What is a Swap?
A swap refers to an agreement between two parties to exchange the cash flows or liabilities from two different financial instruments. The financial instruments swapped can be anything but often involve two ‘legs’: a fixed cash flow (e.g., a loan or bond) and a variable cash flow based on an index price, commodity price, benchmark interest rate, exchange rate, etc. The most common kinds of swap are interest rate swaps and currency swaps.
Swaps, unlike futures contracts, do not trade on exchanges. Rather they happen over-the-counter (OTC). This means buyers and sellers directly negotiate deals among themselves, tailoring each trade to meet their respective needs. While OTCs have their benefits, the lack of standardization and protections can make them vulnerable to defaults.
In this article, the Zero Theft Movement will take a deeper look at swaps and how they work. Keep reading if you want to see how you and the U.S. economy might have been affected by one kind of infamous swap.
Long-Term Capital Management alleged trading strategies eventually failed catastrophically and led to a $3.65 billion bailout in 1998. Should the government have intervened as the lender of last resort? See what the ZT community has uncovered…
Understanding Swaps
Financial players use swaps to acquire a different scheme of payments that better fits with their business/investment needs or goals. Retail clients, investors, or even corporations can have swaps in their portfolios.
All swaps must have the following conditions established:
- The start and maturity dates for the deal
- A nominal price to calculate payments for both sides
- The interest rate, or margin, for each party
- Index of reference for the variable leg
- Frequency of payments
DID YOU KNOW?
The market for swaps represents 80% of the global derivatives market and amounted to $320 trillion at the end of 2015.
Why Swap Financials?
Financial players would want to use swaps for two main reasons: commercial needs and comparative advantage.
Commercial needs
The standard business operations of certain companies can incur interest rates or currency exposures. Swaps allow these businesses to circumvent these extra costs. For instance, a bank might be paying a floating rate of interest on deposits and earning a fixed rate of interest on loans. To match its liabilities to its assets, the bank can use a fixed-pay swap to exchange its fixed-rate assets into floating-rate interests. The variability of its liabilities and assets, therefore, align.
Comparative Advantage
Some companies might want to gain a comparative advantage by swapping for their desired type of financing. Take, for instance, a U.S.-based company that wants to establish itself in Europe. The business has a strong presence nationally, but no foothold overseas. That means it will have a much more difficult time finding favorable financial terms outside of the U.S. To gain a comparative advantage, the company should execute a currency swap in the U.S., providing them the necessary euros to finance its expansion.
Different Types of Swaps
While we have already mentioned different types of swaps, let’s take a closer look at how these trades occur.
Interest Rate Swaps
The most common type of swap, the interest rate swap enables parties to exchange cash flows based on a notional principal amount. Both sides can execute these swaps to either hedge against interest rate risk or to speculate.
To explain how interest rate swaps work, consider them in their simplest, ‘plain vanilla’ form. On one side, party X agrees to pay party Y a fixed rate of interest (dictated by a notional principal) on specified dates (known as settlement dates). Party Y agrees to pay party X a floating interest rate (this too dictated by the same notional principal) on the specified dates. As swaps are OTC contracts, interest payments can happen annually, quarterly, monthly, or on any other schedule that both parties agree to follow.
The LIBOR scandal uncovered alleged manipulation of a global interest rate. Millions of contracts, including swaps, could have been affected by major banks potentially involved in the case.
Commodity Swaps
Commodity swaps involve the trade of a floating commodity price for a set price over a period. Businesses would want to execute a commodity swap in order to hedge against price fluctuations and budget. They get to lock in the current spot price of the underlying commodity.
The underlying commodity must involve a physical product, such as oil, livestock, or coffee beans. Crude oil is the commodity that gets traded most globally.
Currency Swaps
In a currency swap, parties exchange interest and principal debt payments in different currencies. These swaps do not have a notional amount as the principle, but it still gets exchanged.
Countries and businesses can engage in currency swaps. Due to the recent pandemic, the U.S. opened up 14 ‘swap lines’ to help other countries weather the major economic downturn. According to an NPR report, “Dollars are the lynchpin of global trade. International loans, debts, and bank transactions are largely done with dollars. Foreign central banks need dollars to stabilize their financial systems. The dollar isn’t just America’s money. It’s the world’s money. It’s why when the COVID-19 crisis hit, there was a record-breaking rush to get dollars around the globe. And the Fed is the only institution with the power to print them.”
Debt/Equity Swaps
Debt/equity swaps involve trading debt for equity. A publicly traded company would exchange bonds (i.e., debt) for stocks (i.e., equity). These swaps allow businesses to refinance their debt or maintain a target debt/equity ratio.
Total Return Swaps
Total return swaps refer to when the total return from an asset gets exchanged for a fixed interest rate. The financial player who pays the fixed-rate receives exposure to the underlying asset. For instance, an investor can pay a fixed rate to another investor in exchange for the capital appreciation and dividend payments of a pool of stocks.
Credit Default Swap (CDS)
Credit default swaps (CDS) involve an agreement by one party to pay the lost principal and interest of a loan to the purchaser of the CDS in the event a borrower defaults on a loan.
Overzealous investment in CDSs has been cited as a major contributor to the 2008 financial crisis. In essence, the expansion of credit default swaps in the 2000s resulted in the boom of credit default obligations (CDOs). Essentially insurance for the debt in case it defaulted. Hedge funds, banks, and…AIG, a corporation with little relation to the industry, handed out the insurance liberally. But AIG was the odd one out for more than one reason.
Reuters reported that “AIG was on one side of these trades only: They sold CDS. They never bought. Once bonds started defaulting, they had to pay out and nobody was paying them.”
The Center for American Progress, an independent nonpartisan policy institute, claimed “At the time, borrowers’ protections largely consisted of traditional limited disclosure rules, which were insufficient checks on predatory broker practices and borrower illiteracy on complex mortgage products, while traditional banking regulatory agencies…were primarily focused on structural bank safety and soundness rather than on consumer protection…In many of these cases, brokers offered loans with terms not suitable or appropriate for borrowers. Brokers maximized their transaction fees through the aggressive marketing of predatory loans that they often knew would fail.”
Better Markets estimates the 2008 subprime mortgage crisis caused upwards of $20 trillion in lost GDP. See what your fellow citizens have discovered about the potential economic foul play that might have caused the biggest financial collapse in history.
Have you Lost Money due to Manipulation in Futures Contracts?
Swaps play a major part in the global financial economy today. They allow parties to strike deals and achieve their business/investment goals. Their significance makes proper regulation and oversight all the more important.
As illustrated by the role of CDSs in the 2008 financial crisis, irresponsible and sometimes even corrupt financial players can build too much leverage through swaps. Couple that with the lack of standardization with these financial instruments and you have a recipe for disaster. Retirements, investments, savings, job opportunities all took a hit due to the crisis. Some bankers profited from the disaster they’d allegedly caused.
The Zero Theft Movement is dedicated to finding and eliminating the rigged parts of the U.S. economy so that American businesses and citizens can flourish. Our community works to calculate the most accurate estimate for the monetary costs of corruption in the United States.
We achieve this collectively through our independent voting platform. The public investigates potential problem areas, and everyone votes on whether (1) theft is or isn’t occurring in a specific area of the economy, and (2) how much is being stolen or possibly saved. Through direct democracy, we can collectively decide where the problem areas are and start working on addressing them systematically.
Only through hard evidence can we prove where the rigged parts of the economy exist and force Congress to hold all the bad actors accountable.
Standard Disclaimer
The Zero Theft Movement does not have any interest in partisan politics/competition or attacking/defending one side. We seek to eradicate theft from the U.S economy. In other words, how the wealthy and powerful rig the system to steal money from us, the everyday citizen. We need to collectively fight against crony capitalism in order for us to all profit from an ethical economy.
Terms like ‘steal,’ ‘theft,’ and ‘crime’ will frequently appear throughout the article. Zero Theft will NOT adhere strictly to the legal definitions of these terms (since congress sells out). We have broadly and openly defined terms like ‘steal’ and ‘theft’ to refer to the rigged economy and other debated unethical acts that can cause citizens to lose out on money they deserve to keep.
