Sunday, May 6, 2012

Are Interest Rate Swaps Heading the Way of the Dodo?

Previously I wrote about the bad press interest rate swaps have been receiving and that I felt much of the criticism was unjustified. I firmly believe that a lot of the negativity has been due to people not understanding why swaps are useful and, because of this, they fear their use.

Further muddying the waters has been the recent announcement of new margin requirements for over-the-counter (OTC) swaps. The Commodity Futures Trading Commission (CFTC) has published several important rules for compliance, including a proposed start date of October 12. This has been coming for some time with the Dodd-Frank Act requiring most OTC derivatives to be traded on a Swap Execution Facility (SEF). (A SEF is "a trading system or platform in which multiple participants have the ability to execute or trade swaps".)

This has got everyone excited and even saw Risk Magazine undertake a poll to see what the impact of the proposed margin requirements on uncleared trades would have. The results, while on the face of it are not surprising, could well be mis-leading.

60% of respondents to the survey thought end-users will opt not to use derivatives as a result of initial and variation margins requiring to be posted on uncleared swap trades. When the sort of money being talked about in collateral is in the trillions it is not surprising that there is some concern over this, and questions over the use of swaps in the future.

However I think we need to "back the truck up" a bit here. These new regulations do not relate to non-financial entities. The new proposals state "the margin requirements need not apply to non-centrally-cleared derivatives to which non-financial entities that are not systematically-important are a party."

So corporations are exempt and therefore can continue to use swaps as they have done before - as a risk management tool to hedge future movements in interest rate risks. Interest rate swaps have got organisations into trouble in the past and no doubt will do so in the future, but almost without exception the reason that the deals have gone sour is because the people entering into them in the first case did not understand them. Sure the sales people have been gung-ho in some cases and they may or may not have been the best tool to use at the time, but again if the organisations entering into the swaps had a clear understanding of their use, most of these problems would be averted.

It is timely to remind ourselves of what needs to be in place to confidently enter into derivative deals. Firstly, make sure you have an exposure that the derivative will accurately hedge. If as a borrower you have floating rate debt then an interest rate swap whereby you swap your floating interest payments for fixed interest payments would be appropriate. If you have floating rate debt and you sell an option to receive a premium to offset your interest payments, then this is speculation and is not managing your interest rate risk as you still have unlimited risk on the top side.

Secondly, understand the product itself well enough so you know the risks you are taking on board. If you are unsure DO NOT ENTER THE TRANSACTION. Normally plain vanilla deals will suffice, if you move away from the plain vanilla again you need to understand intimately what you are getting into. If interest rates go up what is the impact on your portfolio? Likewise if interest rates go down, what does that mean to you?

Finally you need to be able to record, report and value these transactions so that at all times you have a good handle on your current position and what might happen in the future if interest rates change. If you can't capture your deals appropriately and value them then this is when unpleasant surprises can happen. You need to know your position at all times.

So changes are on their way, but as a business there is no cause for concern that instruments like swaps will no longer be able to be used as a risk management tool. If you follow the common sense rules then they are still an important way to manage your risks - despite what the regulators may seem to be saying.

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