When variation margin attacks: Difference between revisions

===Remember when trusted intermediaries were a thing?===

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 of the financial system was one of circumspect, self-imposed ''prudence'': institutions, staffed by Captain Mainwaring-types provided stodgy, unflamboyant services to clients who were grateful to be offered them, and who would produce sureties for their investments.  

The Banks were “trusted intermediaries”  collective and paying interest on deposits that they then on-lent to businesses, allocating capital that make finance available to people who need it to run their businesses.

Client contracts were one-way affair: since banks were lending customers money, there were no material covenants going the other way. Borrowers might provide collateral for their lending, in the form of security over plant and inventory, (but not cash, seeing as that would be 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 bank’s role here — obviously — that is [[creditor]]: not to take a proprietary position in the customer or its investments, but to manage the spread between deposits and loans and, above all, to get its money back.

The idea here is to set up an idea of a financial services industry with two types of participant: ''intermediaries'' and ''end users''. We have waxed [[Look, I tried|elsewhere]] about the countless ways enterprising  individuals can contrive to interpose themselves into a process that oughtn’t to need ''that’’ much intermediating, but let us, for today’s outing, take it as we find it.

There are various types of intermediary in the market: those that are part of the market infrastructure, like [[Exchange|stock exchange]]s, [[clearing system]]s, securities depositories and so on; then those [[Agent|agents]] 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> at all: [[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 then there are those who ''do'' take principal risk, but  only by lending to the end users, and again 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. In all cases the thing they have in common is that their financial interest is independent of the performance of the instruments in which they are dealing.

The interesting case is the [[swap dealer]]: being a counterparty to a [[derivative]] contract, a [[swap dealer]] is the other side of the trade to its customer and therefore, nominally, fully exposed to the [[underlier]]’s performance. However, [[swap dealer]]<nowiki/>s are generally [[Delta-hedging|delta-hedged]] and in many cases are prohibited by regulation from taking proprietary positions.<ref>This is the famous “Volcker Rule”.</ref>

Intermediaries tend to be regulated and those that take on indebtedness are subject to stringent capital requirements designed precisely to minimise their risk of failure.

==== End users ====

==Enter the swaps==

The [[swap  history|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 [[Set off|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.

{{Sa}}