Earlier in the summer there was a paper in the Journal of Derivatives that every person in securities financing should read. It is called “Embedded Financing: The Unsung Virtue of Derivatives” by NYU Stern Professor Bruce Tuckman. Let us explain.
The author has a deep background in derivatives, modeling, relative value trading and securities funding from stints as Global Head of Quantitative Research in Prime Services at Lehman & Barclays as well as jobs at CSFB and Salomon.
The premise of the article is that the floating rate leg on derivatives is equivalent to funding. For example, if an investor entered into a total return swap (TRS), receiving the return on a security and paying a floating rate leg, it is no different economically than buying the underlying security and funding it via repo. Except the derivative embeds the funding for term whereas the repo funding is typically short and needs to be rolled over. It is a simple observation, but very meaningful in a world that is worried about systemic risk, repos, and maturity transformation. From the paper:
“…The long-term financing embedded in derivative is a virtue because the liquidity of long-term cash financing arrangements (e.g. five-year repo) range from very low to nonexistent. Derivatives, in other words, play a central role toward completing financing markets. Furthermore, by virtue of embedded long-term financing, a derivatives position has significantly less financing risk than an equivalent levered cash position using existing (i.e. short—term) financing arrangements…”
Tuckman looks at the CDS market debacle of 2007-09. Market players thought they could execute a riskless arbitrage by buying corporate bonds and CDS protection on the issuer at a lower spread. But the missing piece was the financing of the cash instrument. When financing became scare and/or more expensive, the basis blew out. What was thought to be riskless ended up creating massive losses. Finadium wrote about this in a 2012 report “The Credit Default Swap vs. Repo Trade”.
From the JOD article:
“…Negative credit default swaps (CDS) basis trades, for example…proved disastrous during the crisis for 2007-2009. These trades effectively bet – incorrectly as it turned out – that short-term funding of corporate bonds would prove just as stable as the long-term financing embedded in CDS contracts…”
The benefits of the long-term funding embedded in the derivative should appeal to regulators. Since the terms are locked in, they can’t contribute to procyclicality. Short-term repos can change terms on each rollover, giving rise to risks in both directions. In stable markets, haircuts might be reduced and encourage over-leverage. In stressed market, they might be suddenly increased, creating something of a cliff risk. Both the repos and derivatives, however, will have variation margin requirements that could change the economics of the trades mid-stream.
The author also notes that centrally cleared derivatives can change IM amounts during the course of the trade based on updated VaR calculations. This feature is not part of bilateral trades, making bilateral deals less procyclical. Its not often that you hear coherent arguments favoring bilateral trades as being less risky than centrally cleared ones.
Tuckman advocates for regulators to not favor leverage via the cash markets (i.e. repo) versus the derivatives market. He writes,
“…Because derivatives have less financing risk, and because their embedded financing does not suffer from the procyclicality of short-term financing, it would be a mistake for regulators to discourage derivatives leverage in favor of leverage through cash financing….”
We might suggest that the repo market is under a lot of regulatory pressure too and not feeling especially favored right now. But regulators efforts on derivatives, especially when it comes to central clearing, are better defined and more evolved than those on securities financing.
It is underappreciated in the securities financing markets exactly how the derivatives markets do many of the same things that repo markets are designed for – often doing it more efficiently. Each could learn from the other.