Betting the Business

When an end-user posts margin on a derivative, the cost of posting the margin is easy to identify. For example, if the margin is funded by drawing down on a line of credit, interest is paid on the credit line. The end-user also earns money on its margin account, so the net cost is the difference between the two cash flow streams. The size of the difference will vary through time and depending upon circumstances. For example, if, as time progresses, the market moves against the end-user, the margin account will be drawn down so that the difference between the two cash flow streams grows.

What about when a dealer bank sells a derivative and forgoes any requirement that the end-user post margin? Some people think the end-user is getting a better deal. If, as time progresses, the market moves against the end-user, it will accrue a liability with the dealer bank. But the end-user doesn’t pay any interest on this liability. So, these people evidently believe, the end-user is getting credit for free.

Actually, the dealer bank is not foolish enough to open a derivative trade with an end-user forgetting about the possibility that the end-user might accrue a liability. The dealer bank does charge for this credit. But the charge is not separately itemized anywhere. Where is it? It’s in the bid-ask spread. When the dealer bank sells the derivative, the terms of the sale bake in a profit. If the derivative is not margined, so that the dealer bank may end up extending credit it will set a wider bid-ask spread and bake in a larger profit.

Just because the price of credit is never separately itemized is no reason to believe the end-user isn’t paying the price.