Master of Derivatives and Shadows
Why this chapter
To understand how you can own the risk without owning the thing, and why whole pieces of the financial world live out of the supervisor's sight.
An analogy
Imagine you have an arrangement with a friend: you pay them a small deposit, and they buy a wagon of grain in their own name and promise to hand you all the profit from a rise in price and to demand from you all the loss from a fall. Formally the wagon is theirs: in their barn, in their papers, in their tax return. In fact it is yours: all the money from it is yours, and so are all the losses. From the outside nothing is visible — the wagon is not in your accounts, and the neighbors have no way of knowing that you have five such friends and a wagon with each. The ninth chapter is about that arrangement, and about what happens when the price of grain falls and the deposit stops covering the promise.
How it works
A derivative does not require money for the whole position — only margin. A total return swap: the bank buys the shares onto its own balance sheet and hands all the risk and all the return to the customer for a fee. The customer gets exposure several times larger than the margin — Archegos held $160 billion of positions on $36 billion of capital (×4.4, and more than that at peak leverage).
Eurodollars are dollars created by banks outside the United States: a London bank makes a dollar loan — and creates a dollar deposit the Fed cannot reach. Trillions of “offshore” dollars.
A stablecoin is a private version of a banknote: the issuer takes in real dollars, issues tokens 1:1, and puts the reserves into T-bills at interest. The issuer's profit = rate × reserves, and the token holders get zero.
The words of this chapter
A derivative
A contract whose value depends on the price of something else. It requires no money for the whole position — only for the collateral, and the rest stays a promise.
It was invented so that you could insure yourself against a movement in price without buying the goods themselves. Later the same instrument stopped being used for insurance and started being used to raise the bet.
Margin and the margin call
Margin is the collateral behind a deal, and a margin call is a demand to top it up urgently when the price has moved against you or your reliability in the counterparty's eyes has fallen.
It was invented so that a counterparty is not left with an unsecured claim. The recalculation runs daily, and sometimes more often.
TRS
A total return swap: the bank buys the securities for itself and passes all their income and all their loss to the customer for a fee. The legal owner is the bank, the economic owner the customer.
It was invented for convenience: the customer gets the position they want without the bother of custody and reporting.
A money market fund
A fund that promises to return what you invested at face value and pays a small income, putting the money into short securities. On the outside it looks like a deposit.
It was invented as a higher-yielding replacement for a bank account, for those who need a warehouse for large sums.
Eurodollars
Dollars created by banks outside the US: a London bank makes a dollar loan and creates a dollar balance in an account, without touching the American system at all.
They appeared not by design but by themselves: if a bank can create money with an entry, it can do it in somebody else's currency too.
A stablecoin
A private token promising an exchange one for one into ordinary currency. The issuer receives real money, issues tokens and puts what it received into short government securities.
It was invented for settlement on a blockchain, where a unit that does not jump about in price is needed.
Seigniorage
The income of whoever issues money: they receive interest on the reserves they have collected and pay nothing on their own obligations.
The concept is old: this is how mints and the first issuing banks earned their money.
What happens to the balance sheet
See where the risk hides in this chapter. In an ordinary purchase the security stands among the property of whoever bought it, and the size of the investment is visible in the same place. In a total return swap the security stands with the bank, while the result belongs to the customer, whose accounts show neither the security nor a debt — only the collateral that was posted. From the outside the position is invisible, and it is invisible to the customer's other banks as well. While the price is rising, everyone is happy. As soon as it falls, the demand for more collateral reaches everyone at once, and whoever sells first survives.
Where the money comes from here
The bank earns a fee for providing the position and interest on the collateral. The customer earns on the movement of the price, multiplied by how many times bigger the position is than the money they put in. An issuer of private tokens earns interest on other people's money while paying nothing at all on its own obligations. The ones who lose are those who believed a promise with neither an owners' cushion nor access to a central bank behind it: investors in funds that promise face value, and holders of tokens backed by tokens of the same issuer. Here is why this matters to you: before any promise to return your money at face value, ask what physically stands behind it and how fast that turns into money. If the answer is “another asset of the same seller,” there is no collateral — there is a mirror.
What people usually get wrong
The common belief. If I do not have the thing on my balance sheet, I do not have the risk on it either.
What is actually true. In a total return swap the security stands with the bank, while all the income and all the loss are the customer's. And in the customer's accounts only the collateral is visible.
The common belief. A token backed by another token of the same project is collateral too.
What is actually true. It is a mirror. A panic hits both sides at once, because both sides were issued by one and the same party. One such project evaporated within days along with 18.7 billion dollars of obligations issued.
The common belief. Only America creates dollars.
What is actually true. Any bank that has made a dollar loan has created a dollar balance in an account, wherever it happens to be. That is how a market worth trillions arose that the American central bank does not control.
After this chapter you will be able to
- read a position by its exposure rather than by the amount that left the settlement account
- tell the legal owner of an asset apart from whoever carries the economic risk on it
- see the difference between an obligation to return face value and a share in assets with neither capital nor insurance behind it
- establish where a token's reserves physically sit and whose bank account the way in and the way out run through
- recognize a construction where the collateral behind an obligation is another token of the same issuer
Check yourself
The customer posted collateral and got, through a swap, a position many times larger. Where is that position visible?
On the bank's balance sheet.
The legal owner of the securities is the bank, so they stand among its property. The customer's accounts show only the collateral posted. That is exactly why one customer's concentration across several banks was invisible to everyone, the banks themselves included.
A fund promises to return what you invested at face value. How does that differ from a bank deposit?
By the absence of a cushion, insurance and access to a central bank.
The promise is the same, and the supports under it are different. A bank has three supports: the owners' capital, deposit insurance and a lender of last resort. A fund has none of them, and in a mass exit the state has to rescue it outside any rules.
A London bank made a loan in dollars. Who created those dollars?
The London bank itself.
The mechanics are the same as in the first chapter: a claim appeared and a balance in an account appeared, only the currency belongs to somebody else. Such money lives outside the American system and does not obey its rules — until settlement is needed.
In short
You can receive all the profit and all the losses on something you do not formally own. All it takes is posting collateral and agreeing with a bank: the securities will be theirs and the result will be yours. From the outside a deal like this is almost invisible, so nobody knows how much of it you have piled up in total. While the price is rising everything is fine, and when it falls, money is demanded of you immediately and by everyone at once. The same thing happens with a promise to return what you invested at face value: if there is no real money behind it, it collapses within days.
Reading is half the job. In the academy this chapter is worked through by posting entries: you run the operations yourself and see whether the balance sheet still balances.