When variation margin attacks

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BLACKADDER: Look, there’s no need to panic. Someone in the crew will know how to steer this thing.
CAPTAIN RUM: The crew, milord? What crew?
BLACKADDER: I was under the impression that it was common maritime practice for a ship to have a crew.
CAPTAIN RUM: Opinion is divided on the subject.
BLACKADDER: Oh, really?
RUM: Yes. All the other captains say it is; I say it isn’t.
BLACKADDER: Oh, God; Mad as a brush.

—Blackadder, Series 2: Potato

Any of the standard reference works will tell you that variation margin is a good thing, apt for ridding the world of the kinds of systemic risk that have the habit of building up in the financial system.

Once upon a time

Shares of ViacomCBS closed down 9% Tuesday, a day after the company said it would raise $3 billion from stock offerings. ViacomCBS said it will sell $2 billion in class B common shares and $1 billion in Series A mandatory convertible preferred shares. The stock offerings come just a few weeks after the company launched its Paramount+ streaming service, and the offerings will help the company bulk up its content. ViacomCBS said it would use the funds to power “investments in streaming,” among other general corporate purposes.

—CNBC, March 23, 2021

When variation margin attacks

In the months leading up to March 2021, Archegos Capital Management took synthetic positions on margin on a handful of comparatively illiquid stocks — ViacomCBS, Tencent Music, Baidu and Vipshop — in sizes that, across multiple prime brokers, were big enough to move the market sharply up. As the stocks appreciated, so did Archegos’ profit, and thus the net equity it held with its prime brokers. Archegos used that net equity to double down, buying the same stocks, pushing them up yet further. The higher they went, the thinner their trading volume, and the more of the market Archegos represented.

Now, hindsight is a wonderful thing, but really there was only one way this was ever going to turn out.

On 22 March, Archegos’ position in Viacom had a gross market value of US$5.1bn. In a cruel irony, Viacom interpreted this to mean market sentiment was so strong that it should take the opportunity to raise capital. Alas, no one was buying. Not even Archegos, since it was tapped out of equity with its prime brokers.

Viacom’s capital raising therefore failed, and all hell broke loose.Archegos is the story of a fund which took synthetic positions on margin in on four comparatively illiquid stocks — ViacomCBS, Tencent Music Entertainment, Baidu Inc and Vipshop — in sufficient size as to push up their market prices. As their valuations increased, so did Archegos’ net equity with its prime brokers. Archegos systematically used the value of that equity to double down on its investments, pushing the stock further up. The further up the stock went the fewer participants were active, meaning total trading volume dropped, off, and Archegos became ever larger part of the market. By 22 March, Archegos’ Viacome position had a gross market value of USD5.1bn. Since Archegos was trading synthetically, it may not have been apparent that to ViacomCBS that there was only one buyer in town.<ref>Report on Archegos Capital Management Not understanding this, in a cruel irony ViacomCBS concluded that market sentiment would support a capital raising, duly launched a USD3bn share offering, which there was only one potential buyer — Archegos — and it was tapped out of fresh equity. The capital raising failed, and all hell broke loose.

Back up, back up: banking, in the good old days

Remember when trusted intermediaries were a thing?

• Banks are these trusted intermediaries that make finance available to people who need it to run their businesses.
• Capital and regulation targeted prudent management of a bank’s balance sheet
• Client contracts were one-way affair: since banks were lending customers money, there were no material covenants going the other way. Businesses might provide collateral for their lending, in the form of plant and inventory, but did not collateralise in cash so much, seeing as that would be largely to defeat the purpose of borrowing in the first place.
• On the other side of the banks balance sheet were deposits. Again, no suggestion that the bank offered security for these: it compensates for the enhanced credit exposure over the risk-free rate with a spread over the base rate.
• Customers who considered them to be over-exposed to as single bank (in the shape of large deposits) simply diversified (or invested in non-cash assets).
• Note the role of banks here is not to take a proprietary position in the businesses to which they lent, or the investments which those businesses made, but to manage their credit exposure on their assets, ensure their deposits funded the business, and to make sure the margin between deposits and loans was enough to remain solvent.

Interbank relationships

There is, and always has been, a healthy interbank relationship, providing liquidity, custody, making markets, foreign exchange, hedging and providing each other short term funding to help manage their daily operations. These interbank relationships tend to be wide and many-faceted and the terms documenting them tended to be short, to non-existent, and bilateral.

The overall vibe

The overall vibes were of prudence: clients would produce non-cash surety, but banks would lend based on the overall understanding of a customer’s position, lending would be broadly proportionate.

Enter the swaps

The history of swaps is interesting and fairly well-documented. It all started in earnest 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 usual banking activity this didn’t involve a bank lending to a customer. Both parties were lending to the other — hence not just parties, but “counterparties”. Day one, as long as you could really treat the opposing loans as setting off, neither party was really lending to the other. 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 netting, which isn’t wildly germane to this essay except to point out that credit mitigation for derivatives works in a very different way to loans: it works by set-off, not security, and it can swing around, depending on the market value of the underlying obligations.
• This is the other thing. Even if, at inception, it was a fair trade: I lend you Swissies and you lend me an equivalent amount of dollars at today’s exchange rate, should that exchange rate move — is inevitably it will — the respective values of the currencies to be returned at maturity (and the coupons due in the mean time) mean that the contract can quickly resemble indebtedness. Say CHF and USD were at parity when we struck our $10m swap. If CHF drops to 50% of the value of USD, then the counterparty paying dollars effectively owes $5m to the one paying CHF. If, tomorrow, CHF rallies 100% and USD drops 50%, tomorrow the indebtedness will be the other way around. Both therefore had significant contingent credit risk to the during the life of the transaction.

Roll forward twenty years and derivative trading had become a twenty billion dollar industry.

See also

• Archegos