What might be the largest margin call in history is ringing fresh alarm bells on Wall Street among those worried about hidden leverage and its potential to fry the financial system. The forced selling of the apparently swap-linked shares at Bill Hwang’s Archegos Capital Management has set off a hunt for other areas of excess — from margin debt to options and bloated balance sheets — after stocks at the centre of a $20 billion block-trade selling spree plunged and investment banks warned of losses.

Today we can share more insights of TRS with you.

Definition of Total Return Swaps (TRS)

A Total Return Swap is a contract between two parties who exchange the return from a financial asset between them. In this agreement, one party makes payments based on a set rate while the other party makes payments based on the total return of an underlying asset.

A TRS is an OTC contract. The maturity and payment schedules is down to the two parties to agree. Depending on the specifics of the contract, the underlying asset may or may not be exchanged between the parties.

The two cash flows are usually referred to as “legs” of the swap. The leg referred to as the floating leg is pegged to a floating rate such as LIBOR. The other leg of the swap referred to as the equity leg is based on the performance of either a share of individual stock or stock index. Unlike interest rate swaps, the equity swap notional resets on each cash flow reset date, depending on the performance of the underlying asset.

Equity swaps allow parties to potentially benefit from returns of an equity security without the need to own its shares. In general, a party enters an equity swap with the objective of either obtaining return exposure or hedge existing equity risk for a period of time.

The most important question we would ask is why people would consider TRS. Here we are.

1. TRS contracts are used for funding

· TRS contracts could include the exchange of the underlying asset. In such a situation, the total return payer party would be delivered the underlying asset.

· With the transfer of the asset and the referenced payments, this contract is unmistakenly starting to look a lot like a repo transaction. That is, the TRS allows us to create a Synthetic Repo Transaction.

· A financial institution then that is looking to fund some of its assets in on its balance sheet could use a TRS instead of a repo transaction.

2. TRS can provide exposure to restricted markets

· In some instances, investors are restricted from accessing specific markets or simply too cumbersome to do so (i.e. accessing the Indian stock market). In these cases, a bank can enable its investors to have such an exposure by structuring a TRS.

3. Other advantages

Other advantages of entering a TRS contract rather than outright buying the reference asset are the usual advantages of OTC contracts. These include:

· You can reference a Notional amount without putting down the total sum (leveraged exposure)

· You can choose your counterparty

· Your firm’s trading mandate may not allow exposure you to hold the underlying asset

· Equity swaps can be also used to avoid transaction costs (including Tax), to avoid locally based dividend taxes

What could be underlying asset?

The underlying asset may be a bond, equity interest, or loan. Banks and other financial institutions use TRS agreements to manage risk exposure with minimal cash outlay. However, in recent years, total return swaps have become more popular due to the increased regulatory scrutiny after the alleged manipulation of credit default swaps (CDS).

What’s included in the “Total Return”?

The total return payments usually include coupons, commissions and price changes of the underlying asset. If the price of the asset goes down, then Party A would be the one paying the total return (Notional * (Change in the underlying asset price)).

Characters of TRS

· Referenced Index

· Spread

· Notional (and whether it’s fixed)

· Pay/Receive

· Price of the Swap

· Dates (effective, maturity)

· Frequency of payments

The most popular types of TRS

Credit Derivatives

The most common type of TRS is that of which the underlying referenced asset is debt (or securitised debt). Examples of such a product could include a Bond, CLO, ABS, MBS, CLN or a Loan (or a basket of these).

This is why the TRS with such underlying is called a credit derivative, as Party A, from the above example, would synthetically be getting exposure to the underlying asset.

Equity Derivatives

Another type of a TRS is that where the underlying asset is that of an equity, an index or a basket of equities. They are usually structured to either reference the total return (changes in price, dividends, commissions, etc.) or only the changes in price.

Having mentioned the characters and benefits of TRS, we need to talk about risks that we need to be aware of.

Credit Risk

As it is the case with most OTC products, there is always counterparty risk. TRS are no different. There are, however, two components of Credit Risk exposure which needs to be considered:

Your counterparty in this transaction could default, before delivering the relevant payments.

The referenced asset’s issuer could default, hence causing the price of the asset to decline.

Market Risk

· Interest Rate risk from the reference rate and the underlying asset

· Equity risk — if the underlying is an equity

· Currency risk — if the payments are in a different currency than the asset