The interest-rate swap was developed in late 1981. By 1987, the market had grown to more than $500 billion (in terms of notional principal amount). What is behind this rapid growth? As our asset/liability application earlier demonstrated, an interest-rate swap is a quick way for institutional investors to change the nature of assets and liabilities or to exploit any perceived capital market imperfection. The same applies to borrowers such as corporations, sovereigns, and supranationals.

In fact, the initial motivation for the interest-rate-swap market was borrower exploitation of what were perceived to be “credit arbitrage” opportunities because of differences between the quality spread between lower- and higher-rated credits in the U.S. and Eurodollar bond fixed-rate market and the same spread in these two floating- rate markets. Basically, the argument for swaps was based on a well-known economic principle of comparative advantage in international economics. The argument in the case of swaps is that even though a high credit-rated issuer could borrow at a lower cost in both the fixed- and floating-rate markets (i.e., have an absolute advantage in both), it will have a comparative advantage relative to a lower credit-rated issuer in one of the markets (and a comparative disadvantage in the other). Under these conditions, each borrower could benefit from issuing securities in the market in which it has a comparative advantage and then swapping obligations for the desired type of financing. The swap market was the vehicle for swapping obligations.

FundsDespite arguments that credit arbitrage opportunities are rare in reasonably efficient international capital markets, and that even if they did exist, they would be eliminated quickly by arbitrage, the number of interest-rate-swap transactions has grown substantially. Another explanation is suggested in a May 1984 contribution sponsored by Citicorp that appeared in Euromoney:

The nature of swaps is that they arbitrage market imperfections. As with any arbitrage opportunity, the more it is exploited, the smaller it becomes….

But some of the causes of market imperfections are unlikely to disappear quickly. For example, insurance companies in many countries are constrained to invest mainly in instruments that are domestic in that country. That requirement will tend to favour domestic issuers artificially, and is unlikely to be changed overnight. And even in the world’s most liquid markets there are arbitrage opportunities. They are small and exist only briefly. But they exist nevertheless.

As this opinion demonstrates, as early as 1984 it was argued that the difference in quality spreads in the two markets may be attributable to differences in regulations in two countries. Similarly, differences in tax treatment across countries also create market imperfections that can be exploited using swaps. Thus swaps can be used for regulatory or tax arbitrage.

Rather than relying exclusively on an arbitrage argument, one study suggests that the swaps market grew because it allowed borrowers to raise a type of financing that was not possible prior to the introduction of interest-rate swaps.

Finally, another argument suggested for the growth of the interest-rate-swap market is the increased volatility of interest rates that has led borrowers and lenders to hedge or manage their exposure. Even though risk/return characteristics can be replicated by a package of forward contracts, interest-rate forward contracts are not as liquid as interest-rate swaps—and entering into or liquidating swap transactions has been facilitated by the standardization of documentation published by the International Swap Dealers Association in early 1987.

Role of the Intermediary

The role of the intermediary in an interest-rate swap sheds some light on the evolution of the market. Intermediaries in these transactions have been commercial banks and investment banks, who in the early stages of the market sought out end users of swaps. That is, they found in their client bases those entities that needed the swap to accomplish a funding or investing objective, and they matched the two entities. In essence, the intermediary in this type of transaction performed the function of a broker.

The only time that the intermediary would take the opposite side of a swap (i.e., would act as a principal) was to balance out the transaction. For example, if an intermediary had two clients that were willing to do a swap but one wanted the notional principal amount to be $100 million and the other wanted it to be $85 million, the intermediary might become the counterparty to the extent of $15 million. That is, the intermediary would warehouse or take a position as a principal to the transaction to make up the $15 million difference between client objectives. To protect itself against an adverse interest-rate movement, the intermediary would hedge its position.

There is another problem in an interest-rate swap that we have yet to address. The parties to swaps have to be concerned that the other party might default on its obligation. Although a default would not mean any principal was lost because the notional principal amount had not been exchanged, it would mean that the objective for which the swap was entered into would be impaired. As the early transactions involved a higher- and a lower-credit-rated entity, the former would be concerned with the potential for default of the latter. To reduce the risk of default, many early swap transactions required that the lower-credit-rated entity obtain a guarantee from a highly rated commercial bank.

As the frequency and the size of the transactions increased, many intermediaries became comfortable with the transactions and became principals instead of acting as brokers. As long as an intermediary had one entity willing to do a swap, the intermediary was willing to be the counterparty. Consequently, interest-rate swaps became part of an intermediary’s inventory of product positions. Advances in quantitative techniques and futures products for hedging complex positions such as swaps made the protection of large inventory positions feasible.

Possibly related posts: (automatically generated)
Development of the Interest-Rate-Swap Market