Lesson 20 of 25 · 7 min

A family office, 2021: how swaps concentrated the risk invisibly

Each lender priced the position it could see, and the position that mattered was the sum none of them saw.

The reason the 2021 episode is instructive is not the size of the position. It is that the position was, in a precise sense, unobservable. A total return swap leaves the economic exposure with the client and the hedge — the actual shares — on the dealer's own books, reported as the dealer's holding. The client's name appears in no shareholder register.

That invisibility runs in two directions. The market cannot see that a single holder has economic exposure to a large share of a company. And each dealer sees only the exposure it has itself written, plus whatever the client chooses to tell it. Margin was therefore calibrated by each firm against the exposure on its own books, while the aggregate across firms was several times larger.

The consequence appears in the exit assumption rather than the loss. Every dealer's risk model asks how long it would take to sell its own hedge. Each answer was tolerable. What none of them could compute was the time required to sell all of the hedges at once, which is the only number that mattered in the week that followed. Track 7 lesson 8 gives the general measure in days of trading volume.

Reported exposures across the financing counterparties in 2021 ran into billions of dollars each, and aggregate exposure was reported at a multiple of the amount any individual firm had written. Reporting rules for large security-based swap positions were subsequently changed so that economic exposure of this kind becomes disclosable.

Key terms

Synthetic exposure: Economic ownership of a share held through a contract rather than the share itself. It carries the price risk without appearing in any register.
Aggregation risk: The risk that several lenders each hold a tolerable exposure to the same client and the same asset, and that the sum is intolerable.
Days of volume: A position divided by normal daily trading volume. The honest measure of how long an exit takes, and it must be computed on the aggregate.

Worked example

Five tolerable books, one intolerable total

Illustrative figures scaled down so the arithmetic is followable; they are not the reported amounts. Five dealers each hold hedge exposure of 640,000 in the same share at a 15 percent margin requirement, in a share whose two-day tradable volume is 900,000.

Margin each dealer collects: 96,000
Each dealer's exit, in two-day volumes: 0.71x
Aggregate exposure: 3,200,000
Aggregate exit, in two-day volumes: 3.56x
Total margin held against it: 480,000
Uncovered loss on a 27 percent fall: 384,000

Each dealer was collateralised for a 15 percent move and could exit in under two days. Collectively they were collateralised for the same 15 percent and needed seven days, which is where the 384,000 came from.

Check yourself

Four dealers each finance 480,000 of exposure to the same share at an 18 percent margin requirement. The share falls 26 percent. How much loss is uncovered in aggregate?

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Educational only. Nothing in this lesson is investment, legal or tax advice, or a recommendation to enter into any transaction. Figures are illustrative and computed from the inputs stated in the lesson.