Quick Takes: A dummies guide to trading interest rate swaps
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Ali Curi: Hi everyone, and welcome to ION Markets Quick Takes. I'm Ali Curi, and every week, along with my guests, Amir Khwaja and Chris Barnes, we take a quick dive into the headlines on the Clarus blog.

Let's get started. 

Hi, Amir. Hi, Chris. 

Amir Khwaja: Hi, Ali. 

Chris Barnes: Hey, Ali. How are you doing?

Ali Curi: I'm doing great. Welcome back to Quick Takes.

Chris, let's start with you. What's your Quick Take for this week? Which headline from the Clarus FT blog would you like to discuss? 

Chris Barnes: All right, Ali, this week is a very special week. This week marks the 10th anniversary of my first ever blog on Clarus. And sadly, that also means it's pretty much 10 years since I actually traded a swap.

And so I thought for today's podcast, rather than what is going on in the markets, regulation, et cetera, what I actually do is air the trading strategy that I actually employed, I used, when I was at a bank. The blog is called "A Dummies Guide to Trading Interest Rate Swaps." When soon as I wrote that, I realized that really plays two ways.

Like I could be saying, "I'm a dummy writing a guide to how to trade interest rate swaps," or I could just be being really insulting to the readers who all think they're dummies. I think what you need to do is go and read the blog and make your own opinion for that. First off, I think it's important to talk a little bit about where I'm coming from in terms of this blog.

So I started my career as a trader at HSBC. The first project I ever did for HSBC in the trading world was actually related to AI. Back in 2001, when I was at university, I wrote a dissertation, which looked at simple recurrent networks and how AI goes about learning patterns. And HSBC saw this dissertation and they were interested in using the tech behind it for some of their trading desks.

So I've always had somewhat of a systematic bent to the way that I look at markets due to that background. That project lasted about six months. At the end of that six months, I was hired onto the rates flow desk in London at HSBC. I spent nine, 10 years there basically trading flow. So when I say trading flow, what I mean is that I don't come into the office in the morning and go, should I be buying buns today?

Do I think that interest rates are going up or down? When I go into the office as a flow trader, I am there to facilitate client trading. So I have a whole book of risk, which has resulted from numerous client trades over the years. I have to manage that risk. I have to do trades as that risk decays, but I'm not actively going out and saying, "Right, today, I'm going to buy a thousand buns."

I'm really there, "I would buy a thousand buns if a client has come in and was on the other side for a swap or some type of structure." When I left HSBC, I then went to State Street. State Street, we were in the process of building a rates trading business. So of course, when you're building the business, that means that you don't have clients on day one.

So I've gone from a world whereby I'm facilitating client flow. To suddenly being sat at a trading desk and the role changes, you are suddenly coming into the office going is today the day that I should buy buns or sell buns? And what number am I going to concentrate on? And what I quickly found with that is, the worst thing that you can possibly do when prop trading, is go in and have no structure and just go in and go, "Right, I see value here. I think a stop losses is here. I will enter the trade here." Because you have so much almost emotional energy invested in each trade that you then put on that you're far too intrinsically linked to each of those positions. And what I found from a trading perspective is that I needed a structure. And so what I've done in the blog is I've laid down the structure as I see it.

And that really starts from, as a trader, "What responsibilities do you have?" You can't just approach trading going, "The only reason I'm here is to make money," right? Because you have to be humble. You have to accept the fact that at times as a trader, you will go through periods of losing money. And so you can't have your be all and end all to be, "I'm here to make money."

I had three, let's say "principles." Number one, is you have to be a responsible guardian of capital. The bank is trusting you with an amount of money, an amount of risk to put into the market. You have to do that responsibly. You are not there just to bet on red or black. You have to do it in a responsible way.

Number two, is that you have to treat every single trade as if it might be your last. If you got knocked down by a bus on the way home, how would you feel if a colleague then had to sit in your shoes, look at your book? Would they sit there and go, "This is an absolute mess. What the hell has he been doing?"

Or would they go back to number one, right? "This guy has been a responsible guardian of capital. I might not agree with the trades that are in the book, but I can see the structure around them."

And then number three is really a lead on from one and two. And that is that you want to structurally position the book so that if you do nothing and the market does nothing, you make money. You're in a worse position fundamentally, if you do nothing and the market does nothing, you're losing money. And the whole concept of term derivatives is that over time they decay. And so you're trying to structure the book so that you have that positive decay. So as time passes, you are making money.

That is something that I call "positive carry." A lot of traders will be very au fait with that term. Sometimes it's frowned upon. You know, you can't only have a book that is positive carry. You have to go back to one and two. You have to be a responsible guardian of capital and you need to treat each trade as if it's your last.

Using those three principles, my speciality when I was at State Street was the short end of the euro curve. So then I spent time researching, watching markets, looking at how I could apply those to very, very specific instruments, right? Because ultimately, as a trader, you have a limited world of actual products that you can trade.

And if you think about how easy they are to trade, then that world of product shrinks and shrinks. So I limited myself to looking at EURIBOR futures. So looking at Schatz futures, Schatz is a two year Euro government bond, and trying to structure the book against potential flows in interest rate swaps from future clients, maybe in FRAS as well, and creating a structure that is positive carry.

Now, I lay out exactly how I do it in the blog, probably not quite the forum to be starting to talk about microflies in EURIBOR and what the carry is between positive and negative positions. Suffice to say, there is a structure there where I say, "Of the first 12 EURIBOR contracts, I identify some as cheap and some as expensive. I want to be long, the contracts that I consider cheap, short the contracts that I consider expensive. The expensive contract should decay, should have positive carry to a cheaper contract, which is next to it." And you're trying to use frictions in the Schatz trading to go in and out of these cheap and expensive contracts.

And that kind of creates a flow type of dynamic in your book, which means you're trading a lot, you're in the market a lot, but you're doing it in a way that you're not crossing bid offers. You're always sitting on the bid so that you're filled on the bid side. So you're not paying away money by trading a lot. You're paid to trade. You've got positive carry. You're paid to do nothing as well. And structurally that creates, let's say a safe harbor, allows you to create meaningful risk. I could talk about this literally all day, right? I sat there, I lived and breathed this strategy for two years, and this is what I did. And it really worked. You know, you obviously have ups and downs, but I can hand on heart say that this strategy worked. With that stated, Amir, you've read the blog. Do you have any particular questions or clarifications on the, on the strategy itself? 

Amir Khwaja: So I guess firstly, it's a great blog for your 10th anniversary.

Chris Barnes: Thank you.

Amir Khwaja: I think rather calling it "Dummies Guide," personally, I would have called it "An Inside Baseball View on Swaps Trading." It's like deep in the nuance and the detail. So I think that's great. And also, you know, I like this concept. You talk a lot about "positive carry" because, we spend most of our time looking at mark to market, gain and loss, right? 

That we forget that essentially, if you're receiving more interest than you're paying away over time and nothing happens, that's a good position to be in, right? 

Chris Barnes: Exactly. 

Amir Khwaja: Personally, for myself, I lost sight of that when the market moved from accrual accounting to mark to market accounting, probably 30 years ago. Suddenly you move towards mark to market accounting, right? 

Chris Barnes: Yep. 

Amir Khwaja: First to accrual accounting and that sort of, it's great to see that's important and the focus on that. And it's not just a case of buying supporting bid offers, right? So I guess my other question would be, how much of this strategy is institutional to the desk and everyone does it and how much is it individual and are there different ways to support flow market making? Is there institutional? 

Chris Barnes: This is something I didn't want to put on the blog. I think it's more of a conversational thing. At the first bank I worked for, I was never taught to trade. I was taught about risk. I was taught how to price a swap. I was taught about the models. I was never taught how to manage that risk.

That was always very much a personal decision. When I left State Street, I was I learned that certain banks and in particular, very large American banks, they have an institutional way of trading and everybody comes in and everybody is taught these first principles from scratch. I came from a bank where for eight years I was doing it, for clients, more by feel. There was obviously a structure around it, but there was not an institutional approach to risk taking, to suddenly having my eyes opened and going, "Okay, there is another way of doing it." And I think that made me fall in love with trading again, because you're doing something that you've been, essentially the same job, but then you're learning and doing it in an entirely different way. And both ways make sense. And that is very much the joy of trading is that you can recreate and reinvent time and time and time again.

As I said, Ali, I could talk about this all day. I think we're gonna run long, so maybe we cut it there, for now. More than happy to I do a part 2, 3, 4. That was a dummy speaking about how he used to trade the interest rate swaps curve. 

Ali Curi: Okay, thank you Chris. And just for clarification, please share with us again the title of your blog post.

Chris Barnes: "A Dummies Guide to Trading Interest Rate Swaps."

Ali Curi: Great. That works. Amir Khwaja, Chris Barnes. Thank you both for sharing your Quick Takes.

Let's do it again next week. 

Amir Khwaja: Thanks, Ali.

Chris Barnes: Thanks, Ali. See you next week. 

And that's our episode for today. You can read more about these topics on the Clarus blog, and you can follow ION Markets on X and on LinkedIn. 

Thank you for joining us.