Interest rate swaps have become an essential tool for interest rate risk management and speculation. With over 300 trillion dollars in outstanding notional and more than 10 trillion dollars traded each week, it is a staple of institutional investing: multi-national corporations, municipalities, sell-side firms, investment managers, and central banks all rely on interest rate swaps to manage interest rate risk.
*Source: US Commodity Futures Trading Commission’s ‘Weekly Swaps Report’ (https://www.cftc.gov/MarketReports/SwapsReports/L1INtRatesTransDolVol.html)
**Type of swaps depicted: Fixed-Float Swap; FRA (Forward Rate Agreement); OIS (Overnight Index Swap); Other ( Basis, Cap/Floor, Debt Option, Exotic, Fixed-Fixed, Inflation, and Swaption)
With IRS such an established player in the world of finance, it’s easy to forget how young these financial products really are. In order to understand the future direction of the market, it’s important to understand how the swaps market evolved into the behemoth we know today.
Swaps trading became an institutional instrument starting in 1981. At that time, the United States had an interest rate of 17%, West Germany’s rate was 11%, and Switzerland had a rate of 8%. The World Bank had reached its borrowing limits on German marks and Swiss Francs. IBM, on the other hand, had large reserves of Swiss francs and German marks, with debt payments owed in both currencies. The two parties realized they could reach a deal to leave both parties better off; together with Salomon Brothers, they engineered a specially tailored contract. Thus, the first swap contract was born.
In the early days immediately following the landmark IBM-World Bank deal, swaps were almost entirely used for hedging rather than speculation, being an attractive option for large companies seeking to protect themselves from rate hikes. As such, the swaps market was entirely made up of bilateral contracts, each with its own custom terms and conditions.
However, in the 1990’s swaps began to become increasingly popular with those looking to speculate on interest rates. Suddenly, IRS was no longer just for corporations hoping to hedge rate risk—it became a bona fide trading product, with volumes exploding through the end of the 20th century into the early aughts. While trading dwindled in the aftermath of the Global Financial Crisis, we’ve seen a steady recovery in IRS trading volumes in the post-crisis markets after 2013.
Source: ISDA SwapsInfo
As the IRS market grew, the products on offer became increasingly sophisticated. Instead of custom-tailored contracts for each set of counterparties, vanilla swaps emerged as a feasible standardized interest rate swap that helped to commoditize the market. This continues today with increasingly-popular MAC swaps, and the standards that have emerged for benchmarking (like the 3-month LIBOR in the US or the 6-month in Europe). At the same time, financial institutions began to customize swaps contracts in every way imaginable, creating cross-currency basis swaps, overnight index swaps, and FRAs—even leading to the rise of credit default swaps.
Some of the popular ways swaps contracts are customized
Regulators caught on to the explosion of the swaps market and have followed suit, putting in place stringent requirements that have made swaps trading a major operational undertaking. Limited regulation started in the late 1980’s when it became clear that these wholly unregulated products carried significant risk. Most famously, this happened in the UK, where a small municipal government lost millions of pounds betting on declining interest rates. Since then, regulators have remained in lockstep with traders’ increasingly exotic swaps contracts. Consequently, IRS regulations are robust, most recently boosted by a bevy of requirements under Dodd-Frank including clearing, SEF execution, and minimum sizing standards.
With its size and regulatory oversight, it’s easy to view the swaps market similarly to any other financial marketplace. However, there are some major differences--the first is the asymmetrical standardization of swaps trading between the dealer-to-dealer market and the dealer-to-client market. Why is the market set up to favor dealers, and how will this imbalance change in the future?
We’ll explore that in our next post: ‘The Tradeoffs and Challenges of Buy-Side IRS Trading”