When variation margin attacks: Difference between revisions

When variation margin attacks (view source)

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 Now, even having applied set-off and netting, either side of a swap contract could still be left with a large, volatile exposure. The exposure could move by hundred of millions of dollars in a single day, and could flip in or out-of-the-money quite suddenly.
-The solution was something called a “[[credit support annex]]” to the {{isdama}}. Under this arrangement, the parties could require set [[initial margin]], and also exchange variation margin reflecting the prevailing exposure under the agreement. This is all rather complicated and fiddly<ref>See our [[CSA Anatomy]], for as much detail as any one person could want.</ref>
+The solution, which arrived a decade or so after derivatives trading started in earnest, was something called a “[[credit support annex]]” to the {{isdama}}. Under this arrangement, the parties could require set [[initial margin]], and also exchange variation margin reflecting the prevailing exposure under the agreement. 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 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.<ref>this was by no means a universal rule, and more sophisticated real money counterparties were requiring variation margin by the the start of the new millennium</ref>
+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.
 {{Sa}}