The Jolly Contrarian on ISDA

The Jolly Contrarian
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Diving into the wellspring of that is the ISDA Master Agreement jollycontrarian.substack.com

Episodes

  1. APR 24

    The boy and his shadow

    Banca Valle del SiliconeNon era Lorenzo MediciIo ho cedole fissateTu le hai variateVogliamo la coperturaFissiamo la procedura —Otto Büchstein, Eggfried When we left off last time Silicon Valley Bank had collapsed. It burned through its “available for sale” portfolio of financial assets — mainly long dated U.S. treasury notes — to meet the surge in withdrawals it suffered when, in early 2023, the U.S. Federal Reserve — the central bankers’ central bank — hiked interest rates to tame inflation, and that caused the cheap money venture capitalists had been hosing at anyone with a pitchbook, a turtleneck and a compelling blockchain story, to suddenly dried up. Suddenly all the bank’s customers needed their deposits at the same time. That’s the deal with deposits: if customers want their money back, you must give it to them. If you don’t have cash on hand, you must liquidate assets. Silicon Valley Bank had ploughed its deposits into safe, long-dated, government-guaranteed bonds — good — but paying what were now uncomfortably low fixed interest rates — bad. It could only sell them at a significant loss. A fixed rate bond’s “discount” to its redemption value is a function of two things: how far its coupon sits below current rates, and how long remains to maturity. The bank’s portfolio was well below market rates and, on average, very long-dated. This added up to a whopping “discount”. You might have questions about that. For one, seeing as “borrowing short and lending long” has been the basic risk of banking since the Medicis, aren’t there tools for managing that risk? Couldn’t Silicon Valley Bank have, like, hedged themselves somehow, to avoid falling down this manhole? Secondly, war stories are all well and good, but what do they have to do with close-out netting on an ISDA? Silicon Valley Bank was just a normal commercial bank, wasn’t it? Did it even have a swap portfolio? Those are good questions and they are related. Duration risk is something the Medicis would have understood and dealt with. It is the ultimate “known unknown”. And there are things you can do to manage it. In fact, until 2022, Silicon Valley Bank did them: it hedged with “over-the-counter” contracts under which it would pay sums broadly equal to its fixed rate bond coupons, and receive floating rate coupons back. The bank announced its strategy in 2021, expecting rate rises from the Federal Reserve. As the market priced in rate rises, those contracts became more profitable. This Substack is reader-supported. To receive new posts and support my work, consider becoming a free or paid subscriber. These hedging contracts were, of course, swaps. So, Silicon Valley Bank did have a swap portfolio. A big one. By the end of 2021, it was $15.2 billion in notional amount. But over the course of 2022, Silicon Valley Bank risk managers believed rates had peaked. They systematically unwound almost all their interest rate swaps to realise mark-to-market profits. This locked in one-off gains, but left the bond portfolio exposed to further rate rises. If, as the bank expected them to, rates eased the bank would realise even more profit. But if they rose further, the bank would be in a jam. It is easy to be wise in hindsight. In Q2 2022, the Fed was only getting started with its rate rises. You can see the timing of SVB’s hedge unwinds below. It is the region in red. So swaps did not cause Silicon Valley Bank’s downfall. To the contrary, the lack of swaps contributed by removing the main buffer that could have absorbed the coming rate shock. You could say the lack of swaps was the proverbial “curious incident in the night time”. Hedging interest rates: the boy and his shadow She returned to the nursery, and found Nana with something in her mouth, which proved to be the boy’s shadow. As he leapt at the window Nana had closed it quickly, too late to catch him, but his shadow had not had time to get out; slam went the window and snapped it off. You may be sure Mrs. Darling examined the shadow carefully, but it was quite the ordinary kind. — J.M. Barrie, Peter and Wendy (1904) This may sound trite, but it is still profound: interest is a consequence of lending. Interest doesn’t — until recently, couldn’t — exist without a corresponding disposition of principal from a lender to a borrower. Interest is to a loan as a shadow is to a boy: term loans cast one sort of shadow —fixed — and deposits cast another — floating — but both depend fundamentally on indebtedness. No Peter, no shadow. No loan, no interest. Duration risk is the problem of trying to match fixed assets that throw one kind of shadow with callable liabilities that throw another. If you could sell a fixed rate shadow, and buy a floating rate shadow, you would be covered. But how do you trade rates without borrowing and lending the principal sums they are derived from? You might, if you lent fixed and borrowed floating over identical terms and for identical principal amounts to and from the same person: then the principal payments would offset perfectly. On the same day you borrow $15.2bn on a fixed rate, you lend $15.2bn on a floating rate, on terms that they will both be repayable simultaneously. No money needs to change hands. This is an excellent solution: principal liabilities wash out to zero: the parties are paying and repaying identical amounts to each other on the same date — leaving only the residual interest rate exposures. The shadows remain; the boys cancel out. But, alas, banks were left with a formal problem, occasioned by the way defaulting companies’ assets and liabilities are usually resolved in bankruptcy: it there were two standalone loan contracts one borrowed, one lent, each supported by valuable consideration and standing on its own as a sensible economic transaction entered at arms’-length, they would be treated for all practical purposes as distinct: one would be an asset and the other a liability, and they would sit on opposite sides of the balance sheet. An insolvency administrator would naturally regard them as different things, having different consequences on the defaulting party’s bankruptcy. A bankrupt’s liabilities are, of course, subject to recovery and resolution contingencies of the bankruptcy process. A creditor might get some or all of its money back; but it might not. A bankrupt’s assets, on the other hand — its claims against its own debtors — are not. They are undiminished. Indeed, the more the bankrupt recovers from its debtors, the more it will have to repay its creditors. So the insolvency process — which is there to protect creditors — would naturally prise apart loans owed by the bankrupt from those owed to it, even if certain pairs of loans were entered together and with a unitary purpose. An offsetting lender/borrower would have to repay one, but file a creditors’ claim in bankruptcy for the other. This rather mucks up the clever idea of cancelling out the two “boys” and being left with their offsetting “shadows”. A bank counterparty would have to hold regulatory capital against its whole loan asset. It would not getting any relief for the value of its offsetting loan liability. In 1981, bankers at Salomon Brothers — who have since passed into JC mythology as the First Men — had two clients, IBM and the World Bank with exactly this problem, only in the converse to each other. The First Men had a bright idea. They called it the “swap”. Swaps “I wonder,” Mr. Darling said thoughtfully, “I wonder.” It was an opportunity, his wife felt, for telling him about the boy. At first he pooh-poohed the story, but he became thoughtful when she showed him the shadow. “It is nobody I know,” he said, examining it carefully, “but he does look a scoundrel.” — J.M. Barrie, Peter and Wendy (1904) Swaps are a really neat idea. They solve that duration risk — the one that has been with us since Lorenzo Medici — in a novel way without blowing up the balance sheet the way offsetting loans would. The essential insight of a swap is twofold: first, find a single counterparty who has the opposite duration problem to you, and secondly, remove the principal exchange altogether. Now you can both hedge your position. Neither of you needs to needlessly inflate your balance sheet. Economically, an interest rate swap is identical to offsetting loans with the same person. The difference is a formal, but important, legal description: rather than the principal exchange being resolved by set-off, it is removed altogether. A swap is in no sense two inverse transactions: it is a single unified Transaction with no principal exchange at all. There is therefore no claim for an insolvency practitioner to make for a “return of principal”. The “boys” are gone. We are left with only their “shadows”. The present value of the offsetting payment streams — the shadows — will fluctuate, but they will always offset each other. So, is this where we talk, finally, about netting, of those offsetting rate flows, and implied exchanges of principal? Is that why we need close-out netting opinions? To reinforce the argument, somehow, that a swap should not be recharacterised as a pair of disguised, offsetting loans? No. That bit is settled: as there is no principal exchange inside a swap, there is nothing for insolvency administrators to claim. Unlike the “offsetting loans” structure, the individual “legs” of a swap do not make economic sense by themselves. You cannot view them in isolation. Rather, the fixed leg is consideration for the floating one, and vice versa. You don’t need enforceability opinions at this level, because here there are no cherries to pick. The “cherry-picking” problem arises only when we try to boil down exposures between different swap Transactions between the same parties under the same ISDA. The Single Agreement In most

    32 min

  2. APR 3

    Borrowing short and lending long

    This is the first chapter in a new series about close-out netting, and the tiresome, hideous problem of close-out netting opinions. If you haven’t already, you might want to check out the introductory prologue, already released. It is here. This is chapter one: we are still in scene-setting mode. Before we get started with the really boring stuff it is worth getting down to brass tacks and asking some really basic questions about how why we even have netting, why regulators care so much about it, what difference netting opinions make and why are they so long? If you thought this was fun, or interesting, please pass it on to someone who you think might like it. But before getting to that we need to go right down into the elephants and turtles of what banking is all about. For to understand why we need close-out netting opinions we must understand what close-out netting does. To understand what close-out netting does, we must understand the point— the importance — of capital adequacy. To understand the imperative of capital adequacy, we must have our heads around the profound structural problem faced by every credit institution: “borrowing short and lending long”. Fundamental intermediation To understand that problem we need to understand the basic function every bank plays in the economy, of taking — with permission, of course — money from those who have more than they need, and giving it — for a fee — to those who don’t have enough. This fundamental business of banking is intermediation. Depositors — those with too much money — lend it to the bank, in return for deposit interest. The bank then lends that money — or, at least, a sum equal to most of it, to borrowers — those of its customers who don’t quite have enough. The bank lends to them, also, in return for interest. I don’t imagine this will come as a great surprise to anyone. As long as the borrowers are as good as their word and pay back what they owe, all is mostly well. If the borrowers can’t pay their money back, then the bank will have a harder time repaying its depositors. That much is obvious. But even if they can, the banks face an embedded structural problem. Generally, banks take in deposits “on call”. They are repayable to depositors on demand: Just stick your card in the ATM and you have have your savings back. But when banks lend money to their customers, they tend to do so on term loans: they can’t ask for their money back when ever they want it. They must wait until the end of the term. This can present banks with a cashflow problem, especially if they happen to field a large amount of withdrawal requests from depositors at the same time. Usually, this doesn’t happen: a bank’s deposit base tends to be fairly stable, and across the bank inflows and outflows on a given day are more or less balanced. But occasionally circumstances can contrive to change that, and things can get pretty spicy, fast. We can best explore this by the sad tale of Silicon Valley Bank. Interlude: The sad tale of Silicon Valley Bank SVB committed one of the most elementary errors in banking: borrowing money in the short term and investing in the long term. —Larry H Summers, 14 March 2023. There are any number of ways to measure the size of a bank: by number of customers, depositors or employees; by branches, by geographic spread or by aggregate value of customer deposits — but the conventional one is total asset value — the aggregate value of all the investments the bank has made — much of it with those deposits. By that measure, in March 2023 Silicon Valley Bank, though founded only 40 years earlier, was the 16th largest bank in the U.S. If you measured Silicon Valley Bank by its number of depositors, it wasn’t nearly as big. Whereas JPMorgan has something like 90 million customers, Silicon Valley Bank had about 40 thousand. And whereas the average customer balance at JPMorgan, across business and retail accounts is about $20,000, the average customer deposit balance at Silicon Valley Bank was a shade under $4,000,000. I can save you a bit of maths here: Silicon Valley Bank was a tenth of JPMorgan’s size, but had one thousandth as many customers. And those customers were not diverse. They were not, like JPMorgan’s customers, a scattered distribution of miscellaneous butchers, bakers and candlestick makers: Silicon Valley Bank’s customers were all techbros. They all knew each other. They were all directionally positioned the same way. They all had lots and lots of spare cash. If you are JPMorgan, the beauty of your retail banking portfolio is that it is not at all concentrated. There are millions of butchers, bakers and candlestick makers, and they all deposit and withdraw their tiny amounts over the month, based on their own unique needs and circumstances. Because they are, for the most part, independent of each other, the overall effect is to smooth out all the volatility in your overall balances. Your “deposit base” is stable. It’s predictable. Silicon Valley Bank was very different. It had thousands, and not millions, of customers, and each one deposited a lot. Their deposit balances ran to millions. It was a really concentrated little bank. What was special about SVB? What was special about its customers? What kind of freak keeps millions of dollars in a checking account? Well, the clue is in the name. Silicon Valley Bank was founded in 1983 by a couple of Bank of America executives who spotted an opportunity to provide banking services to the then nascent “technology industry”. At the time, “Silicon Valley” was a fun name for a rabble of dope-freaks, dropouts and hippies mucking around with soldering irons and BASIC in Cupertino garages. These cats struggled to get accounts at Wells Fargo and JPMorgan. The new bank met their needs. Roll forward 40 years and it’s a different story. Silicon Valley Bank is the go-to bank for the VC crowd. Anyone who was anyone banked there. An SVB card was as much a part of the techbro clobber as the black turtlenecks, immortality vitamins, slap-head anarcho-libertarian ideology, sack-hopping altruism and the simulation hypothesis. But only techbros banked there. Silicon Valley Bank didn’t collect deposits from many butchers, bakers or candlestick makers. It didn’t really want them: when you have queues of unicorn techbros queueing up to stash their cash with you, who has time to onboard the little guys? As time passed, Silicon Valley Bank steadily “lent in” to its niche: it provided startup advice. It made introductions. It had great VC contacts. It did off-the-cuff in consulting. It was part of the valley ecosystem. Some venture capitalists made banking there a condition of funding. Techbros are joiner-inner types at the best of times: this was a network effect on steroids. By 2020 software was eating the world, just like the VC snapperheads said it would, and money was abundant. There was the metaverse, crypto and nascent AI: as long as you had an account at SVB, VCs did not discriminate. They threw money at WeWork, WireCard and Theranos and it was fine. They would happily throw money at you. All you needed was a pitchbook, a hoodie and a compelling story about blockchain. The name of the game was “first-mover advantage”: move fast and break things. Scale. Lever. Dominate the your space. Build a moat. Cash burn was a badge of honour. If you ran out, you just raised more. So Silicon Valley Bank’s main customers, the techbros, had lots of cash. Like, lots. In the U.S., retail bank deposits up to $250,000 are government insured against bank failure by the Federal Deposit Insurance Corporation. For regular banks, most of their deposits are FDIC-protected: only 20% of retail deposits exceed the quarter of a million dollar threshold. You’d expect that: who puts quarter of a mill in a savings account? SVB’s customers, that’s who. Ninety percent of SVB’s deposits were over the $250,000 FDIC threshold. There are two things to take from this: firstly, SVB deposits were stupefyingly big and secondly, they were at risk if SVB should get into trouble. There would be no government bailout. Everyone at Silicon Valley Bank was depositing cash. Almost no-one was borrowing. This is not normal for a bank. Borrowing and lending tend to balance out. When money is cheap, people feel good. They borrow to buy stuff, and pay the borrowing costs out of their income. They put things on the credit card. They buy houses this way. Cars. They put things on hire purchase. They put capital into their businesses. For this, they go to the bank. That’s what a bank does: matches depositors and borrowers. Yin and Yang. But techbros aren’t like normal people. They don’t get money from banks: they get it from venture capitalists. Techbros are — were — structural lenders, not borrowers. So, Silicon Valley Bank had an odd problem: what to do with all these excess deposits? Between March 2021 and March 2022 — in a single year, in the middle of the Pandemic — SVB’s deposit base doubled. It was being given deposit cash in a near-zero interest rate environment. Its interest costs were low, sure, but it had some, and overheads. Without borrowers, it had to find somewhere to park that cash and some income to pay its bills, return a profit, and yet be able to meet deposits if customers suddenly wanted their money back en masse. Usually, customers don’t do that — retail banking is a boring business — but SVB was special. If there could be a secular inflow in, there could be a secular inflow out. SVB had a credible answer. It would invest the deposit cash in U.S. government bonds and highly-rated mortgage-backed securities. These were, it thought, a better bet than mortgages and business loans anyway. The gig for normal banks is to lend that deposit cash to home buyers and businesses. These investments carry credit risk. Businesses can fail. If you’ve l

    40 min

  3. MAR 27

    The Netting Problem

    You’re all here for eternity which, I hardly need tell you, is a heck of a long time. —Rowan Atkinson, Welcome to Hell Every now and then I field an unsolicited offer from someone to help me with “search engine optimisation”. This person says something along the following lines: “In the competitition for attention on the world wide web, getting to the top of the google search results is more important than ever. I can help boost your site in search algorithms, so you rise above your competitors.” Smugly, I always tell these people the same thing: “Look, chump: I write weak satire about financial derivatives. I don’t have any competitors. No-one else is that stupid.” The JC’s basic gig is to investigate the background context about things that are usually taken for granted — or ignored — to shed light on the business, economics and rationale of capital markets activity. It is all pretty arcane, dry stuff. By design, I tend to think: the dense thicket of bumferous tedium is an imposing barrier to entry — “moat” is the latest buzzword. It keeps insiders at an advantage. My own attention-span is short so, while I was scaling that barrier, to keep myself interested, I resolved to make it fun to write — and therefore fun to re-read. There’s a mnemonic quality to it too: the more colourful you can make it, the easier it is to remember. So the JC presents material in an off-beat way. Since industry is populated, largely, by “on-beat” people — the financial services industry doesn’t exactly encourage loose cannons — I often wonder who my audience is. The answer I usually settle on is, “me”. But there is a small band of fellow travellers out there. The loose cannons. The inquisitive. The easily bored. I know it. You keep your cards close, but you know who you are. So I box on. In any case The Jالی Contrarian™ started as a handy, non-linear way for this low-trajectory loose cannon to store “tacit” knowledge as he went along: crib notes, good practice, bad practice, old wives tales, wry observations and functional know-how about who does what, why, and the practical ins and outs and theoretical background to these mad legal contracts. And here, fifteen or so years later, we are. The thing about tacit knowledge is that it is tacit: forty or more years of people doing, but not writing down, this stuff means there tend to be large holes in the record, here and there, where institutional memory has disappeared altogether. Here I have feely made stuff up, a series of “just so” stories to put this into some kind of context, even if it is a false one. I have recently completed a long series about collateral that was like that. It is not easy to write entertainingly about swaps. Rib-ticklers do not exactly leap off the page: there are no star-cross’d lovers, dark and handsome strangers, boy wizards or bunny-boiling sociopaths. Actually, I am not sure about this last one: there is something of the Hannibal Lecter about those prepared to write tomes about aleatory contracts, a topic we will shortly get to. But even so, there are levels of dullery. Variation margin is one thing: you can crowbar in Jimi Hendrix anecdotes and Monkey! references into that. But close-out netting? We are on a different level here, readers: it isn’t just arcane and technical: it is, at a fundamental level that even the most ardent ninja will feel to her marrow, stupefyingly dull. So we will try to liven it up with a little Kabuki theatre for you all, from the pen of that finest exponent of finance fiction, Hunter Barkley. This is from his forthcoming novella Close-out! Close-out! Close-out!. The warehouse was dark. Condensation dripped. Water pooled. Steam hissed. Algy led. Boone stayed close. They ran silent: matched strides. Tracked footprints. They moved like feral cats. They went room to room. Algy cleared left and right. He cleared out the corners. He waved them through. They made it to the central chamber. It was dark. They went in. A solitary downlight picked out the Hackthorn goon: Cass Mälstrom, C.O.O. He sat at a card table in the middle of the floor. He had game. He was ex-McKinsey. A real thought-leader. He sat tight. He didn’t move. Boone coughed. Mälstrom looked up. “Is that you, Boone?” “Yes, Cass, it’s me.” “You alone?” “Look, I just want to sort this out. I didn’t want this — none of us did — but you gave us no choice. Why didn’t you pick up the phone, Cass?” “I — I been busy, Opco.” Mälstrom seemed edgy. He clocked Algy. “Who—hey, who’s that? I said come alone! I said no fuzz, Boone.” “Algy’s not a copper, Cass! He’s my bagman. He’s got what you want, if you’ve got what we want.” Boone nodded at Algy. “Show him, Al.” Algy opened the kimono. He flashed his trench. He dangled his wares. MTMs glittered from the lining on either side. Mälstrom whistled. “Pretty.” “So, we got ours, Cass. Now, how’s about you?” Mälstrom swallowed. Beads pricked on his pink forehead. “It’s — it’s a—all here.” Mälstrom seemed suddenly nervous. He motioned at a calico sack on the desk, next to a fruitbowl. Algy muttered, “What’s with the summer fruit, Opco? I don’t like it. Something ain’t right.” Boone held up a finger. “We showed you ours, now you show us yours. Just let us see what you have, Cass, and we can be on our way. We just want what’s owed to us. We don’t want any trouble.” Another voice came out of the dark. Urgent. Malicious. “Who said anything about trouble?” A loud click. Boone knew at once: it was the sound of a bump-stock OSLA being cocked. “Wh—?” “Not so fast, Mr. Boone.” Boone said, “I say, who is this?” “Your worst nightmare.” A long glinting copper barrel moved into the spotlight throw and pressed against Mälstrom’s temple. Mälstrom squeaked. “Just do what she says, Opco. Just do it. Sh — she’ll kill me! I’ve seen what she can do! She’s not kidding around!” A tall woman in black chiffon moved into the light. “I don’t believe we’ve met, Mr Boone. I’m Emsworth, of the O. A.” “A banko!” hissed Algy. “Yes, Mr. Farquhar, a “banko”. A liquidator. A receiver with a mandate to resolve. Hackthorn Capital Partners L.L.P. is my baby now. My baby, and your problem. Now, let’s have your MTMs, Mr. Boone. Nice and slow. Come along.” Emsworth reclicked the OSLA and shoved it against the hedgie’s temple. Mälstrom re-squeaked. “Do it, Boone!” “Put down your money, Mr. Boone.” Boone nodded to Algernon. Carefully, Algy placed the MTMs down, one at a time. “I did all the calculations just like you said I should, Opco, under Section 6(d). I gots all the statements.” “Ok, Al, count them off.” Algy busied himself around the table, placing bags in a row. “Here’s our forty five for you. For this next one, you have to put down twenty six for us. We put twenty two for you. You put eighty five down for us.” It took fifteen minutes. Algy stood back, proud of his work. Emsworth smiled. “Goooood. I like it when people are sensible.” “All right, Ms. Emsworth. You’ve had your fun,” said Boone. “Now it’s your turn.” Algy nodded. “Right. So now you gots to put down your OTMs too. The ones for us.” Emsworth chuckled. “I don’t think so.” She swept Algy’s piles into a black Samsonite and snapped the lock. “Hey!” squeaked Algy. Boone took a step forward. Emsworth re-cocked the OSLA. “Easy, now: let’s not do something we’ll any of us come to regret, Mr. Boone.” Boone stopped. “All right, all right: but this is not how it’s supposed to work, Ms. Emsworth. That’s not the deal. We settle down. We net, positives against negatives. Tell him, Cass.” Mälstrom whimpered. Emsworth twisted her face into a long, deep, cruel laugh. “Oh, Mr. Boone. You poor deluded fool. This is Guatemala. You’re not in Kansas any more.” She reached over to the fruitbowl, plucked a cherry and raised it slowly to her thin lips. “Jeepers, Boone, look out! I think she’s — cherry-picking!” cried Algy. Emsworth smiled and bit. The fruit burst. Crimson juice ran down her chin. “I say, Mr. Boone, your little monkey is perceptive. I am “cherry-picking” — just as I am entitled to do.” Opco said, “Now look here. This is a single agreement! We square up. That is the deal! What about your OTMs? What about the money you owe us?” “But, Mr. Boone: we are through the looking glass now. We hav emade the phase transition from the normal world into bankruptcy. The normal rules do not apply. Now, if you’ll excuse me, I have what I need, and I have a plane to catch.” “What about my money, Emsworth?” Emsworth yanked a circuit breaker and another downlight glared. “If you want your OTMs you shall have to wait for them. And fight for them.” The spot revealed a rusted metal cage. A dozen big cats paced inside: leopards. Tigers. They growled. “What the hell is this”? “Can’t you read, Mr. Boone?” There was a stencilled sign above the cage: “CREDITORS”. “Mr. Mälstrom’s creditors. You are welcome to join them. They are all looking a bit peckish, don’t you think, Mr. Boone? Shall we feed them?” Emsworth dangled the MTMs. “Stop this! Tie them up!” “Tie them up? Oh, no, Mr. Boone. That would never do. They are unsecured. If you want your money, you’ll have to scrap them for it.” Emsworth lobbed the calico sack into the cage. The big fat cats fell upon them in a threnody of gnashing maws. “All yours, Mr. Boone! Good day!” Official Assignee, First Class M. T. Emsworth threw the circuit breaker. The room went black to the reverberating sound of her calculating laughter. “Nein!” Ogfried sat bolt upright, drenched in sweat. A light clicked on. He blinked. The Gräfin stirred, rolled over, pushed up her sleeping mask and regarding her husband painedly. “Vot is ee

    37 min

  4. MAR 6

    Variation margin: deep history Pt 3

    This is part three of a multi-part series about the deep and largely apocryphal history of collateralised lending. Here are parts 1 and 2. For those who can’t be bothered to read parts 1 and 2, but still want to read part 3 — I mean, suit yourself — or who have read them but just forgot, here is a recap. This Substack is reader-supported. To receive the best posts and support this struggling artiste, consider becoming a paid subscriber. Only half a pint a week and you get the satisfaction not just of feeling like a Renaissance patron: you get access to Premium JC and all kinds of neat stuff. Recap We started with the simple question — simple for securities lawyers and ISDA ninjas, that is: it might not occur to anyone else — “why do Americans prefer collateral pledges and Brits prefer title transfer collateral?”. In part 1 we covered the difference, in the JC’s argot, between “collateral” and “security”: “collateral” is something you hand over to your creditor. “Security” is an enforceable legal priority you grant over assets you do not hand over. These are quite different modes of performance assurance, especially when it comes to managing a creditor’s “cost of funding” indebtedness it is owed. We are accustomed to thinking mainly about credit risk — lawyers are prone to catastrophising and never looking on the bright side — so in Part 1 we spoke a bit about a happier reason for taking collateral: funding optimisation. In other words, making more money. In part 2 we will traced a “just so” history of financial collateral from no collateral or credit mitigation, to merchants knocking about on the high seas and off the Barbary coast — we spoke a bit about poor old Shylock in the Merchant of Venice — to customary liens and pawnbroking arrangements — this was all the excuse I needed to tell an amusing story about Jimi Hendrix, and I may well come back to it — and fetched up with an exposition on the development from the 19th century of modern financial markets — negotiable bonds, stocks, centralised markets with oddly gesticulating men in silly blazers and ladies scribbling things on blackboards — to electronic markets, clearing, custody, and the opportunity these modern collateral arrangements presented to lenders to better manage their funding costs. That is, make money. We ended with an odd question: if borrowers were providing more moneys’ worth in collateral than the actual money they raised, could creditors use that collateral somehow to offset their funding costs of the very loan the borrower used to buy the collateral and did that mean, in a round about way, that borrowers were, in effect, lending to themselves? In this part we will alight on the answer which, at the risk of spoiling it, we will discover to be Yes. That is weird enough but we will see that, thanks to some odd wormhole or eddy in the flow of spacetime, this means a bunch of different financial instruments, that seem quite different from each other, seem to collapse down to a single wave form, and become the same. We will compare collateral arrangements with the financial transactions they collateralise and see how —if viewed in purely economic terms — they are not really that different. Things get a bit strange loopy. So, without out further ado, let’s play the third act of this odd movie. The hidden financing in every swap “What is dull is never done.” —The Swappist Oath But hang on, if a swap is a “self-funding” loan then, by ponying up collateral, isn’t the “borrower” lending to itself? The answer is, in a sense, yes. But that is the very distinction between “borrowing” and “financing”. Borrowing is the outright transfer of capital. The lender gives money, outright, and accepts the borrower’s unadorned credit risk for its return. Financing is the temporary conversion of an existing asset into cash. You give the asset away in return for cash, against a promise to repay the cash against return of the asset. It is a “swap”, of sorts, even if not quite in the sense implied in an ISDA. The financier’s risk is different: it has intraday exposure not to its financing counterparty, but to the financed asset. This usually has a greater value than the sum advanced: as much as 30% more. Only if the asset suddenly collapses in value — if it “gaps down,” in the vernacular — does the financier have any credit risk to its financing counterparty for repayment. The financier, in the vernacular again, has “second-loss” risk to its counterparty. So, to labour the point: Lending is the outright, uncollateralised transfer or money from lender to borrower. Financing is the temporary, and reversible, exchange of an asset for its cash value. From one angle only — that of “an advance of money from one party to the other” — do they look the same. In the round, economically, they are quite different. It is a fun exercise to bucket different financial products into loans and financings: A swap as a financing The mark-to market exposure under a ISDA Master Agreement, not counting its CSA, represents outright indebtedness. Not necessarily to the dealer: the indebtedness — the “Exposure” — can swing in and out of the money. In an odd way, a Swap portfolio resembles a revolving credit facility — an overdraft. The only difference — and it is structural and not economic — is that the “withdrawals” and “deposits” in a swap are beyond the control of debtor and creditor. They are generated by — they are “derivatives” of — market movements on transactions. But swaps were not designed to be like overdrafts. They are meant to be “unfunded” instruments. They were designed, by the First Men at the dawn of the Age of Swaps, as paired, offsetting loans, the principal sums of which are meant cancel each other out. What is left is, literally, a “derivative” of the exchanged loans: the present value of remaining cashflows under one loan deducted from the present value of the remaining cashflows under the other. This is a neat expression of the market delta. Since swap dealers are not meant to be borrowers nor lenders, and don’t take deposits to fund their operation they are not necessarily regulated or capitalised to take large debt exposures to their customers. It would be eye-wateringly expensive to do so even if they were. So, dealers require the their swap exposures to be transformed from loans to financings that do not attract the same capital charges. A CSA is designed to solve that problem. Economically it is the inverse of a portfolio of swaps. So, if a swap is an overdraft facility, so is a CSA: only its equal and opposite. Both are outright disposals of capital. Of course, a CSA can only exist with an ISDA. A CSA existing independently is a nonsense. CSAs are sort of “ISDA-linked swaps”. Their “underlier” is the net Exposureof the very ISDA they are collateralising. When we add a CSA to counteract an ISDA Exposure they cancel each other out: Exposure goes one way, variation margin goes the other, and — hey presto — there is no longer an outright disposal of capital. We have a financing. Usually, a financing starts with a party putting up an asset to raise money. In a margined ISDA, that sequence is reversed — the dealer “lends” money, and the customer punts over an asset to collateralise it, and that makes it into a financing — but economically, they are the same, whichever comes first. From this perspective, a swap looks like a margin loan from a dealer to a customer to buy a financial asset. Instead of giving money to the customer to buy an asset, the dealer uses it to buy the asset as a hedge, for its own account. The dealer now owns the asset, but pays away all the its economics to the customer. It also looks a repo, which looks like a stock loan, which looks like PBr. Are all just different articulations of the same principle. Financing. I feel like I have been labouring this point. Time to move on. The financing parcel game Triago: All the world’s a margin loan —Each man a mere financier:Who calls out wonkish marks andPledgès troth o’er something fancierWhate’er fetches upAnd passeth thy criteriaRehypothecate the lot, dear friend—In a flush of rehysteria. —Otto Büchstein, Die Schweizer Heulsuse Recall that what an outright lender cares about is making sure its cost of providing capital — the cash it has to stump up to make the loan — is less than the return it gets from lending it. Borrow cheap, lend expensive. (Seems trite, I know, but does not seem to have occurred to the treasury department at Silicon Valley Bank.) Generally, a bank funds its loan book by borrowing, from retail depositors, commercial paper, medium term notes, bonds raised in the debt markets — and repos — but that is to give away the punchline a bit so let’s park that. The bank must pay interest on, and hold capital against, those “funding liabilities”. The difference between the amount of interest a bank can earn from lending money, and the amount it must pay to acquire that money, is its profit margin. A bank that could find a way of lending money to X without first having to borrow it from Y would be in a rather special place. A place that would seem, rather, to transgress the laws of banking physics: how can you lend something you do not first have? Like this. Step one: take financial collateral from your borrower thereby converting an outright loan into a financing. Step two: convert that financial collateral into money, and repay your lenders with the proceeds. Behold: the beguiling magic of a margin loan. By financing — that is, converting into money — the collateral it received from its borrower, a margin lender no longer needs to borrow the money it used to make the margin loan. The margin borrower is, effectively lending to itself through its collateral. Selling the collate

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  5. FEB 13

    Variation margin: deep history Pt 2

    Thanks for reading! This post is public so feel free to share it. This is part 2 of an essay. Here is variation margin: deep history part 1. There will be a third. Refresher Prompted by the simple question “why do Americans prefer collateral pledges and Brits prefer title transfer collateral?” we were talking last time about the difference, in the JC’s argot, between “collateral” on one hand and “security” on the other. In this sense, “collateral” is something you give bodily over to your creditor. “Security” is an enforceable legal promise you make over assets you keep hold of yourself. These are quite different modes of performance assurance. They have different effects when it comes to doing the two things any lender cares about: managing the debtor’s credit risk and managing the creditor’s cost of funding the debt. Another quick definition pit-stop: I sometimes refer to “borrowers” and “lenders” here, but more properly I should say “creditor” and “debtor”, because the same principles apply whether you have extended a formal “loan” or you are simply owed money under some other credit arrangement. A swap, for example, is not a formal loan, but any mark-to-market exposure under a swap, economically, is the same as a loan: specifically, like an overdraft, with a fluctuating balance accruing interest at a floating rate. Now, since, when discussing loans, most lawyers rarely think past credit risk, we spoke a bit about the seldom discussed but vital, business of funding optimisation. We will do a bit more of that in this episode. Along the way we will encounter Shylock, Spinal Tap, the Osmonds, the widow Herring, a nice fish restaurant overlooking a beautiful lake in the Ostallgäu and a resourceful young private in the house band of the 101st Airborne by the name of James. Dans une coquille de noix In part two of this essay I will trace the development of financial collateral from pure credit mitigation — from no collateral to customary liens to pawnbroking arrangements — to modern margin arrangements which introduce an important new feature: funding cost management. How can a creditors use collateral posted them to offset or optimise their costs of funding their exposure? For most of history, security interests and even possessory collateral served only the purpose of credit protection. Funding management couldn’t come into it because the assets involved were unique, illiquid, or both. The creditor was obliged, therefore to just sit on them. But just sitting on productive assets and not using them is a cost and a missed opportunity in any business. Finance is no different. We will see how as fungible, liquid financial instruments emerged in the 19th century, institutional creditors began to monetise their collateral portfolios, converting them, temporarily, into cash. The modern derivatives market developed out of that capability. Though we started looking purely at collateral arrangements established to offset the risks and costs of extending credit, we will pause to notice how these arrangements resemble, very closely, other kinds of financial transaction in the market place. There is a sort of fractal similarity here. This idea of funding optimisation is embedded in every aspect of the financial markets. But let’s not get ahead of ourselves. Let’s start at the beginning. There’s a good play about this. Play the movie. Ja. Play. Collateral as a credit tool A pound of flesh? Shylock: But ships are but boards, sailors but men; there be land rats and water rats, water thieves and land thieves—I mean pirates—and then there is the peril of waters, winds, and rocks. The man is, notwithstanding, sufficient. Three thousand ducats. I think I may take his bond. The Merchant of Venice, I, iii Shylock, you may remember, could not take collateral, or security, but had only Antonio’s word as his bond: Antonio was, in the vernacular, “expectation-rich, but asset-poor”: all his worldly possessions were out and about, on the water, in pursuit of riches but at the mercy of the land rats and water thieves of the seven seas. Shylock was right to have been worried. It all went horribly wrong for Antonio as buccaneers on the high seas laid low his assurances. It hardly worked out any better for Shylock — xenophobia and the finer points of Venetian contract law — did for his, but at least drama fans got a pleasant evening out if it. But all this — well, drama — for the want of tangible performance assurance. The famous “pound of flesh” is a kind of security, but it is not “collateral”. We could, therefore, regard The Merchant of Venice as a morality play about the danger of uncollateralised lending. But collateralised lending goes way back before Shakespeare’s time, of course. Collateral 101: credit risk From the dawn of history — as Nigel Tufnel might say, hundreds of years before that — private lending arrangements have involved credit risk. That is their fundamental wager: I lend you money; you spend it. I hope you are wise enough, and honest enough, to give it back. The amount a debtor pays for the privilege of obtaining credit represents two things: the “time value” of the money borrowed — the opportunity cost of extending credit to this debtor and not using the money for something else — and a “credit spread”: a “premium” representing the creditor’s assessment of the risk the debtor won’t pay it back. Whether a debtor repays depends firstly, on its honesty and secondly its solvency: its general business acumen over the period of the loan. This is a matter of a creditor’s personal faith: credit is, literally, latin for “he believes”. Credit risk is not hard to get your head around, and lawyers spend an awful lot of time worrying about it. Traditionally, there are three ways to manage it: by taking “security”, by taking “collateral” or by obtaining “sureties”. A quick reminder: I treat these three concepts as mutually exclusive in a way that does not really reflect common usage. Lawyers are oddly casual in their terminology here. Security Creditors can take security — the debtor grants the creditor abstract legal rights over some of its assets, but continues to hold and use those assets. For example, a mortgage. The debtor lives in the house, but if she does not keep up her payments, the creditor can turf her out and sell it to recover its debt. Collateral Creditors can take collateral — the debtor physically delivers assets to the lender for safekeeping, as a bond against repayment. For example, a pawnbroking arrangement. The pawnbroker holds your asset until you repay your loan, and can sell it if you don’t. Sureties Creditors can take sureties — a trusted third party underwrites the debtor’s obligation to the creditor. A guarantee or a letter of credit. I mention sureties for completeness: I am not going to dwell on them as they aren’t really practical funding mitigants. I don’t want to get ahead of ourselves, but in the 19th century creditors began to look for ways to reduce the absolute cost of money they were lending, and wondered whether their credit mitigation arrangements might help. Physical collateral: liens and pledges Taking physical collateral against a debt obligation is as old as civilisation. Its simplest, most customary form is the lien. Liens Liens are “customary” in the sense that they did not grow out of some brilliant legal innovation but were an existing cultural practice that the law simply recognised. A lien is the original “self-help remedy”: oh, you want your watch back? Pay your bill. Possession is nine-tenths of the law. Liens are all about possession. They arise automatically and without formality: when you take your car in for a service, the mechanic can hold onto it until you have paid your bill. Say, after an agreeable meal at the delightful Fischerhütte in Hopfensee, you are caught short. The proprietor points to your watch as a condition to letting you out the door. This is mostly an honesty play, rather than a solvency one: what matters isn’t the watch’s realisable value so much as its value to you, and the hassle of having to replace it. Herr Fischer has very little interest in selling your watch: he is in the business of serving up Zanderfilet mit frischen Kräuter-Rahmschwammer rather than hocking off collateral to settle his debts: he just wants his punters to enjoy their perch and pay their bill. It is very good by the way. Primarily, liens are a practical lever to make sure debtors do the right thing. They are an assurance mainly, of honesty. They not a great mechanism for recovering debts if they don’t. Hence — as with a mechanic’s lien over your car — the collateral value is often out of all proportion to the debt. The practical value of a lien is its awkwardness. Even a bankruptcy administrator will find it financially expedient to settle the lienholder’s bill — or walkaway altogether — than challenge the effectiveness of a lien. We can see here the power of sentimental value. It brings the borrower back to the table regardless of any rational assessment of value the collateral. But you can take it a bit far: The original human shield A quick amusing sidebar, for which I am indebted to regular correspondent Mr. Johnston, who is a bottomless source of such ribaldry: the old case of Herring v Boyle (1834) 1 CM&R 378. It concerns a schoolmaster, Boyle, attempting to extract school fees from a widow, Mrs. Herring, for the education of her 10-year-old son. On Christmas Eve Mrs. Herring arrived at Mr Boyle’s school to collect her lad for the holidays. At the time she was up-to-date with her fees, but a new instalment was due the following day. Fearing he might not see the pair again, Boyle took an imaginative, if idiosyncratic, approach to the situation. In effect, he asserted a lien over the lad. You may have your

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  6. FEB 6

    SLAPPs, without prejudice and a latter-day Albert Haddock

    A case concerning a snippy letter from a lawyer who should have known better to another one, who did, is an odd departure point for an excursion into without prejudice, but here we are. This is what I would call an “Albert Haddock” case. Albert Haddock was A. P. Herbert’s ornery civilian litigant, always getting himself in trouble, or up the nose of the authority, presenting negotiable cows to the revenue, when on a flooded road arguing that vessels should pass starboard to starboard and so on. Albert Haddock is fictional. His real-life counterpart here is a chap called Dan Neidle. Mr. Neidle should understand I mean “Haddock” in the most reverential way: the JC is a big fan (of both Messrs. Haddock and Neidle). I like people who “poke the Borax” and I have no great fondness for civil litigators. And as we will see, there is nothing quite like a bit of “Neidle needle”. That said, the ultimate outcome of this case, in which Mr. Neidle’s antagonist was exonerated from disciplinary charges sent his way, seems right. We will come to that in good time. First, the facts. Facts In July 2022 Dan Neidle, nowadays something of a public provocateur on matters of tax policy, but for many years Clifford Chance’s head of tax, published some embarrassing allegations about the tax affairs of the then recently-appointed Chancellor of the Exchequer, Nadhim Zahawi. Unwisely — has no-one heard of the Streisand Effect? — Mr. Zahawi “went to the mattresses”. He engaged a firm of solicitors to shut Mr. Neidle up. That firm of solicitors was Osborne Clark. Carriage of the matter fell to one Ashley Hurst, a litigation partner. Mr. Hurst’s first instinct was sensible: he messaged Mr. Neidle suggesting they chat. Mr. Neidle was having none of it. He told Mr. Hurst to put whatever he had to say in writing. Mr. Hurst replied, “Trying to avoid that. We can speak WP [“without prejudice”] if you like.” Again, Mr. Neidle declined. He said, “Please note I will not accept without prejudice correspondence.” Mr. Neidle said this because “without prejudice” communications have a special status in civil litigation. In essence, they cannot be put before the court. Mr. Neidle did not want to cede his right to put anything Mr. Hurst said before the court. “If you are not prepared to say it out loud,” Mr. Neidle implied, “do not say it.” This did not deter Mr. Hurst. He composed a snippy letter he will have since come to regret. Snippy letters are part of the stock-in-trade of civil litigation. Much of it is resolved without resort to much else. Most people back down at the first missive they receive on law firm-headed notepaper. Mr. Neidle is not most people. He is not the backing-down type. Law firm-headed notepaper was not going to cow him: his own name had been on law firm-headed notepaper for many years. He does not frighten easily. He likes a scrap. Mr. Hurst ought really to have known this, from a casual read of the papers. It seems he did not. Mr. Hurst emailed his snippy letter to Mr. Neidle. It was ill-judged in a few respects, but in one especially: it claimed to be “without prejudice and confidential”. It said: It is up to you whether you respond to this email but you are not entitled to publish it or refer to it other than for the purposes of seeking legal advice. That would be a serious matter as you know. We recommend that you seek advice from libel lawyer if you have not done so already. There was no attempt to settle the dispute at all. Mr. Hurst’s letter was not an attempt to stave off litigation, but a veiled threat to embark on it: Should you not retract your allegation of lies today, we will write to you more fully on an open basis on Monday. In the meantime, our client reserves all of his rights, including to object to other false allegations that you have made. I am available to discuss if you change your mind on having a phone call. That could well save time and expense on both sides. Even at this stage, Mr. Hurst held out hope that a phone call might de-escalate things. He hoped in vain. Mr. Neidle gave Mr. Hurst a polite version of what we might call the “Pressdram Salute”. He published Mr. Hurst’s “without prejudice and confidential” letter and, not long afterward, referred Mr. Hurst to the Solicitors Regulation Authority, complaining that Mr Hurst’s use of the “without prejudice” label amounted to, or somehow hinted at, a “strategic lawsuit against public participation”. So-called “SLAPPs”, in which the moneyed and powerful use the legal system to stifle fair enquiry into matters of general public interest, have become a bane of public life in the UK. The SRA has been on the warpath against them. It saw in Mr. Neidle just such a “public participant” and, in Mr. Hurst’s letter, an intolerable attempt to muzzle him on Mr. Zahawi’s behalf. It began an investigation that culminated, 18 months later — no-one could accuse it of precipitate action — in a referral to the Solicitors Disciplinary Tribunal, on the grounds that Mr. Hurst was engaged in an illegitimate SLAPP. Before we get to that, it is worth recounting what happened in the meantime, without the SRA’s intervention. Firstly, Mr. Neidle did not retract any of his allegations, and in fact doubled down on them. Secondly, Mr. Zahawi did not exercise any of his “reserved rights”. None of the veiled threats in Mr. Hurst’s letter came to pass. To the contrary, in January 2023, Mr. Zahawi was reported to have paid a penalty to HMRC. Shortly after that the Prime Minister’s Independent Adviser on Ministers’ Interests identified that he had breached the ministerial code seven times. The Prime Minister sacked Mr. Zahawi from his post as Chancellor of the Exchequer the same month. Within a year, in the face of growing opposition from his own constituency party, he announced he would not stand in the 2024 General Election. That is to say, thanks in significant part to his misconceived attempt to limit Mr. Neidle’s “public participation” Mr. Zahawi’s political career spectacularly imploded. We should take heart from this outcome. It feels like a system working well: hubris is rewarded with nemesis. The cosmos has delivered its own savage justice. In its perverse way, a prominent politician’s freedom to detonate his own reputation seems a positive constitutional safeguard. It is not clear what further action is needed. The Solicitors Regulation Authority did not agree. It came for Mr. Hurst. Two days after the Chancellor’s sacking, the SRA referred him to the Solicitors Disciplinary Tribunal. It accused him of breaching SRA guidance by improperly labelling his correspondence “without prejudice”, “confidential” and “not for publication”, when the conditions justifying those labels were unfulfilled. This seems a rather timid complaint. SRA guidance cautions solicitors not to intimidate or mislead third parties, and to take particular care with the vulnerable or unrepresented, but the SRA’s focus on these formal indicators, rather than the substantive intimidations in the body of the letter, seems rather, well, formalistic. It may be because it seemed a “slam dunk” contravention of SRA guidelines. They specifically call the formal labels out: One way this can happen in this context is by labelling or marking correspondence ‘not for publication’, ‘strictly private and confidential’ and/or ‘without prejudice’ when the conditions for using those terms are not fulfilled. In any case the SDT heard the matter in December 2024 and, in May the following year, handed down its decision. It agreed that Mr. Hurst had acted improperly and fined him £50,000. Mr. Hurst appealed. In January 2026 the administrative decision of the High Court upheld his appeal and overturned the SDT’s finding. In light of the practical resolution of events — Mr. Hurst’s client torching his own political career — and the curiously formalistic approach to the disciplinary breach, this seems the correct outcome. This Substack is reader-supported. To receive new posts and support my work, consider becoming a free or paid subscriber. Without prejudice “Without prejudice” is, in JC’s view, a silly frippery of the civil courts. In seeking to imbue a kind of legal privilege to bona fide settlement offers — a privilege they absolutely do not need — the courts have evolved a fiddly, confusing and self-contradictory cranny of procedural jurisprudence. Rather than regarding them simple markers of a constructive approach to dispute resolution, the court is expected to pretend that formal settlement overtures do not exist. They acquire an odd, mystical, Schrodinger’s cat-type status, though, because — sometimes — they can be presented when it comes to arguing about costs. But that’s as may be, however: the “without prejudice” rules exist and we are stuck with them. So is Mr. Hurst. A key plank in the SRA’s argument was that Mr. Hurst’s communication was no kind of settlement offer, and that therefore labelling it “without prejudice” was improper and intimidating. This idea is implicit in its guidance, quoted above. But this gets things exactly backward: a “without prejudice” label (for whatever reason it is applied!) is the opposite of threatening: it signals a settlement offer. One should be overjoyed to receive a without prejudice letter. The “prejudice” it seeks to avoid is to the interests of the sender. Without prejudice is defensive, not intimidatory. It is a white flag, not a black one. That, indeed, is why the courts developed its silly jurisprudence: to spare the sender’s blushes: to prevent disclosure before court a document which on its face speaks to its author’s weakness. “Without prejudice” seeks to avoid misconstrual as a concession of weakness from the sender, not aggression. The SRA guidance in this regard seems

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  7. Variation margin: deep history Pt 1

    JAN 30

    Variation margin: deep history Pt 1

    In the worlds before Monkey, primal chaos reigned.Heaven sought order — butThe phoenix can fly only when its feathers are grown.The four worlds formed again and yet againAs endless aeons wheeled and passed.Time and the pure essences of heaven,The moisture of the Earth, the powers of the sun and the moonAll worked upon a certain rock, old as creation, and it becameMagically fertile.That first egg was named, “Thought”.Tathagata Buddha, the Father Buddha, said:“With our thoughts we make the world.”Elemental forces caused the egg to hatch.From it then came a stone monkey.The nature of Monkey was —Irrepressible. — David Weir, Monkey 1978 As JC starts to overhaul the CSA Owners’ manuals I thought it might be nice to take a step back and look at the deep background to collateral as we glom it today. The road is long, and it has its roots in custom and practice in the industrial revolution. There is deep mythology in play, too. I know this because I made it up myself. I was prompted to embark on this by the question: “Why is collateral pledged under New York law CSAs while it is title transferred under English Law ones?” Like so many of the mystic principles of the law, younglings are told this at an impressionable age, expected to absorb it, take it as read, and thereafter not ask impertinent questions about it. JC’s dismal career trajectory might have something to do with asking questions that were impertinent — or stupid — in the supervising partner’s eyes there is little difference. In any case, I asked myself this question and — well you know me, readers — I went and fell right down a rabbit hole, didn’t I? So here is the JC’s deep backgrounder on collateral, security and the role they play in mitigating credit risk and financing costs of lending and financing in modern markets, and why English law variation margin arrangements tend to be by title transfer, and New York ones by pledge. Where the fossil record is incomplete — or I can’t be bothered looking into it — I have followed the time-tested JC tactic of making it up out of whole cloth. This is my truth. Buckle in! This Substack is reader-supported. To receive new posts and support my work, consider becoming a free or paid subscriber. Security & collateral. Credit & funding This is a story about two pairs of concepts: “security” vs. “collateral” and “credit” vs. “funding”. These pairs relate to the business of lending and subtly different, financing. In their way, they help to distinguish between “lending” and “financing”. “Lending” and “financing” is another pair of conjoined, but independent, concepts. It is profound, and resists frontal assault. We can attack it through these proxies. Security vs. collateral The first pair is “security” and “collateral”. Herewith the first JC invention: a clean distinction between them. For the purposes of this essay, and perhaps only for the purposes of this essay: Security is an immaterial legal right—a mortgage, charge, lien, an equitable interest. Collateral is physical possession of a material thing—an asset, delivered to a creditor’s order for safekeeping. You may not find it in Black’s Law Dictionary, but it is a practical distinction. Lawyers tend to use the concepts interchangeably: they fulfil similar roles when it comes to mitigating credit risk, but as we will see, not when it comes to funding. Mainly, lawyers understand credit risk better than they do funding, because credit is the risk something might in the future go wrong, and that is a commercial lawyer’s main preoccupation. But funding is no less — nay, in the round, more — important. But we will get to that. Now, there are collateral arrangements, security arrangements, and those that are both. I wanted to highlight a term here that captures either legal theoretical interests, whether or not also involving possession, and title transfer collateral interests that necessarily do but, as best as I can tell, there isn’t one. I thought it might be “encumbrance”, but that implies a security interest, as does “surety”. I tried “posted”, but that conveys the transfer of possession. The commodities people have a concept of “performance assurance”, but that is too wide. Might this be a rare justification for and/or? I thought that was annoying for a moment but, maybe it is the point. Collateral and security are quite distinct things. They can be, but (in the UK at least) are not often seen in the same room together. You can have a security interest without any collateral (e.g., an assignment by way of security over contractual rights) and you can have a collateral arrangement without a formal security interest (e.g., a title transfer credit support arrangement). And you can have both. The classic case is the lien. TL;DR: Security depends on legal magic to work. Collateral doesn’t. So, that is the first pair of concepts. Security: immaterial rights. Collateral: stuff. Credit vs. funding The second pair is “credit risk” and “funding”. Credit From early in our careers we learn that, when it comes to handing money over to strangers, credit risk is a lender’s most obvious concern. Even lawyers understand it instinctively: will the borrowers be able repay? What are my weapons if they cannot? Where a lender has collateral, there is little fuss. She holds it. She can sell it, claim what’s owed and give whatever’s left back. Other creditors can squabble over that to their hearts’ content. Our heroic lender is away, Scot-free. Where the lender has only security, she is still okay: she can jump the unsecured creditors in the queue and seize secured assets — whereupon they become like collateral, so she can sell them and account for the profits — but to do that she must take formal legal steps, which require a court’s help and are easy to muff up. There is always the risk of challenge by other creditors. If we invert the old saw Security is one tenth of the law. Possession, is the rest. Another difference between security and collateral is who has the use of the assets in the mean time? The lender holds collateral assets. The borrower gives them up at the outset. The borrower holds secured assets. The borrower keeps possession, but is restricted in what it can do. The lender has no right to intervene unless and until it is entitled to “enforce” its security. But this is an action of last resort, taken only with heavy heart and when all hope is lost. Everyone — borrower and lender alike — is fervent in their hope they this day never comes. Usually, it never does: a bankruptcy is a remote possibility: a “tail event”. it happens rarely. But it is catastrophic when it does. Security arrangements where the borrower gets to keep its asset are therefore contingencies: forms of insurance a lender puts in place to guard against extreme events. Collateral arrangements, where the borrower collateralises day one, are not. Another difference — a corollary to the above — is the depth of credit mitigation. The “credit value” of identified collateral is inherently limited to its liquidation value: once it is gone, it is gone. Hence, collateralised obligations tend to be subject to a haircut, regularly “marked to market” and exchanged to ensure there is always a buffer to cover the debt after liquidation. By contrast, a security right against a person is usually unlimited, to the value of the debt, against the person who grants it. You can pursue the guarantor to bankruptcy, if need be, to recover a beneficiary’s debt. On the other hand, “enforcing” against collateral is dead easy: you just sell it. No particular ceremony, though you must be carefully to achieve a fair price in the market. The more liquid your collateral, the easier that is to monitor. But enforcing security interests is elaborate, involves lawyers, courts and frequently bankruptcy administrators. So credit is the assessment of a borrower’s likelihood of repay her debt. “Credit risk mitigation” is anything a lender does to improve that likelihood in the event of the borrower’s failure. Security interests and collateral arrangements both mitigate credit risk. Funding Funding is the business of finding the money with which a lender makes a loan in the first place. Lending institutions need reliable funding sources: those may be their own customer deposits, separate banking facilities, or medium term note and commercial paper programmes and the bank’s repo and securities lending arrangements, whereby it “lends out” its inventory of securities held for investment, as hedges and as collateral in connection with its customer trading business. This unglamorous but important business — making sure there is enough money available to lend, and at good rates, to whoever wants to borrow — falls to the bank’s treasury department. Wherever it comes from, money — “funding” — comes at the cost of the interest the bank must pay on it. A bank will do whatever it can to reduce its “cost of funding” and broaden its sources of funding. A day one cost Unlike credit risks, funding costs are remote contingency that everyone hopes will never happen. They are a fundamental input cost to the business of providing loans. Optimising funding costs can dramatically boost a bank’s overall performance. Getting it wrong can, in rare cases, be catastrophic — the classic example is Silicon Valley Bank — but in any case, managing funding is not a “once in a blue moon”, tail-risk sort of thing. It matters on every loan on every day. The imperatives of funding optimisation, therefore, have quite different implications for the kind of security or collateral involved. Though collateral and security interests both address the credit risk, only possessory collateral is any use in managing its funding costs. Security ⇒ credit.Collateral ⇒ funding. Forma

    32 min

  8. JAN 23

    Credit Support Annex: Preamble

    This is a free preview of a paid episode. To hear more, visit jollycontrarian.substack.com This is going to be quite the epistolic journey. Like a Dickens novel designed for people with no taste in literature and an unusually high threshold for pain. I have started to refresh the CSA pages. As I go I am going to put out newsletters and podcasts. Here is the first once. Premium subscribers: the premium version of the podcast covers all the economy material, too. You don’t need to — but are fully welcome to! — listen to them both. Eco-subscribers: for the price of half a pint of alcohol-free beer at the JC’s local every week, you too could have all the extra jokes, analysis and nasal mumbling that the Premium subscribers get. Sign up to the premium substack, and you get automatic access to the premium JC This Substack is reader-supported. To receive new posts and support my work, consider becoming a free or paid subscriber. The preamble to ISDA’s CSA On preambles, weapons in Russian plays, etc. The “preamble” is the throat-clearing passage of a commercial legal document: the scene-setter that puts you in the right place, the right frame of mind, and gives you a non-spoiling sense of what is coming. It is the warm-up question on Millionaire, designed to settle an anxious contestant down, so you might expect there to be little more to say about it. Now occasionally a preamble might introduce a key fact into the narrative — a kind of “Chekhov’s gun” that the reader must mark, bear in mind, make mental note of, and prepare for its discharge in the third act. The preamble to ISDA’s suite of Credit Support Annexes is no exception. There are not one, but now seven: the first was released to the Americans in 1994, a couple followed for the Brits in 1995, and four more came with the algal bloom of margin regulation in the latter half of the 2010s. The different CSA varieties have different preambles casually mentioning different firing irons fixed to the wall over the fireplace. So what is all that about, then? Credit Support Document or Transaction? The 1994 NY law CSA declares itself to be: ...a Credit Support Document under this Agreement while the 1995 English law CSA that followed hard on its heels reports that the credit support arrangements it documents: ...constitute a Transaction (for which this Annex constitutes the Confirmation). Isn’t that odd? In the ISDA universe, “Transactions” and “Credit Support Documents” are mutually exclusive things: one is an integral exchance done under the ISDA Master Agreement, the other an independent covenant that stands apart from the Aïessdiyé. Can the ’Squad, in their Wording, have meant them to be different?[1] Well, roll forward a brace of decades and see what has changed. It is the post-apocalyptic year of our lord 2016. The kind warm glow of ISDA watches over the planet’s “safe, effcient markets”. The CSA form has been updated for the new regulatory world — but the, hark! The same dissonance! The 2016 English law VM CSA, too, is a “Transaction” while its American brother the 2016 ISDA VM NY CSA is still a “Credit Support Document”! This cannot be — and not is it — an accident. Now, English lawyers like to collateralise by title transfer, and Americans by pledge. The reasons are deep and somewhat interesting — there are some essays about it in the premium content — but in any weather this leads to some profound conceptual differences between the forms of CSA, even if the practical differences are minimal. Title transfer CSAs are Transactions Since collateral passes under title transfer CSAs by title transfer, it is not a security arrangement as such: rather, the parties agree to transfer collateral to each other outright, with no expectations beyond the recipient’s conditional obligation to return something economically equivalent when trading circumstances require it. This return obligation is a debt claim against the recipient for payment of an equivalent asset and not any kind of bailment, custody arrangement or ownership right in the asset originally posted. Indeed, it resembles — is characterised as — an odd, highly personalised, self-referencing derivative Transaction. Security interest CSAs are Credit Support Documents Because they are traditional security arrangements, the security interest CSAs are characterised as “Credit Support Documents” and not “Transactions” under the ISDA Master Agreement. So a title transfer CSA works by eliminating the out-of-the-money’s indebtedness by creating an equal offsetting indebtedness which may, if push really comes to shove, be netted down to mostly nothing. A security interest CSA, by contrast, grants accepts some collateral and takes a traditional security interest over it as a surety for the indebtedness comprising that ISDA Exposure. That surety is a different covenant. It does not affect the quantum of the obligations under the ISDA: it comes into play only once they have not been honoured. These are theoretical, and not practical differences. In practical fact, the arrangements are identical. Still, this is magical, bamboozling stuff — deep ISDA lore — even though, at least where rehypothecation is allowed — and it almost always is — it makes no real difference, to the parties whether the collateral is pledged or title-transferred, because from the moment it is reused, the pledgor has only a “credit claim” against the secured party for its return. Credit support generally Credit support is designed to mitigate the frightful credit risks the parties present to each other by obliging them regularly to “cash up” their net Exposure. It should go without saying, but let’s say it: at any time, on a net basis, only one party can have an Exposure to the other. What with Independent Amounts — more of a vogue back in the 1990s in the ancient CSAs, more frowned on in the regulatory VM world of the mid 21st century — you could have both parties holding the other’s collateral, but variation margin, reflecting the actual mark-to-market value of actual transactions, could only be pointing in one direction at a time. “Credit support” transferred under a CSA is designed to offset, as closely as possible, the value of that overall “Exposure”: what the “out-of-the-money” party would owe the in-the-money party were all Transactions terminated and the ISDA closed out on any given day. The differences betwixt, and the impact of, regulatory margin Thanks to the global financial crisis and the subsequent move towards regulatory margin there are now, as I mentioned, six theoretically “live” versions of the CSA. They are as follows: The 1994 and 1995 versions may still kick around in name, but will have been heavily modified to comply with Reg Margin requirements. The main ones are the 2018 Regulatory VM CSAs — these tend now to be cash-only, zero-threshold, single-currency affairs. The Regulatory IM CSAs are a fact of life, if your portfolio is big enough to be in scope, but these are generally less operationally troublesome, though structurally complex. Most of the JC coverage will focus on the variation margin CSAs, therefore. Prime brokerage There is one corner of the market where CSA arrangements still differ a bit, and that is the Prime Brokerage world, where a customer will have a margin loan arrangement, stock lending, custody and cash accounts, and the broker will “net margin” the customer across its whole portfolio. There will still be VM CSAs, but they do quite a lot less lifting. There is a whole different part of this wiki devoted to that business. See prime brokerage. We will carry on with a deeper look at the theory and the practical differences below. Thanks for reading! This post is public so feel free to share it.

    30 min

  9. 09/13/2025

    Withholding tax and gross ups

    We’re no strangers to levyYou know withholding rules and so do I:Some tax commitment’s what I’m thinking ofYou wouldn’t get this from any other guy.I just wanna say I’m imputatingGotta make you understand: Never gonna gross you upNever gonna write you downNever gonna reach around and withhold youNever gonna make you cryNever gonn’ indemnifyWhat they can’t recharacterise can’t hurt you. We’ve known each other for so longI sealed your deed but you’re too reserved to stamp itInside we both know what’s been going onWe goin’ away, yes we’re gonna glamp itAnd if you ask me, I’m deferringMy cashflows to the next financial year: Never gonna gross you upNever gonna write you downNever gonna reach around and deduct youNever gonna make you cryNever gonn’ indemnifyWhat they recharacterise will hurt you. —Rick Astley’s IFA And to this end they built themselves a stupendous super-computer which was so amazingly intelligent that even before its databanks had been connected up it had started from “I think, therefore I am” and got as far as deducing the existence of rice pudding and income tax before anyone managed to turn it off. —Douglas Adams, The Hitch-Hiker’s Guide to the Galaxy We all know we are liable to tax on our income: this is in the “rice-pudding” category of “things that are deducible from first principles”. Now, broadly speaking, the taxman has three ways of extracting his slice of the action from the torrent of money sloshing around the financial system: he can take tax away, he can add tax on, or he can ask you to account for it later. Taxes he takes away, we call “withholding taxes”. Taxes he adds on, we call “consumption taxes” Generally, withholding and consumption taxes we call “indirect taxes” because a tax burden that ultimately falls on a person such as an employee, investor or purchaser is collected via an intermediary such as an employer, bank or retailer. The alternative is direct tax, which you pay yourself. Generally, you do this at the of the year by means of a tax return. Withholding taxes Withholding taxes are deducted from payments owed by intermediaries to the taxpayer. Here the intermediary remits the tax directly to the tax department on the taxpayer’s behalf. The best example of a tax withholding is P.A.Y.E. income tax. Withholding is often also applied on income payments under financial instruments — dividends, interest payments, but beyond that is pretty rare, for reasons I will come on to. Consumption taxes Consumption taxes are added on to the price of goods and services a taxpayer buys, so the seller acts as an intermediary, collecting the tax and remitting it to the tax department on the taxpayer’s behalf. The most common examples of consumption taxes are sales taxes, goods and services taxes and value added taxes — these are really just different names for the same thing. (For spods: the technical difference between VAT/GST and sales tax is that the former are payable at all points in the payment chain, whereas the latter are only payable on the final retail sale, though intermediaries paying VAT/GST can reclaim VAT on inputs, so the net effect is the same.) Direct taxes Or, as a last resort, the taxman can ask a taxpayer to give a full account, at the end of the year, for all her financial affairs by means of an annual tax return. Here the taxpayer must tot up all her earnings, incomings, outgoings, and credits she has received for taxes already withheld or surcharged, any taxable events, depreciations, imputation credits, concessions, benefits, exemptions and reliefs — and then apply the labyrinthine tax rules to it. For most of us indentured wage servants, P.A.Y.E. takes most of that pain away. For those outside the cosy embrace of formal employment, it is quite the process to work out, what ultimately must be rendered unto Caesar. This is a bane — it is a proper ball-ache — but yet a boon, because beyond P.A.Y.E. your tax liability falls on your net profit at the end of the year, so you can deduct your operating expenses from your income. You only pay tax on the difference, whereas a wage-earner pays tax on her gross income and cannot deduct her costs of providing her labour (her suits, bus ticket and so on). Note this difference: it is important when we get to the question of gross-up. Why tax departments like indirect taxes Tax departments like indirect taxes. They get paid sooner and more reliably, and if there is an overpayment, it is someone else’s problem to figure it out, prove it and ask for the money back. And putting the obligation on a payer at the point of payment means it is more likely taxes get paid. Equally, it is easier for a working stiff to not have to worry about receiving extra money, sitting on it, not “losing” it and then remembering to pay it when due at the end of the year. Having the whole ugly business handled automatically is, for most of us, a blessing. Likewise, hoping tourists pay taxes they owe on goods they bought and took home, or foreign investors pony up taxes owed on local interest and dividends is a bit wishful: it is better to take it first and let the taxpayers ask any questions they may have later. The tax department isn’t going anywhere: tourists you may never see again. The problem with indirect taxes This is all very well in these limited case where the final tax amount due is a determinable percentage of a given payment, as it is for wages, investment income, and certain types of retail sales. But most tax-relevant payments flying around the financial system aren’t like that. Payments made for goods and services between businesses don’t very well reflect those businesses’ final tax obligations. In fact, they bear no relation to them at all. A service sold today for £100 might cost the provider £95 to render. The provider should not have to pay tax, therefore, on that whole £100, but only on its net profit — in this case, £5. If withholding were imposed, the payer would be paying a £20 withholding in respect of a likely tax of just £1— being 20% of the actually realised £5 profit. But even that per-item net profit amount is variable. It is not determinable at the time the payment is made. The profit on a given transaction, at the point of payment for the service is a mystery. It will change from day to day as market conditions, supply, demand, and input costs fluctuate. Sometimes the provider will make a big profit. Sometimes it will the service at a loss. But in any case it won’t immediately know what its net profit on a given item is — and of course net profit is not itemised and determined per unit sold in any case. So business-to-business payments are hardly a suitable topic for indirect taxes which, by nature, are fixed, and meant to be a close-to-final estimate of the total tax payable on a given transaction. Hence: withholding taxes are generally not imposed on sales, and intermediaries are exempted from consumption taxes. Why salaries and investment income are different Salaries and investment income are the two unusual cases where indirect taxation, levied at the point of payment, is practicable. Since, generally, an employee can’t set her income off against her expenses — the tax is effectively levied on her gross income, not her “net profit” from her employment — she can’t write off her power-suits, penthouse suite, Maserati lease, luxury yachts and all-expenses paid week-long “conferences” in the Swiss Alps against her taxable income, as the self-employed gladly do. This is why, for the average working stiff, P.A.Y.E. is an effective and unobjectionable way of paying tax. There is little benefit to being paid money you are just going to have to pay back to the taxman at the end of the year. Investment income, on the other hand, is suited to indirect taxation because it is already a “net return” on a given transaction. Take a loan: I give you a million quid; you give it back. Expense-wise, we are flat. Assuming you remain solvent, the difference on the transaction is the interest you may me. That is my net return from the transaction. I do not incur any other costs specifically relating to this loan that I would not be incurring anyway. Taxing authorities are especially fond of indirect taxes on “cross border” payments from persons in their jurisdiction to persons outside it. Tax authorities have some, er, means of persuading their own citizens to pay their taxes. These are strangely ineffective against foreigners who do not have a meaningful presence — meaning assets — somewhere the tax authorities can conveniently park their tanks. Why all this matters: finance contracts vs commercial contracts All commercial lawyers are alike. Each tax lawyer is unique in her own way. Buchstein, Anna Carriedinterestova Now the Jolly Contrarian’s sophomore ramblings about income tax are all well and good — if you have made it this far, well done and thanks for bearing with — but you may be wondering what all this has to do with negotiating contracts. It is this: tax, insofar as it presents in legal contracts, baffles most practising commercial lawyers. They don’t care about it, they don’t understand it and they are not very good at it. They find people who are good at it to be weird. For commercial lawyers tend to be very much of a piece. They all enjoy the same things, talk in the same mannered way and do the same sorts of things — dull things — at weekends. You know them when you see them, by their dreary dress, dowdy haircuts, awkward dispositions and the peculiar mannerisms commercial lawyers affect when two or three gathered together. You know to avoid them at dinner parties: they make terrible “middlers”. Tax lawyers, on the other hand can be quite exciting, but often in alarming ways. They do not have a common type the way commercial lawyers do: among them will be balloonists, bike

    45 min
  10. LIBOR rigging

    03/28/2025

    LIBOR rigging

    This is a public episode. If you'd like to discuss this with other subscribers or get access to bonus episodes, visit jollycontrarian.substack.com/subscribe

    50 min
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Diving into the wellspring of that is the ISDA Master Agreement jollycontrarian.substack.com

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    The Jolly Contrarian
  • Years Active
    2024 - 2026
  • Episodes
    10
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    Explicit
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    © Olly Buxton
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