Future, Forwards, Kittens, Swaps, How Many Were Going to St. Ives?

There was a discussion on huffpo live the other week about futures and "the futurization of swaps" [scary! buy another AR-15!]. The panel was good but from the comments and questions it's clear there is a ton of confusion around basic concepts and terminology.


Derivatives
A nebulous term that pretty much covers any financial instrument (think "tradeable") whose value is derived from something else (an "underlying"). Yeah, I know, that's not particularly helpful. It's easier to understand by example. If I buy a truckload of corn from you, that's not a derivative. If you and I agree that I will buy corn from you exactly one year from now for a specific price, that's a derivative. If you buy stock, that's not a derivative. If you buy a simple option on stock, that's a derivative. Derivatives can be really simple and straightforward, like those examples, or they can be so complex that almost no one, including the people pricing and trading them, can understand them. Blanket claims about derivatives being destructive or evil should be avoided. Warren Buffet had a quote about derivatives being "weapons of financial mass destruction" that gets universally misunderstood and overused. He wasn't talking about stock options or currency forwards.

Swaps
Speaking of misunderstood and overused, how 'bout those "swaps"? This word gets used interchangeably, as if interest rate swaps, fx swaps, asset swaps, credit default swaps, and so on were all the same thing. They're not.

First, let's make up a new type of swap: The NBA Scoring Rate Swap, the "SRS". This will be based on two numbers: one is a fixed number that we simply set and agree on, the other is a variable number based on real-world observations. The difference between the fixed number and the observed/variable number will be used to see who pays whom what. In our SRS, we'll say that the variable number is the number of points scored by a particular NBA team in each game. The fixed number can be anything we want. So maybe you're interested in an SRS on the New York Knicks. We'll set the fixed scoring rate at 100 points per game. The variable scoring rate will be however many points the Knicks score in each game. Suppose you're the client and I'm the dealer and you come to me wanting to enter into an SRS agreement on the Knicks. You can either "pay" the fixed number and thus "receive" the variable number, or vice versa. I'm a dealer, I don't really care. But if you want the SRS based on a specific fixed number, I'll price it up based on my forecasting models for how many points per game the Knicks are going to score, and depending on the difference between that and our agreed fixed points per game, there might be a fee involved in entering into this deal.

So anyway, say you want to pay me a fixed scoring rate of 100 points per game, and receive from me however many points the Knicks actually score in each game, and we agree that each point is worth $1. My models forecast that the Knicks will score 99 points per game, so I think I'm likely to make money from this and thus we enter this agreement at no charge to you. So how does this work? Well, in game 1 of the season the Knicks score 104 points, so I pay you $4. Prior to game 1 we knew that you'd pay me $100 regardless, and I'd have to pay you $1/point once the game was over and the variable number for that game became known. To not be tedious we net the numbers and exchange only the difference. In game 2, the Knicks score 100 points and no money changes hands. In game 3 the Knicks only score 88 points so you pay me $12. And so on for the entire season.

So we entered into an agreement such that each Knicks game would end up generating a cash flow between the two of us, and that cash flow would be based on the difference between the points they score in each game and 100. Why would you want to do this? I have no idea, and as a dealer I don't really care. My *sales* staff might care. They might come up with a variety of reasons why you should want to do this. Maybe you run a taco stand and have a promotion to give away some food whenever the Knicks score more than 100 points in a game so want to hedge your losses. Or maybe you have a view that the Knicks will score better than everyone expects and want to try to make some money from this view. Doesn't really matter.

So that's a pretty simple swap and we can probably agree that doesn't seem particularly nefarious. We might touch on this example later as we look into collateral, but for now let's talk about some real swaps.

FX swaps: "FX" stands for "foreign exchange" and means currencies. [Possibly a topic for another post, but I think the notion of exchange rates and how they are "set" via the workings of a free market is completely baffling to a large number of people.] And FX swap is exchanging currencies now(ish) and later exchanging them back (more or less). I'll buy some ££ from you this week, paying you in $$, and 3 months from now I'll sell you back ££ and you'll give me $$. Why we'd do this and how we determine the exchange rates doesn't really matter, the point is that basic FX Swaps are simple things and even Warren Buffet doesn't lose any sleep over them.

Interest Rate Swaps: a basic interest rate swap (IRS) is similar to our SRS, above. One side pays or receives based on a fixed interest rate while the other side receives or pays based on a variable ("floating") interest rate. Anyone who has looked at mortgages should be able to understand this. Maybe you want to exchange the uncertainty of variable cash payments for something fixed. These can be pretty straightforward and not very evil. Variations, on the other hand, can be fiendishly complex, especially when various types of interest rate instruments are "structured" into a single complicated deal.

While basic interest rate swaps can be pretty easy to describe and understand, they can still cause trouble if entered into by people who don't fully grasp the ramifications of the agreement. Many of them last for many years and are sometime regretted. In the US, municipalities are allowed to enter into agreements that, probably sensibly, local governments in other countries (e.g. UK) are prohibited from. Interest rate swaps can be made arbitrarily complex and terms can be obfuscated and dealers can "mis-sell" them. Local governments and unsophisticated business entering into complex deals with investment banks are kind of like a gambling neophyte stumbling into a smokey back room at an illegal club and misinterpreting the welcoming smiles of the poker players around the table as friendliness. There's been no shortage of irresponsible behaviour around all sides of that table.

Credit Default Swaps: now we're talking. I don't know why these are called "swaps". Here's the simplest way to understand them: they are default insurance. If you buy "protection" in the form of a Credit Default Swap (CDS), you are buying insurance to pay you in the event of a company defaulting on its debt obligations. This makes a tremendous amount of sense if you have actually lent that company some money (by buying its bonds, say), in which case, you have an insurable interest. Suppose you have no insurable interest in that company. Why are you allowed to buy insurance on it without an insurable interest? I have no idea. You are not allowed to buy home insurance on your neighbour's home, for hopefully obvious reasons. Suppose an employee of yours takes out a big car loan. Should you be allowed to buy insurance such that if he misses a loan payment you make some money? Welcome to the world of CDSs. So these are pretty simple conceptually but very strange in practice. And I hope it's clear that there's a pretty big difference between a CDS, an IRS, an FX Swap, and an SRS such that using a blanket term "Swaps" when trying to have a meaningful discussion about, say, industry reform, can be counterproductive.


So what's all this about "futurization" and exchanges and such?
Let's forget about swaps for a moment and look at some more terminology.

Futures & Forwards
If you and I agree that 6 months from now I will buy 100 gallons of frozen orange juice concentrate from you for $1000, that's a forward. If we did that on an exchange, we'd call it a future. When we're talking about futures, we're using shorthand for a whole bunch of features that come with something being a "future" rather than a bespoke "over the counter" [OTC] agreement. Being a future implies the product is regulated, standardized, and is valued (maybe) and margined (definitely) differently. More on that in a minute.

Collateral
Suppose we've done the Knicks Scoring Rate Swap above and, shortly after agreeing on the deal, the top 3 scorers on the Knicks all get lost for the season to injury and the coach announces a new "defense first" philosophy. Looks like their scoring will go way down, and you'll potentially be owing me a lot of money. My calculation of the theoretical value of the deal now shows it is worth much more to me, but I'm worried about actually realizing all that profit. So I ask you to post collateral with me. This is pretty similar to a loan, in that I think you owe me a lot of theoretical money in the future, so have effectively extended credit to you, and want you to post collateral with me as a bit of protection. Suppose further that 2 weeks into the season the remaining good scorer on the Knicks is traded for a defensive specialist. I think the value of the deal is even more in my favor, and I calculate the difference in collateral I think you should post to me, and politely tell you about it (margin call!).

This could have easily gone the other way -- with the Knicks dumping all their defensive players, hiring a "shoot early and often" coach -- in which case you would want collateral from me. If I'm a big SRS dealer and you're a small client, I would never want to have to post collateral to you but would require it from you. So you don't have any way to mitigate the risk of dealing with me as a counterparty but hey, I'm a big bank, what's the worst that can happen? If by contract or regulation we each have to post collateral to each other this is a "bilateral" agreement. This is much more common now than it was six years ago, as you might guess.

So getting back to futures: when you trade a future you have to post collateral based on an initial margin calculation and then you pay or receive funds every single day based on the new value of the thing you've traded. (Valuing by observed traded prices is called "marking to market". Valuing by whatever method you invent is "marking to model".) So if we've entered 6-month frozen orange juice concentrate futures contract each of us will pay or receive based on the price fluctuations daily. The price could fluctuate massively but since we settle up each day, rather than at the end, the risk of not getting settlement (all the things ultimately owed) is greatly mitigated.

Exchanges
If we do "exchange clearing" or settle via "clearinghouses", what this means is that a central body -- exchange/clearinghouse -- becomes the counterparty. If you do the initial trade on an exchange, rather than over-the-counter, settling this way is part of the bargain. But it is possible -- and in the future will be increasingly mandatory -- to do a trade over the counter but then move ("novate") the trade to a clearinghouse to deal with the rest of the life of that trade as far as settlement is concerned. What this really means is that you no longer care who you did the trade with, the central body becomes your counterparty. If First Bank of Rufus goes bankrupt you don't care, the exchange still makes good on the money owed to you for the rest of the life of the SRS or the Frozen Orange Juice Concentrate Future or whatever other things we'd traded but moved onto the exchange for settling.

So rather than having to manage counterparty risk and collateral agreements with every single entity you trade with, an advantage of the exchange model is that you really only face off with 1 -- the exchange.

So what's "futurization" then?
Well, there are a couple aspects. One is simply requiring clearinghouses to deal with settlement. The other is going farther and requiring standardization of instruments so the traded instruments are more fungible and observable.

One More Word On Collateral
This post has really gotten out of hand and is most likely incomprehensible because I can't be bothered to edit or rewrite it, but one important thing to understand about collateral: different collateral has different "quality". If you get a collateralized loan at your bank the bank will discount ("haircut") the value of what you're signing over to them as collateral. If you use your car, they might discount 50% vs. blue book value. Your house might be discounted much less. Your beer can collection much more. The entity effectively extending credit can be as flexible as they want on what they take as collateral, but they discount based on quality.

Unfortunately, exchanges are going the way of accepting only very high quality collateral rather than simply accepting a range of quality and haircutting appropriately (we're talking bonds here mostly, not cars, jewelry, or houses). This demand for high-quality collateral has some bad effects -- actually increases systemic risk and decreases transparency, but that's a topic for another day.