Liars Poker is a book my Michael Lewis about his time in the 1980s as a bond salesman in the now infamous Salomon brothers. In the book, he describes the game named in the title (Liars Poker). I know it more commonly as bluff. You hand out the cards, the first player picks a number, and puts down n cards of that numbers "3 Ace's" for example. Now, once you do that, the other person, based on their cards, has to guess if you're a big fat liar.

This is a very basic game illustrating something - this is betting game, based a lot on luck, a bit on your cards knowledge, but mostly luck, and reading people. You base it on how much you trust them, with some level of know they might be bullshitting you.

Now - What are swaps? A year ago, I started work in a financial services company. I had to work with some "instruments" called derivatives. So I started, in my free time, reading a bit about it. Why is this important? well as it turns out a lot of the big banks are exchanging money with each other. These instruments are probably working to give you the returns on your accounts. And what do they work on exactly?

So first - bonds. The very basic thing - a loan. That is all a bond is. It is loan, with a bunch of extra things to attached to it. But at it's very core, it is a loan. When a government issues a bond, you are simply lending it money, which it returns back to you in small increments with interest.

THAT is it. Nothing more. Now, you take this simple loan, and you start trading it with other people - that is a bond. Basically, who you can trade your share in the loan with other people. Why would you trade it? Perhaps you can no longer afford it. The return rate fluctuates for various reasons. Because people want to ? Put a pin on it.

Now, let us say you are an Indian company, and you have borrowed money from the Indian bank in rupees. Now, there is another company, and american one, large multinational, which wants to borrow in rupees. They think this will be profitable for various reasons. Put a pin on it. On the other hand, you want the attractive interest rates that a multinational corp gets. So you and this big american company exchange your interest rate payments. I scratch your back you scratch mine type of situation. This is what a swap is. At it's very basic level, it is SPECULATION about interest rates offered to another party. And the only reason the other party would get different interest rates is due to thier creditworthiness.

The Indian company can afford to pay the loan back at interest rates offerered by US treasury. But because they are less notable in that market, less CREDITWORTHY, they are not offered the same features. So our big American company offers to sidestep this whole beauracratic thing, and offer the Indian company the good rate (which it believes it will pay back). In return it converts its dollars to rupees each time to pay the Indian company's loan.

This is exactly what happened in the first swap deal in the 1980s, brokered ofcourse by Salomon brothers. It was between IBM and the World Bank. In this case, the World Bank wanted to borrow Swiss Francs but did not have access to it's market (the swiss government had put a limit on World Bank borrowings). IBM , for some reason, had a lot of Swiss franc debt. It wanted access to the U.S Treasure rates the World bank had access to. So they essentially Swapped their loan payments for an agreed upon period. IBM paid the US dollar loans, and the World bank paid the swiss franc loan. This was the world's first currency swap.

A question I always had was - WHY do interest rate fluctuates. What does this mean - bond price, yield etc. Why are people not being offered the same rates anyways. Effectively, why can't you scratch your own back. Well you just can't reach there. In the same country for example, two parties may have wildly different "credit worthiness" on the surface, but may, in reality, according to the playing parties, have different abilities. Interest Rates change, or ability to borrow changes. An interest rate is the "cost of borrowing" or the return on spending. If you think, you have a lot of people asking for money from you (a bank) then you can offer the people giving you money to allow for these transactions a better return. But if those same borrowers stop return your money, you can't give back as much. It is not a static loan, it changes because people's demands change. And any swap is just a way to speculate on what this could be.

So, this is just one kind of Swap. But there are many - Interest Rate, Credit Default, etc. Many of them have had a huge effect on our lives in a million invisible ways. And it is all based on CREDITWORTHINESS DIFFERENTIAL. Who is creditable, for what reason? Are those reasons valid in the eyes of market players. So effectively, are your cards good, and are you lying, or not?

References

1.World Bank Document Explaining Swaps
2.Case Study Explaining the original Swap mechanics
3.Liar's Poker

Post Notes

1. I'd like to point the reader to the fact that Salomon brothers was also the place where the infamous Mortgage Backed Security was born. So if you were at all affected by the Global Financial Crisis in 2008, you know where it started atleast. And the people who started it with real pieces of work. Eating cheeseburgers at 8 AM in the morning, betting on coworkers' running races, cursing out MBAs - that was their lifestyle. A lot of the finance sector has been professionalised since 2008. Perhaps that is for the best. But atleast the gluttony was visible then. The name of the Book Liar's Poker comes from a time the heads at Salomon brothers jokingly played the game for a million dollars. But the players knew they weren't joking at all. They knew the real deal. These people will bet on anything.

2. This post was written after a prompt in Bangalore's Indie Web Club. "Write about a topic you're an expert on to introduce it to a beginner". I am not an expert - call it enthusiastic learner. But I have read a bit about this, and wanted to collate it somewhere. So, a note of thanks to them.