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.

Since, like Captain Redbeard Rum, your loyal contrarian is going to run against what all the other captains will tell, you, let me set the scene with a story.

Once upon a time in America

Shares of ViacomCBS closed down 9% Tuesday, a day after the company said it would raise $3 billion from stock offerings. 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

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.

Now here is an interesting thing. Because Archegos gained their market exposure using swaps, by regulation, their brokers were obliged to pay the value of their net equity to them, every day, in the form of variation margin. To be sure, the broker usually pays VM into an 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 is utterly weird. It is like forced lending against asset appreciation. 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.

This is very different from cash margin lending. Had Archegos put the equivalent physical positions on, using margin loans, its brokers 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 brokers 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 world is going to hell.

A dissonance

So there is this dissonance, between physical prime brokerage, where advancing cash against net equity is at the broker’s discretion — oh, sure, you have withdraw your equity at any time, but you have to take it in kind — and synthetic prime brokerage, where cash payment is required by regulation. It is inevitable for clients and their advisors to ask, “well, if I can withdraw my 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 is” — call this the Captain 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?”

WHY NOT, my friends, WHY NOT?

Now, if someone would kindly hold my beer:

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: institutions staffed by Captain Mainwaring-types providing stodgy, unflamboyant facilities and services to clients who were grateful to be offered them, and who would produce whatever sureties their banks required to advance their resources.

The idea here is to set up an idea of a financial services industry with two types of participant: intermediaries and customers. We have waxed 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.

Intermediaries

There are various types of intermediary in the market: the market infrastructure: stock exchanges, clearing systems, securities depositories and so on; then those agents who earn only a commission from their involvement, and take no principal risk at all: cash brokers, investment managers, clearers, market-makers and intermediate brokers; and then there are those who do take principal risk, but only by lending to customers, and again don’t participate in the upside or downside of the investments they are financing: banks. In all cases the thing they have in common is that their financial return is not linked the performance of the instruments in which they are dealing.

Customer contracts with intermediaries were a one-way affair: since intermediaries were providing services and resources — lending money, handling brokerage orders and so on — legal covenants went one way only.

Inter-dealer relationships

Of course, intermediaries must interact with each other, providing each other liquidity, market access, custody, foreign exchange, hedging and short term funding. These interbank relationships tend to be wide and many-faceted and the terms documenting them tended to be short to non-existent, and bilateral.

Customers

Customers are those who do have skin in the game: they take all the benefits — less the fees, commissions and financing costs of their intermediaries — 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. More speculative investment vehicles may be highly geared and quite likely to blow up.

Up until the early 1980s, this was all quite well settled, but innovations in the market, technology and regulation began to change things.

The times they are a-changing

The multi-coloured swap shop

The 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.

Everyone else recognised this to be a cool idea, and before you know it, swaps trading was a trillion dollar industry. Okay; this took a bit of time, but in the geological history of finance from the time of Hammurabi, it was the blink of an eye. But anyway, note a few things:

Unlike traditional banking activity, swaps were bilateral. In one sense, both parties were lending to each other — hence they were not just parties, but “counterparties”. In another sense, neither was: as long as you could offset the swapped loans at inception a swap trade was market neutral.

But a swap trade does not stay market 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; 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”.

Intermediaries, redux

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 dealers intermediaries in the traditional sense, having no “skin in the game”? In one sense, no: being a principal to the swap contract, the 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 dealers generally delta-hedge their risk. In many cases are prohibited by regulation from taking proprietary positions. 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.

Deregulation and electronic trading

At about the same time computer-based trading began to revolutionising the financial markets and the madcap spirit of 1980s free-love laissez-faire delivered their radical deregulation. It is not unreasonable to suppose these conditions contributed to an explosion in the market for OTC swaps during the 1980s.

Risk management under the ISDA

It did not take long for folks to realise that these new swap things presented a whole new class of risks.

Swaps provide “unfunded” financial exposure to assets: you don’t own the assets, much less pay for them: you don’t have to put any money down up front at all. This is, economically, the same as betting. Given the size of individual swap transactions — typically in the millions of dollars — your total notional exposure can quickly blow out of all proportion. The market hit upon two neat tricks to manage these risks: netting and credit support.

We are not really concerned with netting here — the JC has plenty to say on that topic 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 ISDA Master Agreement. This idea — close-out netting — was a stroke of genius, and the brave commandos of ISDA’s crack drafting squad™ encoded this “single agreement” concept into the 1987 ISDA and its successors.

But even with netting, counterparties to a swap relationship could still have large, volatile exposures to each other. The highly levered nature of swap transactions meant that one’s total net exposure could swing wildly in a single day, and could flip in or out-of-the-money quite suddenly.

A solution arrived a decade or so after swap trading started in earnest. In 1994 ISDA released a “credit support annex” to the ISDA Master Agreement under which, the parties could require initial margin, and also exchange variation margin reflecting the prevailing exposure under the agreement. This is all rather complicated and fiddly but the gist of it was that either side could calculate its net exposure on a day and require the other side to post credit support — usually in the form of bonds or liquid securities — to it to hold as collateral for that exposure.

The benefits of credit support accrued largely to to bank counterparties who, over this period, were subject to increasingly stringent and detailed rules about how much capital they were required to hold against trading exposures to their customers.

By and large, at least in the early days of credit support, customers were not so concerned with the creditworthiness of their swap dealers — this was dealt with by “prudential regulation” of the financial services institutions — so many credit support arrangements were one way only car that is to say the customer posting credit support to the dealer and not vice versa.

The idea that light touch prudential regulation was enough to absorb systemic risk in the financial system evaporated forever during the 2008 financial crisis in which every major dealer had at least a near-death experience if not an actual one.

A couple of ironies: firstly, the excessive leverage in bank balance sheets was partly driven by capital treatment provided to collect right swaps. In any event, the error of unregulated derivatives was over. A raft of new regulations came in including global regulations requiring compulsory posting of variation margin on all the most common forms of swap contract.

A number of things changed, even for those dealers with existing variation margin arrangements: the new arrangements were required to be bilateral, daily, and settled in cash.

The theory of the game here is that existing derivative exposures are effectively settled to market in cash daily, limiting counterparty exposure. But no allowance was made for the distinction between dealer and customer.

Let's just stepped back into the world of margin lending to compare these new derivatives arrangements with traditional relationship between a bank and its customer. A customer who buys a security on margin pleasures that security to its prime broker as collateral for its loan repayment liability. If that security appreciates this generates a net equity position with the broker, but does not automatically entitle the customer to further borrowing against that asset. To be sure, the customer may withdraw its equity, but only by taking possession of the shares it has bought. Removing excess shares from the prime brokers account does not fundamentally change the debtor/creditor relationship between broker and customer. It is also true that the prime broker does not have a beneficial interest in the asset and the customer’s asset should be excluded from the brokers’ insolvency estate in the case of its bankruptcy.

The nature of a synthetic swap position is different in that regard: any positive equity is an unsecured claim against the prime broker. However, traditionally, this credit risk would have been managed by reliance on prudential regulation rather than funded credit mitigation.

The customers entitlement in case of extreme appreciation of its asset would be to transfer a portion of that exposure to a different counterparty there by diversifying its risk.

See also

• Variation margin

• Archegos
• Swap history