Interest rate and credit default swaps
Overview
A swap, which is a derivative contract, is an agreement between two parties to exchange cash flows based on a formula that has been agreed upon in advance.
The two types of swaps are interest rate swaps and credit default swaps, and they serve completely different functions. Interest rate swaps hedge against interest-rate fluctuations, while credit default swaps hedge against the risk of a borrower defaulting.
In this case too, both types of swaps are traded directly between institutions and not on public exchanges.
Interest rate swaps
An interest rate swap consists of an agreement between two parties whereby they exchange interest payments on a predetermined notional amount, typically with one party paying a fixed rate and the other paying a floating rate which is periodically adjusted in relation to a benchmark such as SONIA in the UK.
It is important to note that the notional amount itself is not transferred; only the difference between the two interest payments is passed on. Companies use such swaps in order to manage risk, since a business has obtained a loan at a floating rate it is exposed to the risk of interest rates rising, which would in an unpredictable manner increase its debt costs, so by means of a swap in which it pays a fixed rate and receives a floating rate it effectively converts its floating-rate loan into a fixed-rate one, at the cost of giving up the opportunity to benefit from falling rates in return for the certainty of knowing its future interest payments.
For example, a UK-based company with a £10 million loan at SONIA plus 1% enters into a five-year swap in which it commits to paying a fixed rate of 4% on a notional amount of £10 million and, in return, receives floating SONIA payments. If SONIA later increases to 5%, the cost of the loan will be 6%, that is £600,000 per year, but through the swap it gets 5% from the bank, or £500,000, which it uses to offset the loan payment, while it pays out the fixed 4%, or £400,000, to the bank. When the three cash flows are added together, the company's actual cost is fixed at 5% of £10 million, £500,000 a year, regardless of what level SONIA reaches.
Credit default swaps
A credit default swap (CDS) is like insurance that protects against the event of a bond or loan issuer going into default. The person who buys the swap pays a fixed premium, given as a spread in basis points against the notional amount, to the person who sells it. In return, if a particular "credit event" occurs, most frequently default, bankruptcy or restructuring, the seller pays the buyer an amount corresponding to the loss suffered.
Unlike ordinary insurance, the buyer does not have to hold the actual bond; a CDS can in fact be bought merely as a speculative bet that a company or a country will go bankrupt, and it was exactly this feature that caused the market to become so much larger and so much more dangerous than the value of the debt it was based on.
2008 financial crisis
Credit default swaps play a central role in the account of the 2008 crisis, with AIG serving as the most clear example of this. By the close of 2007, via its financial products division, AIG had taken up approximately $527 billion worth of CDS contracts, these covering protection against synthetic CDOs, structures in which no actual mortgage bonds were held at all, and so the same mortgage risk could and did have its insurance provided by a number of different institutions.
As house prices in the United States fell and the number of defaults rose from 2007 to 2008, AIG received enormous collateral calls which it did not have sufficient liquid capital to meet. Because many of its counterparties were among the largest banks in the world, its failure would have posed a threat to the entire financial system and would have prompted a US government rescue that in the end amounted to about $182 billion.
Regulation
The response involved a full overhaul of derivatives rules on both sides of the Atlantic. The US Dodd-Frank Act of 2010 required standardised swaps to be traded on regulated platforms and cleared through central counterparties (CCPs) rather than settled bilaterally, with mandatory clearing taking effect in 2013. The EU's European Market Infrastructure Regulation (EMIR) also contained a similar requirement.
Even though central clearing does not eliminate risk, it does transfer it to another party: a CCP has both parties to a transaction posting collateral and shares the losses among its members if one of them defaults, replacing the complicated and invisible web of bilateral exposures that made it so difficult to unwind AIG's positions in 2008 with a much more transparent and better-capitalised system.