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von Holger Langer, LL.M.

Swaps and Derivatives

A. Definition of swaps and derivatives

I. Derivatives

  • three main groups of financial products
    • exchange traded futures and options
    • debt obligations with “unusual” rates of return
    • individually negotiated, bilateral, OTC notional amount transactions, such as
      • swaps with payments based on movements in interest, currency, equity or commodity indices or other priceable variables and
      • swap-related products with characteristics similar to options, such as caps, floors etc.

II. Description of swaps

A swap is an agreement between two parties to pay each other a series of cash flows, based on fixed or floating interest rates in the same or in different currencies

1. Interest Rate Swaps

  • obliges the first party to pay an amount equal to interest which
    • would accrue on an agreed notional amount
    • during calculation periods
    • within an agreed term
    • at one type of interest rate
  • obliges the second party to do basically the same
  • to the extent that payment dates are simultaneous, the parties typically net payments, with the party owing the larger amount paying the difference to the other party
  • notional amount in interest rate swaps is not paid!!!
  • Three basic types
    • fixed (e.g. 8%) to floating (e.g. LIBOR)
      • at the end of the calculation period, interest is calculated on the basis of the notional amount for both interest rates, the amounts are compared and the difference is paid by the party owing the larger amount
    • floating to floating
    • fixed to fixed
      • one party might have an uneven cash flow, e.g. estimated revenues in uneven periods of time, but might want to level this out for tax or accounting purposes
      • the swap would exchange a fixed interest rate over the term against payments based on a fixed schedule

2. Currency swaps

  • obligations
    • first party to pay an amount in one currency, usually at periodic intervals
    • second party to pay an amount in a different currency at the same or different intervals
  • amounts may be expressed as
    • stated amounts (implicitly inclusive of interest and principal) due at stated times
    • interest accruing on notional amounts in different currencies + exchange of those notional amounts at maturity
  • not uncommon to have the notional interest rates in a currency swap calculated on different bases so that effectively interest rate swaps and currency swaps are combined
  • payments, even if due on the same date, are usually not netted but paid gross
  • Three types (fixed to floating, floating to floating, fixed to fixed)

3. Variations / Fully paid transactions

  • some variations exist in which one party fully performs on the effective date, while the other party has a contingent obligation in the future depending on rate movements (similar to options)
    • cap
      • the purchaser of a cap pays the seller of the cap a fee, usually at the beginning of the term
      • if the actual interest rate determined on the specified basis (e.g. six month LIBOR) exceeds the agreed upon cap rate (strike level, e.g. 8%) for any calculation period, the seller pays the purchaser an amount equal to the interest that would accrue on the notional amount at a rate equal to the differential for the relevant period
      • “ceiling” arrangements that hedge the purchaser’s exposure to rising interest rates
    • floor
      • reverse of a cap
      • protection against a decline in interest rates below an agreed level
    • collar
      • combination of cap and floor
    • swap option (“swaption”)
      • one party, for a fee payable generally on the trade date, agrees that the other party can cause a swap between the parties to become effective at a later date on the pre-agreed terms or for the seller to cash settle the swaption through payment of the value of the swap as of the exercise date
      • the seller of the option will use the fee to hedge against any potential loss resulting from exercise of the option

B. Uses of Derivatives

I. Reduction of borrowing costs

  • basic assumption is that one party has access to a particular financial market on relatively more favourable terms than the other (and vice versa)
  •  both parties would incur debts in the market in which they have the relatively more favourable reception than the other and, by swapping, effectively obtain financing in the desired form at a lower rate that they otherwise would be able to obtain

II. Asset and liability management

  • Swaps can be used to alter a party’s existing liability structure
  • when a borrower has only floating rate liabilities (because the fixed rates were high at the  time) he can enter into an interest rate swap and convert the floating rates into fixed rates rather than prepayment and renegotiation of the outstanding loans

III. Other uses

  • investment device
  • financial service and dealing instrument

C. Parties involved in a swap transaction

  • end-users
    • the two parties that wish to swap
  • dealers 
    • in reality it is rather unlikely that the two end-users would be able to locate each other exactly at the time they need the finance
    • in addition, parties generally prefer to deal with a financial institution (confidentiality, credit standing)
    • major financial institutions therefore began to act as dealers for swaps, by assuming the role of a counterparty to their customers
      • as counterparties they faced the credit risk of each end-user
    • transactions entered into were immediately matched or hedged by an opposite transaction, retaining a spread for the institution for the services and the risk
    • leading dealers now hold portfolios and act as intermediaries between the end-users

D. Documentation

  • early swap deals were carried out using individualised documentation, each document was negotiated separately and in great detail
    • procedure was time consuming and led to large delays in execution
  • in response to this several organisations concerned with the finance in swaps developed standard terms and/or standard agreements
  • the most widely used of these agreements nowadays is the ISDA Master Agreement (Multicurrency – Cross Border) (1992)

I. ISDA Master Agreement

  • single agreement that is intended to regulate the relationship of the parties for all transactions between them
  • transaction comprises usually
    • the Master Agreement, which is a detailed document governing most of the aspects of the relationship
    • a Schedule attached to the Master Agreement, in which the parties can add, amend or vary details of the Master Agreement
    • a separate confirmation, in which the detailed economic features of the transaction are recorded
    • a booklet drafted by ISDA containing definition on economic terms, which can be incorporated into the confirmation
  • advantages of the single agreement approach
    • convenient that all swap transactions may be contained in one single document
    • two interlinked effects of great importance
      • since the master agreement governs all swap transactions between the parties there is no need to negotiate the immense amount of legal terms following each transaction
      • netting of several transactions may be more likely accepted by regulators in various jurisdictions if all transactions are governed by the same agreement, possibly resulting in a reduction of the capital adequacy requirements
      • this means in turn that cherry picking is avoided, i.e. some jurisdictions allow insolvency administrators to choose the contracts to be performed in an insolvency (“cherry picking”)
      • in short, an insolvency administrator should probably be able to pick and choose between different agreements, but he should not be able to do so in respect of transactions contained within the same agreement
      • key question, however, is whether contractual arrangements can defeat bankruptcy legislation which expressly prohibits set-off or rescission
      • in addition, efficient netting arrangements serve as credit enhancement and reduce the need for security (see infra)

II. Provisions

  • each transaction is to be evidenced by a confirmation which is incorporated into the agreement
  • Netting
    • settlement netting
      • s 2(c) provides that on each payment date all amounts payable in the same currency and in respect of the same transaction are netted so that the party who owes the greater sum pays the difference to the other party
      • payment obligations are subject to the conditions precedent that no event of default, or early termination has occurred
      • intended to reduce risks which occur in relation to the regular payments under the swap agreement if one of the parties becomes insolvent before paying the amount he owes
        • under a normal transaction, one party would deliver payment, but the counterparty would become insolvent before payment
        • result would be that the first party’s exposure would be the full amount payable
        • if the transaction is netted, only the difference becomes payable, so that in the event of insolvency of the counterparty, the exposure is limited to the difference
    • close out netting
      • if one of the parties becomes insolvent before settlement date, the other party has a right of early termination of the agreement
      • question arises whether outstanding termination values and payments can be netted against each other
        • as was pointed out before, some jurisdictions allow for cherry picking
        • an insolvency administrator could therefore select to perform the favourable contracts (in the money) and repudiate the unfavourable ones (out of the money)
        • for the non-defaulting party the situation would be the other way around, i.e. the favourable contracts would not be performed
        • problem cannot be overcome by choice of law, since in case of insolvency there is usually mandatory application of the laws of organisation of the defaulting party or, in the case of assets, the lex situs of the assets, regardless of a choice of law
      • ISDA Master Agreement provides for close-out netting
    • mechanism of close-out netting
      • if at any time an event of default has occurred and is continuing, the non-defaulting party has a right to terminate the agreement
      • the loss to each party by this early termination is then calculated according to a specific formula and is netted
      • accordingly, two separate legal components
        • rescission (closing, termination) of all outstanding obligations
          • effect is that unmatured obligations are cancelled
          • permitted in most jurisdictions on insolvency
        • set-off of resulting losses and gains (i.e. the transaction values)
          • insolvency legislation differ widely on this point
          • the argument against set-off is that in the framework of insolvency proceedings it constitutes a disposition of property and is therefore void
          • however, under English the application of the liquidation set-off rule is mandatory and cannot be contracted out, so that provisions of the Master Agreement which go further, will probably be overridden, but the result is still a net position
        • Automatic early termination
          • if applied, then an early termination in respect of all outstanding transactions will occur automatically upon the occurrence of specified events
          • tries to cancel and set-off immediately prior to the start of insolvency proceedings, so that these actions will not be caught by a possible nullification after the commencement of the insolvency proceedings
  • Payments upon early termination
    • once early termination has occurred, payments must be calculated
    • ISDA Master Agreement provides for two methods of determining payments
      • Limited Two-Way Payments
        • if the netted amount represents a liability to the defaulting party, the defaulting party pays the amount to the non-defaulting party
        • if the amount is a liability to the non-defaulting party, the non-defaulting party pays the defaulting party nothing
        • problems arise when the non-defaulting party has already made a front-end payment
      • Full Two-Way Payments
        • like limited two-way payment, but the non-defaulting party pays the defaulting party
      • in pro-debtor jurisdictions limited two-way payments are seen as unjust and full two-way payments are necessary
        • under English law, full two-way payments are not needed for validity (it was even questioned if such a clause would be enforceable)
  • Termination
    • right to terminate transpires on the occurrence of
      • a termination event
        • cover incidents which may affect the existence or performance of outstanding transactions but the occurrence of which cannot be blamed on any of the parties
        • e.g. illegality, tax events, tax events upon merger, credit event upon merger
      • an event of default (as listed in s 5(a) of the Master Agreement)
        • failure to pay or deliver
        • breach of agreement
        • credit support default
        • misrepresentation
        • cross-default
        • bankruptcy etc.
  • Grossing-up
    • Master Agreement provides in s 2(d) for the grossing-up of  withholding taxes
  • Representations
    • as in other finance facilities
    • e.g. status and power to enter into the agreement, all necessary consents obtained, no conflict with applicable law, legal and valid obligations, no event of default etc.
    • are deemed to be repeated each time the parties enter into a transaction

E. Risk management in derivative transactions

  • rather than creating new risks, derivative instruments allow risks to be unbundled and transferred between market participants
  • derivatives possess a number of characteristics, the effect of which is to make appropriate risk identification and control more complex but also more essential
  • risks in derivative can be categorised in different ways

I. Market risk / Rate risk

  • the risk that an asset will decline in value (that it will go out of the money and, thus, become unfavourable)
  • assessment is based on a mark-to-market valuation of derivatives and the underlying instruments
  • nowadays, risk management on a portfolio basis, which leaves a smaller residual risk to be hedged

II. Credit risk

  • arises when a party to a contract enjoys a favourable position (in the money) and the counterparty defaults
  • the theoretical amount at risk is the cost of replacing the contract with a new one, less any recovery
  • different ways to obtain replacement of the cash flows of an interest rate swap
    • recreated through a combination of new borrowings and investments
    • replaced by entering into a new swap transaction with another party (the loss will then be the front-end fee to the new counterparty)
  • Credit risk cannot be fully estimated in advance
  • core question is whether counterparty can perform in time and has sufficient debts to pay its assets, i.e. creditworthiness
  • in practice, a dealer will have a pre-approved credit line with respect to each prospective customer; if the limit is reached, collateralisation provides an opportunity to continue dealings
  • Collateralisation
    • achieved by taking security over assets
    • commercial implications
      • it is essential for the secured party, not to be under-secured
      • it should carefully be considered how and with which frequency mark-to-market valuation should be carried out
      • unilateral or bilateral collateralisation (as a matter of negotiation between the parties)
      • credit rating
    • strong connection between netting and collateralisation: if netting arrangements are enforceable there will be less incentive (for parties as for regulators) to press for collateralisation
    • common way of providing security for OTC derivative transactions
      • transfer cash and/or investment securities to the counterparty and to grant a charge over the goods delivered
        • fixed or floating
          • fixed = over specific assets
          • floating
            • class of assets present or future
            • assets can change from time to time in the ordinary course of business
            • until some step is taken by the chargeholder to enforce, the borrower may continue business with the assets
        • form = mortgage, pledge (leaves title to the goods with the borrower but gives possession to the lender) or hypothetication
        • problem: registration requirements
      • set-off and transfer agreements
        • problems in insolvency
          • no recognition of agreement
          • recharacterisation as security and, thus, subject to registration requirements
      • problems with securities held on deposits (Euroclear / Cedel), since only book-entries rather than physical delivery
        • lex situs not easily applicable
        • under English law the interest of the account holder against the custodian can be given as security
        • under Belgian and Luxembourg law no problems, since proprietory claims to account holders with Euroclear and Cedel are granted
        • possible problems however with all other jurisdictions

III. Legal risk

  • main questions
    • capacity of the counterparty to enter into the transaction
      • dealers should be recognised as swap dealers
      • especially public authorities might not be permitted to enter into swap agreements
    • legality of the agreement
      • gambling laws

F. Capital Adequacy

  • from the point of view of swap counterparties, one of the main problems with the Basle Agreement was that risk-based capital was assessed on the gross exposure
    • a reduction in capital adequacy requirements for netting agreements was not recognised
    • therefore, all swap arrangements were assessed at their notional value
  • however, in 1994 and 1995 two amendments to the Basle Agreement were published providing for such recognition if certain conditions are met
    • the netting agreement must create a single legal obligation such that, in the event of insolvency, the counterparty would have an obligation to receive or pay only the net sum of unrealised gains and losses (as in the ISDA Master Agreement)
    • there must a written and reasoned legal opinion supporting the validity of the netting arrangement under each of the jurisdictions concerned
    • procedures must be in place that the legal validity of netting arrangements is under constant review (in light of possible changes in the relevant law)
  • conditions seek to ensure that the netting arrangements are enforceable and minimise the risk for capital adequacy purposes
  • payments under the limited two-way payment clause will not be recognised under the amendments