Interest rate swaps

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See MarketsReformWiki for a summary of swap classes to be cleared on the CFTC Final Determination: Clearing Requirement for Credit Default Swaps and Interest Rate Swaps page.

Interest-rate swaps (IRSs) are private OTC derivatives contracts agreed between mostly large financial institutions and corporations. IRS contracts allow participants to swap short-term cash flows from fixed income assets in the same currency. The spread between IRSs and short-term interbank rates is considered a key indicator of market sentiment.

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The most popular interest rate swaps are those exchanging fixed-rate debt securities for those with floating or variable interest rates or vice versa. The most common, called vanilla IRSs, use the floating 3-month or 6-month LIBOR interbank rate, while basis swaps exchange one floating interest rate for another.[1] Hedgers can use interest-rate swaps to protect against declining or rising interest rates; speculators who believe interest rates will rise can use IRSs to short sell fixed-income securities like bonds.

In late September 2008, in the midst of a debilitating freeze in global credit markets, the spread between a two-year interest-rate swap and two-year T-notes rose to a record level of 166.38 basis points.[2]. Issuers of debt such as municipal bonds that held interest rate swaps with now-defunct Lehman Brothers were forced to liquidate their positions and replace their counterparties.

The CME Group offers futures on interest rate swaps, as a result of its acquisition of the CBOT. Its futures products include:

In 2008, International Derivatives Clearing Group (IDCG) was formed becoming the first central clearinghouse for over-the-counter (OTC) interest rate swaps (IRS) in a regulated futures environment available to all market participants.

IDCG’s centrally cleared IRS futures contracts are economically equivalent to plain vanilla IRS contracts currently traded in the OTC market. IDCG’s product offerings include:

  • SwapDrop – Participants trade IRS contracts bilaterally and then use SwapDrop.com to give up the OTC trade to the clearinghouse, thereby replacing the OTC contract with economically identical IRS futures contracts (via the EFS mechanism). These contracts are then cleared and settled through IDCG.
  • IDEX USD Interest Rate Swap Futures Contracts are futures on United States dollar-denominated interest rate swaps with a notional value of $100,000, requiring the exchange of periodic payments of semi-annual fixed rate payments based on the futures price in exchange for quarterly floating-rate payments based on the 3-month US Dollar London Interbank Offered Rate (the “USD LIBOR”).

Latest news

  • In November 2010, Tradeweb, an online derivatives market, became the first trading platform in the U.S. to handle a fully-electronic interest rate swap trade between Deutsche Bank and a US-based asset manager which was then cleared through a clearing house. In this case the trade was cleared through the CME Group. [3][4] The trade was significant because it met the broader objective of new regulatory reform rules under the Dodd-Frank Wall Street Reform and Consumer Protection Act, which dictate that standardized swaps be traded on "swap execution facilities" and be centrally cleared by a clearing house.

The rates on Asian IRSs declined recently to its lowest in almost two years, a sign that banks in those countries will continue lowering interest rates into the foreseeable future.[5] Asian central banks in countries from South Korea to Indonesia have already cut interest rates as inflation falls, with South Korea's 7-day repo rate recently falling 75 basis points to 4.25 percent while its swap rate fell recently to 4.66 percent.

References

  1. Interest Rate Swap. RiskGlossary.com.
  2. Swap Spreads Widen to Record Amid Bailout Concern. Bloomberg.
  3. Tradeweb Unveils First Fully Electronic, Cleared US Rate Swap. Wall Street Journal.
  4. Tradeweb executes first cleared swap trade. Financial Times.
  5. Asian Interest-Rate Swaps Signal More Rate Cuts Are Coming. Bloomberg.