The New Lombard Street by Perry Mehrling

Author:Perry Mehrling
Language: eng
Format: epub
Publisher: Princeton University Press

The important point is that, because the swaps were arranged not as a swap of actual IOUs but rather as a swap of implicit IOUs, they were not treated as loans for regulatory purposes. As such, swaps provided a natural way to get around regulations designed for traditional bank balance sheets, regulations that typically scaled both required reserves and required capital to the size of the balance sheet. Here is the origin of the so-called shadow banking system. In this regard, note that Mr. Interest is in effect borrowing short-term and lending long-term, just like a bank, and is thus exposed to both liquidity and solvency risk just like a bank, but without the associated regulatory apparatus or support—no backup liquidity support from the Fed, and no backup solvency support from the FDIC. If the short-term interest rate rises above the contracted fixed rate, Mr. Interest will find himself having to come up with liquid funds to pay out on his (implicit) short-term liability, even as the value of his (implicit) long-term asset has fallen, leaving him with a capital loss as the swap moves into the money on the side of Investor.

It follows that Investor's risk hedge is only as good as his counterparty. This counterparty risk can be managed by requiring that Interest (and Default) post “margin” to ensure performance—this is the collateral that Fischer Black was talking about—but the counterparty exposure remains. If the value of the swap moves by more than Interest (or Default) can tolerate, exhausting their ability to post collateral, the continued viability of the risk transfer depends on the counterparties being able to cap their losses by engaging in an offsetting swap with someone else. In the brave new world of modern finance, risk management ultimately depends on liquid swap markets, and liquidity means shiftability.

Now, as the previous discussion of currency swaps has made clear, the source of market liquidity in the swap market is the swap dealer who makes a two-way market by quoting both bid and ask prices. In the absence of such a dealer, if a counterparty defaults before the end of the contract, whatever risk was being transferred by the contract reverts to its original holder, who must look around for another counterparty. Swap dealers take on this rollover risk by standing in between the ultimate counterparties. Just as in the case of currency swaps, the liquidity of the IRS and CDS markets depends on a dealer infrastructure that makes two-way markets in these swaps. And just as in the case of currency swaps, the willingness of dealers to make markets depends on their ability to hedge the mismatch in their swap book.

For the interest rate swap case, the Eurodollar forward market and the closely associated Eurodollar futures market provide a natural hedge.7 Imbalance in the underlying demand and supply of interest rate swaps thus shows up as an imbalance in the market for Eurodollar forwards and futures that pushes forward interest rates away from expected future spot interest rates.

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