to which the answer is either: “Huh. I hadn’t thought of that. Yes, I suppose you are right” — call this the “all other captains” argument; or: “Well that just goes to show what a misconceived idea compulsory two-way variation margin | On its face, this is a fair question, to which the answer is either: “Huh. I hadn’t thought of that. Yes, I suppose you are right” — call this the “all other captains” argument; or: “Well that just goes to show what a misconceived idea compulsory two-way variation margin is. There’s no way on earth I’m automatically paying out your equity in cash” — call this the “Redbeard Rum” argument. | ||
The [[JC]] prefers the Redbeard Rum argument. | |||
“Come on, JC: I know you are a cranky old bugger. But do you really mean to say you are going to swim against the tide of all that consensus?” | “Come on, [[JC]]: I know you are a cranky old bugger. But do you really mean to say you are going to swim against the tide of all that consensus?” | ||
WHY NOT, my friends, WHY NOT? Now, if someone would kindly hold my beer: | WHY NOT, my friends, WHY NOT? | ||
Now, if someone would kindly hold my beer: | |||
==Banking, in the good old days== | ==Banking, in the good old days== | ||
In the good old days — in the time of the [[Children of the Forest]], before the [[First Men]] — the overall vibe of the financial system was circumspect, self-imposed ''[[prudence]]'': musty institutions, staffed by Captain Mainwaring-types, providing stodgy, unflamboyant loan facilities and broking services to clients who were grateful to be offered them, and who would produce whatever sureties their banks required as a condition to being allowed to do business. | In the good old days — in the time of the [[Children of the Forest]], before the [[First Men]] — the overall vibe of the financial system was circumspect, self-imposed ''[[prudence]]'': musty institutions, staffed by Captain Mainwaring-types, providing stodgy, unflamboyant loan facilities and broking services to clients who were grateful to be offered them, and who would produce whatever sureties their banks required as a condition to being allowed to do business. | ||
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==== Intermediaries ==== | ==== Intermediaries ==== | ||
There are lots of types of intermediary: those who comprise market infrastructure: [[Exchange|stock exchange]]s, [[clearing system]]s, securities depositories and so on; those who earn only a [[commission]] from their involvement, and take no [[principal]] risk<ref>I include here “[[quasi-agent]]” roles that are conducted on a [[riskless principal]], but (absent insolvency) are economically neutral: thse participants are remunerated by [[commission]] or fixed [[mark-up]] and do not have “[[Skin in the Game: Hidden Asymmetries in Daily Life - Book Review|skin in the game]]”.</ref>: [[Cash brokerage|cash broker]]<nowiki/>s, [[Investment manager|investment managers]], [[Clearing broker|clearer]]<nowiki/>s, [[Market-maker|market-makers]] and [[Intermediate broker|intermediate brokers]]; and those who ''do'' take principal risk, but only by lending to their customers, and don’t participate in the upside or downside<ref>Barring through “gap loss” where, due to portfolio losses, the customer is insolvent and cannot repay its loan.</ref> of the investments they are financing: [[Bank|banks]]. | There are lots of types of intermediary: those who comprise market infrastructure: [[Exchange|stock exchange]]s, [[clearing system]]s, securities depositories and so on; those who earn only a [[commission]] from their involvement, and take no [[principal]] risk<ref>I include here “[[quasi-agent]]” roles that are conducted on a [[riskless principal]], but (absent insolvency) are economically neutral: thse participants are remunerated by [[commission]] or fixed [[mark-up]] and do not have “[[Skin in the Game: Hidden Asymmetries in Daily Life - Book Review|skin in the game]]”.</ref>: [[Cash brokerage|cash broker]]<nowiki/>s, [[Investment manager|investment managers]], [[Clearing broker|clearer]]<nowiki/>s, [[Market-maker|market-makers]] and [[Intermediate broker|intermediate brokers]]; and those who ''do'' take principal risk, but only by lending to their customers, and generally don’t participate in the upside or downside<ref>Barring through “gap loss” where, due to portfolio losses, the customer is insolvent and cannot repay its loan.</ref> of the investments they are financing: [[Bank|banks]]. | ||
All of these intermediaries have one thing in common: their remuneration does not depend on how their customer’s | All of these intermediaries have one thing in common: their remuneration does not depend on how their customer’s investments perform.<ref>Unless they perform ''so'' badly they cause the customer’s bankruptcy.</ref> Intermediaries do not have [[Skin in the Game: Hidden Asymmetries in Daily Life - Book Review|skin in the game]]. They are not supposed to lose ''any'' money, let alone billions of dollars of the stuff. | ||
==== Customers ==== | ==== Customers ==== | ||
Customers, of course, ''do'' have skin in the game: they take all the benefits — less their intermediaries’ fees, commissions and financing costs of course — and absorb all the losses of their investments. They may be institutional (pension funds, investment funds, multinationals) or retail (private investors) and while the range of investment products they can invest in will depend on their sophistication and financial resources, they are not subject to any kind of prudential regulation. They can, and do, blow up. | Customers, of course, ''do'' have skin in the game: they take all the benefits — less their intermediaries’ fees, commissions and financing costs of course — and are first in line<ref>Of course, if the investors should run out of sponges, or their buckets are all full, while there are still some losses left to go round, these get passed to the poor [[Bank|banker]]<nowiki/>s and [[Intermediary|intermediaries]] who may still be owed something. This is why we say investors have a “[[first-loss]]” risk: once they have been wiped from the horizon, any remaining losses go to the investors’ [[Creditor|creditors]], who thus have “[[second-loss]]” risk, whether they like it, or even know it, or not.</ref> to absorb all the losses of their investments. They may be [[Professional client|institutional]] (pension funds, investment funds, multinationals) or [[Retail client|retail]] (private investors) and while the range of investment products they can invest in will depend on their sophistication and financial resources, they are not usually not subject to any kind of prudential regulation. They can, and do, blow up. | ||
More speculative investment vehicles may be highly [[Vega|geared]] and quite ''likely'' to blow up. This is where intermediaries have some tail risk: if the customer has blown up, the intermediary loses anything it | More speculative investment vehicles like [[hedge fund]]<nowiki/>s may be highly [[Vega|geared]] and quite ''likely'' to blow up. This is where intermediaries have some [[second-loss]] tail risk: if the customer has blown up, the intermediary loses anything the customer still owes it. Investment funds have ''no'' capital buffer. When they “[[Gap-risk|gap]]” through zero, their counterparties absorb ''all'' their market risk, despite wishing to have none of it. [[Broker]]s, banks and and [[dealer]]s ''do'' have a capital buffer, and if their clients’ positions gap through zero, can usually absorb losses, as Archegos’ [[prime broker]]s ably proved. | ||
But in any weather, up until the early 1980s, you were either a customer or an intermediary and the above was all quite well settled. But innovations in the market, technology and regulation began to change things. | But in any weather, up until the early 1980s, you were either a customer or an intermediary and the above was all quite well settled. But innovations in the market, technology and regulation began to change things. | ||