Swap history

{{a|isda|{{subtable|Bilateral netting
Careful consideration has been given to the issue of bilateral netting, i.e., weighting the net rather than the gross claims with the same counterparties arising out of the full range of forwards, swaps, options and similar derivative contracts.

The Committee is concerned that if a liquidator of a failed counterparty has (or may have) the right to unbundle netted contracts, demanding performance on those contracts favourable to the failed counterparty and defaulting on unfavourable contracts, there is no reduction in counterparty risk.

Accordingly, it has been agreed for capital adequacy purposes that:

(a) Banks may net transactions subject to novation under which any obligation between a bank and its counterparty to deliver a given currency on a given value date is automatically amalgamated with all other obligations for the same currency and value date, legally substituting one single amount for the previous gross obligations.

(b) Banks may also net transactions subject to any legally valid form of bilateral netting not covered in (a), including other forms of novation.

(c) In both cases (a) and (b), a bank will need to satisfy its national supervisor that it has:7

(1) a netting contract or agreement with the counterparty which creates a single legal obligation, covering all included transactions, such that the bank would have either a claim to receive or obligation to pay only the net sum of the positive and negative mark-to-market values of included individual transactions in the event a counterparty fails to perform due to any of the following: default, bankruptcy, liquidation or similar circumstances;

(2) written and reasoned legal opinions that, in the event of a legal challenge, the relevant courts and administrative authorities would find the bank's exposure to be such a net amount under:

- the law of the jurisdiction in which the counterparty is chartered and, if the foreign branch of a counterparty is involved, then also under the law of the jurisdiction in which the branch is located;

- the law that governs the individual transactions; and

- the law that governs any contract or agreement necessary to effect the netting.

The national supervisor, after consultation when necessary with other relevant supervisors, must be satisfied that the netting is enforceable under the laws of each of the relevant jurisdictions;

(3) procedures in place to ensure that the legal characteristics of netting arrangements are kept under review in the light of possible changes in relevant law.

Contracts containing walkaway clauses will not be eligible for netting for the purpose of calculating capital requirements pursuant to this Accord. A walkaway clause is a provision which permits a non-defaulting counterparty to make only limited payments, or no payment at all, to the estate of a defaulter, even if the defaulter is a net creditor.. Despite running a swap shop, 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 equivalent value in USD), at fixed dollar interest, each of us to then pay interest payments in the currency of our respective loans and repay the other on the same day in 5 years’ time?

I lend you dollars. You pay me interest in dollars. At the same time, you lend me sterling, and I pay you interest in sterling.

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.

That was about forty years ago. The swaps market has since grown. A lot. At last count there were roughly USD65 trillion notional in swaps traded each year. For the little that is, in practice, worth.

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. They thought about doing this in the Basel I capital accord in 1988 and got cold feet. Their feet had warmed up sufficiently by 1995 for the committee to provide:

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