Swap history

ISDA Anatomy™ →Go uptown 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: (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. — Basel Capital Accord: Treatment of potential exposure for off-balance-sheet items, April 1995 Index: Click ᐅ to expand: ISDA Navigation See ISDA Comparison for a comparison between the 1992 ISDA and the 2002 ISDA. The Varieties of ISDA Experience Subject 2002 (wikitext) 1992 (wikitext) 1987 (wikitext) Preamble Pre Pre Pre Interpretation 1 1 1 Obligns/Payment 2 2 2 Representations 3 3 3 Agreements 4 4 4 EODs & Term Events 5 Events of Default: FTPD • Breach • CSD • Misrep • DUST • Cross Default • Bankruptcy • MWA Termination Events: Illegality • FM • Tax Event • TEUM • CEUM • ATE 5 Events of Default: FTPD • Breach • CSD • Misrep • DUST • Cross Default • Bankruptcy • MWA Termination Events: Illegality • Tax Event • TEUM • CEUM • ATE 5 Events of Default: FTPD • Breach • CSD • Misrep • DUSS • Cross Default • Bankruptcy • MWA Termination Events: Illegality • Tax Event • TEUM • CEUM Early Termination 6 Early Termination: ET right on EOD • ET right on TE • Effect of Designation • Calculations; Payment Date • Payments on ET • Set-off 6 Early Termination: ET right on EOD • ET right on TE • Effect of Designation • Calculations • Payments on ET • Set-off 6 Early Termination: ET right on EOD • ET right on TE • Effect of Designation • Calculations • Payments on ET Transfer 7 7 7 Contractual Currency 8 8 8 Miscellaneous 9 9 9 Offices; Multibranch Parties 10 10 10 Expenses 11 11 11 Notices 12 12 12 Governing Law 13 13 13 Definitions 14 14 14 Schedule Schedule Schedule Schedule Termination Provisions Part 1 Part 1 Part 1 Tax Representations Part 2 Part 2 Part 2 Documents for Delivery Part 3 Part 3 Part 3 Miscellaneous Part 4 Part 4 Part 4 Other Provisions Part 5 Part 5 Part 5 Tell me more Sign up for our newsletter — or just get in touch: for ½ a weekly 🍺 you get to consult JC. Ask about it here.

The sacred prehistory of “the one agreement to rule them all” — the Single Agreement; known these days as the ISDA Master Agreement — predates even the First Men and, yea, even before them, to the black dawn of prehistory when free cash flows were first discovered in the wild and artificially set against each other for pleasing effect by the Children of the Forest. Swaps were even mentioned in passing in the Old Testament:

But if he be poorer than thy estimation, then he shall present himself before the calculation agent, and the calculation agent shall value him; And if it be a physical settlement, whereof men bring an offering unto the LORD, all that any man giveth of such unto the LORD shall be holy. And if he shall at all swap cashflow for asset, yea, or asset for cashflow, then the exchange thereof shall be holy.

—Leviticus 27:10

Alas this ancient wisdom was buried during the destruction of the great library at Alexandria, and was not re-discovered until Salomon brothers had a bright idea in their Manhattan shoe-shop in 1981.

Modern history

Swaps originated in the UK in the late 1970s, days, when men were men and governments were suspicious of foreign speculators fannying around in their currencies. 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 faced significant demand from its borrowers for Deutschmarks and Swiss francs, but the Swiss and German governments limited the amount of borrowing the World Bank could do in their currencies. IBM, on the other hand, already had plenty of CHF and DEM, but wanted to increase its U.S. dollars since 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 as it set out in the panel to the right.

In other words, you must have a legal opinion assuring you that netting would work in insolvency in all relevant jurisdictions. This seemed harmless enough in 1995 — even prudent — 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