What it means
Most swaps are not traded on a public exchange the way shares are. Instead a company calls a bank, the bank quotes a price, and the two sign a private contract, often with the bank then passing the risk on to other dealers.
Over time this creates a dense mesh of obligations running between banks, funds, corporates and clearing houses. Because everyone in the mesh owes something to someone else, the health of one participant can affect many others.
Regulators care about swap networks for exactly this reason, since a failure at a large dealer could spread losses quickly. After the 2008 financial crisis, many standard swaps were pushed through central clearing houses, which stand between the two original parties and guarantee the payments.
Day to day, being part of a swap network means having the legal paperwork in place with each dealer, usually an industry master agreement and a credit support annex that sets out the collateral rules. It also means reporting trades to trade repositories, which are databases that let regulators see who owes what.
For a corporate treasurer, the practical result is that the choice of dealer, clearing route and collateral terms all affect the real cost of a swap. The central bank version works differently.
When two central banks agree a swap line, one lends its own currency to the other in exchange for the partner's currency, and the arrangement is reversed later at the same exchange rate. This lets a foreign central bank provide dollars to its local banks during a squeeze without having to sell reserves in a hurry.
A useful nuance is that networks can also reduce risk when they are managed well. Netting, where offsetting trades with the same party are combined into a single net amount, and portfolio compression, where redundant contracts are cancelled, both shrink the total exposure that sits in the network without changing anyone's economic position.
In practice
Real-world examples.
Example
A mid-sized manufacturer wants to fix the interest rate on a floating-rate loan and asks three banks for swap quotes. It already has a master agreement with only one of them, so choosing the cheapest quote would mean weeks of legal work, and the treasurer decides the existing relationship is worth a small price difference.
Example
A pension fund holds hundreds of swaps with a handful of dealers to hedge its long-term liabilities. Each year it asks its dealers to take part in a compression exercise that cancels offsetting trades, which cuts the number of live contracts and the collateral it has to post.
Example
During a period of stress in funding markets, a regional central bank draws on a swap line with a larger central bank and lends the dollars it receives to local commercial banks. The local banks can then pay their short-term dollar debts without dumping assets at a loss.
Case study
Seen in the real world.
Harbourline Energy is an illustrative, fictional shipping and fuel company that hedges its borrowing costs through interest rate swaps. For years it dealt with a single bank, which was convenient but meant that all its hedges depended on one counterparty's credit strength and pricing.
The finance director decided to widen the network. Harbourline signed master agreements with three dealers, agreed to clear its standard trades through a central clearing house, and set up a monthly report showing its exposure to each counterparty.
In the illustrative follow-up year the company found that competition between dealers narrowed the spread on each new swap, and the monthly report revealed that one counterparty held far more of its exposure than policy allowed. Moving some trades to the other two dealers fixed the concentration before it became a problem.
Watch out
Common mistakes.
- Assuming a swap network is a single physical system or exchange, when it is really a collection of bilateral contracts, clearing houses and data repositories.
- Believing that central clearing removes all counterparty risk, when it concentrates that risk in the clearing house and still requires members to post collateral.
- Treating a central bank swap line as a gift of money, when it is a temporary exchange of currencies that is reversed at the original rate.
Questions
People also ask.
Why do regulators monitor swap networks so closely?
Because the failure of a heavily connected participant can pass losses to many others, so supervisors want to see who owes what and how much collateral backs it.
What is netting in a swap network?
It is the practice of combining offsetting amounts owed between two parties into one net payment, which reduces the exposure each party carries.
Do small companies need to join a swap network?
Not directly, since they usually deal with one bank, but they still benefit from or depend on the network through that bank's own trading and clearing arrangements.
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