When variation margin attacks: Difference between revisions

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]].  

The [[swap  history|history of swaps]] is interesting and fairly well-documented. It all started in earnest in 1981, with a bright idea [[Salomon Brothers]] had to match up IBM, who needed U.S. dollars but had a load of Swiss francs and Deutschmarks, with the World Bank, which had all the dollars anyone could need but needed to meet obligations in CHF and DEM which it wasn’t able to borrow. The two institutions “swapped” their debts, exchanging dollars for the European currencies and paying coupons on them, with an agreement to return the the same values of the respective currencies at maturity.

Unlike traditional banking activity, swap transactions are bilateral.  In one sense, ''both'' parties were lending to each other — hence they were not just parties, but “''counter''parties”.<ref>Or maybe this just means they sat at a counter. This has just occurred to me. Why not? These are [[OTC|over-the-counter]] derivatives, after all.</ref>  In another sense, ''neither'' was: as long as you could [[Set-Off|offset]] the swapped loans, at inception a swap trade was market neutral.<ref>Law students will know this notion of enforceable set-off is a tricky one, especially if you are trading across international markets, where insolvency regimes are capricious, and might struggle to understand it, in a way they tended not to struggle with ordinary secured lending. Hence the great, tedious topic of [[Close-out netting|netting]], which isn’t wildly germane to this essay except to point out that [[Credit risk mitigation|credit mitigation]] for swaps by set-off, not security, and credit risk can swing around, depending on the market value of the underlying obligations.</ref>  

But a swap does not ''stay'' neutral. Its [[mark-to-market]] value will change, and can swing around. Depending on how the cross-rates move, ''either'' party can be owed money. Hence the concept of “[[moneyness]]”: either party could be [[in-the-money]] or [[out-of-the-money]].  

This was quite a different thing, and it really challenged the regulatory philosophy of financial services regulation. Until now, there had always  been an intermediary and a customer, and you always knew who was who: the intermediary was authorised, regulated to provide its services and appropriately capitalised ''to protect the customer'';<ref>And its depositors: also customers.</ref> the customer didn’t need to be regulated as it the intermediary could obviously look after itself.

The evolution of swaps challenged that: now either party could be creditor or debtor. It was hard to know who to regulate. Who needed protecting from whom? Did they ''both'' have to be regulated? Or ''neither''? For the first couple of decades, the regulatory answer was basically “neither”.<ref name="fwmd">Hence widespread allusions to the wild west, [[Locust|locusts]], [[Black swan|black swans]], casino banking, [[financial weapons of mass destruction]] and so on.</ref>

So, the clarity about who was an intermediary broke down a little. Swaps were a financial product in which there did not necessarily need to be an intermediary at all: the very first swap, between IBM and the World Bank, was effectively a transaction between two customers, in that each took principal risk to the transaction. And there is an entire realm of swap trades ''between'' intermediaries, where neither side is a “customer” as such.  

But the huge preponderance of swap volume is between an [[intermediary]] — a “[[swap dealer]]” — and a [[customer]] — indelicately described as an “[[end-user]]”. So are [[swap dealer|swap dealers]] intermediaries in the traditional sense, having no “skin in the game”? In one sense, no: being a principal to the swap contract, the [[swap dealer|dealer]] takes the other side of the trade to its customer, and is fully exposed to the [[underlier]]’s performance. But in another sense, it ''is'' an intermediary: [[swap dealer]]<nowiki/>s generally [[Delta-hedging|delta-hedge]] their risk. In many cases are prohibited by regulation from taking proprietary positions.<ref>This is the famous “Volcker Rule”.</ref> In the classic case of equity swaps, the dealer executes a physical trade in the cash market, holds or finances that position, and prices its swap at exactly that price. It has no net exposure to the trade at all. Economically, it is no different from a broker lending on margin.

We are not really concerned with netting here — the [[JC]] has plenty to say on that topic [[Close-out netting|elsewhere]] — so let’s quickly deal with it: just as you could offset the [[present value]] of the opposing legs of each swap to calculate a positive or negative [[mark-to-market]] value for that swap, so too could you offset positive and negative [[mark-to-market]] values for different swaps to arrive at a single net exposure for your whole {{isdama}}. This idea — [[close-out netting]] — was a stroke of genius, and the brave commandos of {{icds}} encoded this “[[single agreement]]” concept into the {{1987ma}} and its successors.  

But even with netting, the highly [[Leverage|levered]] nature of swap transactions meant that one’s overall net exposure could swing around wildly.

A solution arrived a decade or so after swap trading started in earnest. In 1994 ISDA released a “[[credit support annex]]” to the {{isdama}} under which the parties could exchange “credit support” to each other to offset their prevailing exposures to each other. This is all rather complicated and fiddly<ref>See our [[CSA Anatomy]], for as much detail as any one person could want.</ref> but the gist of it was that you could calculate your net [[exposure]] to your counterparty on any day and, if it was over an agreed threshold, you could require your counterparty “post” cash, bonds or liquid securities to you as collateral for that exposure. If the exposure swung back, the counterparty could require you to return those assets tomorrow. Rinse and repeat.

Like the {{Isdama}}, the [[CSA]] is a bilateral document: it assumes the parties are equal, arm’s-length counterparties and that each can post to the other. In the early days, [[Swap dealer|swap dealers]] often adjusted their CSAs so that only the customer posted credit support. Over this period, the [[Basel Accords]] published increasingly stringent and detailed rules<ref>Basel I was 30 pages. Basel II, published June 2006 (whoops!) was 347 pages. Basel III, as of September 2021, is 1626 pages.</ref> about how much capital banks should hold against their trading exposures to their customers. If at first customers were less bothered about the creditworthiness of their swap dealers,<ref>To be sure, sophisticated investment managers were already requiring their dealers post [[variation margin]] by the the start of the new millennium.</ref> this all changed, fast, during the 2008 financial crisis in which every major dealer had at least a near-death experience, if not an actual one.

Suddenly the dealers, themselves, were a source of systemic risk. The regulatory reform machine moved into overdrive; the era of unregulated derivatives was over. Regulators the world over began requiring all swap counterparties to collect [[variation margin]] on all common forms of swap contract: bilateral, daily, and in [[Cash|''cash'']].

Now remember that old distinction between intermediary and customer. Intermediaries are meant to be well-capitalised; they don’t have a dog in the fight: their interest is just in collecting their commission. Their customers take the market risks.

Swap dealers ''look'' like they are taking market risks, but they are not. Post Volcker, they are not ''allowed'' to. Swap dealers are passing on the return of their hedging activity to their customers, and collecting commissions and interest on financing.<ref>We have in mind [[Synthetic equity swap|synthetic equity derivatives]] here. This may be less clearly the case in other asset classes, but it is still (post Volcker) broadly true for all of them.</ref>

You can, and physical [[prime brokerage]] customers do, achieve exactly the same effect with a margin loan: the customer buys shares on margin; the [[prime broker]] holds the shares as collateral for the loan. If the shares decline in value, the broker may call for more margin. If the shares rise in value, the customer generates increased equity with the broker, but is not automatically entitled to the cash value of that equity. There is no variation margin, as such.

The prime broker may ''agree'' to lend more against that equity — that is the business it is in, after all — but it is not ''obliged'' to.  The customer cannot force the broker to lend against the equity. As long as it leaves enough equity in the account the customer may withdraw excess equity, but only by taking the shares it owns. Withdrawing ''shares'' from a prime brokerage account doesn’t fundamentally change ones debtor/creditor relationship. Withdrawing cash ''against'' shares assuredly does.