When variation margin attacks: Difference between revisions

Now this is all completely normal in the world of latter-day [[Derivative|derivatives]]: regulators mandated [[variation margin]] into pretty much every major market on the planet following the [[global financial crisis]] ''in the name of reducing systemic risk'' — but all the same, in the context of [[Archegos]], it made a bad situation worse. It ''forced'' [[swap dealer]]<nowiki/>s to lend to their client against appreciating assets that were increasingly likely to then ''de''preciate again.  

Customers, of course, ''do'' have skin in the game: they take all the benefits — less their intermediaries’ fees, commissions and financing costs — and are first<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 the losses of their investments. They may be [[Professional client|institutional]] ([[pension fund]]<nowiki/>s, [[investment fund]]<nowiki/>s, multinationals) or [[Retail client|retail]] and while the range of investment products they can invest in will depend on their sophistication and financial resources, usually they are not subject to any kind of prudential regulation. Customers can, and do, blow up.  

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, yes: 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.

==== 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.<ref>These three forces combined to create a mammoth. [http://faculty.citadel.edu/silver/IF/MBA_course/Chap9_Swap_Evolution.pdf Citadel] estimates USD interest rate swaps volumes went from from zero in 1981 to over half a billion dollars by 1987. </ref>

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.<ref>Besides any [[initial margin]] your counterparty required: see below.</ref> This is, economically, the same as betting.<ref>It is also the same as buying (or selling) insurance, with one difference: to be insured, you must suffer an insurable loss.</ref> 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 [[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 transaction 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 swap transactions 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. Giving effect to netting contracts, and attaining the capital relief they promise is now a multi-million-dollar industry.  

But even with netting, the [[Leverage|levered]] nature of swap transactions means that your overall net exposure can still swing around wildly.

In 1994 ISDA released a “[[credit support annex]]” to the {{isdama}} under which the parties could exchange “credit support” to offset their respective net exposures. 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 is that you calculate your net [[exposure]] under an {{Isdama}} on any day and, if it is over an agreed threshold, you can require your counterparty “post” you cash or securities as collateral for that exposure. If the exposure then swings back towards your counterparty tomorrow, it can require you to return equivalent assets . 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. This made sense, since end-users of swaps tend not to be prudentially regulated and therefore are not heavily capitalised, whereas intermediaries and swap dealers usually are. What is more, 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.  

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> They are somewhat at the mercy of their customers: having put positions on, their legal rights to terminate them again tend to be legally and [[Commercial imperative|commercially]] circumscribed. Customers can terminate at any time — it’s their investment — and for any reason, including vague nervousness about the solvency of their dealer.

You can, and physical [[prime brokerage]] customers do, achieve exactly the same effect with a [[Margin lending|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.

[[Market risk|''Market'' risk]] is the risk that an asset goes ''up'' when you want it to go ''down'', or ''down'' when you want it to go ''up''. [[Credit risk|''Credit'' risk]] is the risk that the person whom you want to pay you that return cannot, because that she is ''broke''.

[[Variation margin]] is meant to neutralise both: if the day’s loser squares up the value of her loss each day in collateral to the winner, the parties reduce their respective credit exposure to nil: if neither party owes anything on the trade, there is no credit risk.

And here we see the buried credit risk of variation margin. As those positions appreciated, the brokers were obliged to pay their cash value, in VM, to Archegos. Archegos used some of this rising equity to buy more shares in the same stocks, further pushing up their price, obliging the brokers to pay more VM.  

Say it held 100 shares at 40, fully margined. Should they appreciate to 60, it's net equity increases 2,000. Broker credits it with the cash and it buys a further 25 shares at 60, pushing the price to 80. This results in a net equity increase of 4000, to 10000, so the broker pays out 4000 more, Which it used to buy a further 40 shares. Note it's holding is 165 shares and the price surges to 100. Broker dutifully credits a further 6500 in VM, which the customer withdraws and uses to buy another 55 shares, taking is total holding to 220.

 

 

Now the stock retreats to 80. The broker calls for margin, but the customer has no cash. Three customer tries to sell positions but suddenly the ask 50. Even if the customer sold its whole holding at this price — fat chance in a thin falling market, the broker would lose 1500 of its cash.