Swap history

Swap agreements originated in the UK in the 1970s, days, when men were men and governments were suspicious of foreign speculators fannying around in their currencies. Despite running a swap shop in the 1970s, Noel Edmonds was not involved. HMRC, for example, would tax foreign exchange transactions into and out of sterling, constraining capital flight, it was thought, and increasing domestic investment.

Still, there was a whole world out there waiting for British money to chase it. So those financial wizards in the city had an idea. How about, simultaneously, I lend you a million pounds, at fixed sterling interest, and you lend me a million and a half dollars (being the prevailing value of a million sheets in USD), at fixed dollar interest, each of us to pay interest in the currency of our respective loans and repay the other on the same day in 5 years’ time?

Genius.

Thus, originally, swaps were offsetting loans in different currencies. This arrangement allowed each side to access the foreign exchange of the other country and avoid paying any foreign currency taxes.

IBM and the World Bank entered into the first formal swap transaction in 1981. The World Bank needed to borrow Deutschmarks and Swiss francs to finance its operations, but the Swiss and German governments prohibited it from borrowing activities. IBM, on the other hand, already had large amounts of those currencies, but needed U.S. dollars at a time when interest rates were high.

Salomon Brothers came up with the idea for the two parties to swap their debts. IBM swapped its borrowed francs and marks for the World Bank’s dollars. This swaps market has since grown exponentially to trillions of dollars a year in size.

Banks around the world thought, “now, that’s a sweet idea”. But they encountered legal and financial reporting complications, however: Unsecured loans attract a lot of regulatory capital if you’re the sort of entity like a bank who has to hold regulatory capital. Was there some way the banks could offset the receivable on the loan they had made against the amount they had borrowed, to reduce the risk of the overall transaction and therefore reduce the regulatory capital charge?

It turned out there was. It is called “netting”, but it is a complicated legal mechanism, especially in the insolvency of your counterparty. All kinds of local insolvency rules might interfere with your right to “net” these strange, exotic contracts called “Sw-æps”.

So, the Bank of International Settlements hastily made up some rules to make sure banks were diligently applying netting treatment. You must have a legal opinion assuring you that netting would work in insolvency in all relevant jurisdictions. This seemed harmless enough in 1981, rather like it seemed harmless in 1865 to require someone to walk in front of those new-fangled “automobiles” waving a red flag to warn unsuspecting passers by. And that day a cottage industry was born which, to this day, employs literally tens of thousands of people and wastes hundreds of millions of pounds in compliance each year.

See also

• Red Flag Act
• Netting
• Noel Edmonds’ Multi-Coloured Swap Shop - through which vehicle Noel Edmonds popularised swaps amongst a generation of British children. The UK remains the centre of the global swaps industry to this very day.

Thanks to

• Helpful article on Investopedia