What is a swap bank?
Swap banks are institutions that act as brokers between two counterparties who enter into interest rate or currency swap agreements and in some cases wish to remain anonymous. It brings both sides of the transaction together and usually earns a small premium from both counterparties to facilitate swaps.
- Swap banks are institutions that act as two unnamed counterparty brokers wishing to enter into interest rate or currency swap agreements.
- Counterparties prefer to use swap banks as intermediaries to mitigate risk.
- Swap banks also provide clients with the benefits of anonymity and expertise in swap contracts.
Understand swap banks
Swaps are derivative contracts that allow two parties to exchange financial instruments. These products can be almost anything, but most swaps include cash flows based on the notional amount agreed by both parties. Principals usually do not change hands. Each cash flow constitutes one leg of the swap. One cash flow is generally fixed, while the other is variable. That is, it is based on benchmark interest rates, floating exchange rates, or index prices.
Swaps are not traded on exchanges and individual investors are usually not engaged in swaps. Rather, swaps are over-the-counter (OTC) contracts between companies or financial institutions. However, small financial institutions may have access to this market through swap banks.
Generally speaking, a company does not approach other companies directly to create a swap contract. Instead, the swap bank adjusts the company’s swap contract. In most cases, the identities of the trading partners are unknown to each other, and often to swap banks.
Benefits of swap banks
There are three major advantages to using a swap bank when concluding a swap contract. They are anonymity, risk reduction, and better expertise.
- Many companies want to remain anonymous so as not to lose their competitive advantage. In other words, they may not want others to know what they are doing regarding funding, risk management, and perhaps where they place their capital. Swap brokers allow you to hide your identity with a small premium.
- One of the greatest risks in swap transactions is counterparty risk, or the risk that the other party will fail to meet its obligations, including default. All swap cash flows often go through swap banks that collect and transfer recurring payments. This often includes credit services, from assessing counterparty creditworthiness to guaranteeing timely payments of cash flows.
- Swaps can be complex, so companies that do not have the right resources in either expertise or experience will benefit from the expertise of swap banks. This allows for better conditions for small or inexperienced counterparties. It also provides access to a large universe of potential counterparties. This is especially useful for customers who swap infrequently or for the first time.
Swap banks transfer these profits to swap counterparties, but bear the risk of fees in their own right. This includes interest rate risk. If the rate changes while either receiving or paying a portion of the swap is complete, the bank is at risk for the rest of the period. Credit risk is the greatest threat to leaving a swap bank on the hook if one party defaults. And finally, finding a particular swap counterparty can be difficult. This is called mismatch risk.