Foreign Exchange Swap Trend Development


Examine the latest trends and key features in the swap market, and understand their impact on swap trading and how they shape the market landscape.

Recent developments in the swap market show that swap transactions exhibit a series of unique characteristics and prospective trends. The following will discuss several key features and development trends of swap trading.

1. The composition of participants in the swap market is shifting from end-users to intermediaries.

The swap market consists primarily of two participant groups: end-users and financial intermediaries. These two groups utilize the swap market for different purposes.

End-users, including banks, corporations, financial and insurance institutions, international organizations, agencies, and government departments, utilize the swap market primarily for:

Financial intermediaries or interbank participants, on the other hand, employ the swap market to generate fee income or profit from trading opportunities. This includes banks and securities firms from the United States, Japan, the United Kingdom, and other European countries. For commercial and investment banks, swap transactions are an attractive source of off-balance-sheet income.

The actual composition of the swap market reveals that the transaction volume of end-users is greater than that of financial intermediaries. As of the end of 1988, out of a total notional principal amount of $10.102 billion for interest rate swaps, end-users' swap amount was $6.689 billion, while the swap amount among member banks of the International Swap Dealers Association was $3.413 billion.

Entering the 1990s, with the decline of mergers and acquisitions in the corporate sector, leveraged swap transactions and merger-related swaps decreased, leading to a reduced growth rate in end-user demand for swaps. In contrast, the utilization of swaps by financial intermediaries increased. By the end of 1990, the proportions of end-users and financial intermediaries in the total outstanding notional principal amount of interest rate swaps were 61% and 39%, respectively. In the first half of 1991, newly arranged interbank swaps amounted to $335.4 million, accounting for 44% of the total newly arranged notional principal amount of interest rate swaps.

2. Swap traders are becoming more sensitive to counterparty risk.

The swap market exhibits a dual nature. On one hand, it functions as a wholesale market where transactions follow predetermined rules and take place on screens. Approximately one-third of interest rate swaps and one-fourth of currency swaps are relatively standardized transactions. On the other hand, swap transactions occur over-the-counter, with a retail market or discretionary characteristics, requiring individual arrangements for each trade.

While this provides flexibility for traders, it often results in greater opacity due to individual arrangements or end-users' motivations, compounded by significant uncertainty in regulatory norms for over-the-counter transactions by various national authorities, leading to substantial market risks. In January 1991, the UK House of Lords passed a law rendering government authorities, including local officials, participating in swap transactions and related activities illegal. This law caused substantial losses for many participating banks in swap transactions.

Since the 1990s, due to the ordinary crises in Western banking, numerous bank bankruptcies, and credit downgrades, swap participants have faced increased counterparty risk. The market's response to heightened counterparty risk has been the shortening of newly arranged interest rate swap tenures. Longer-term swaps are arranged by institutions with higher credit ratings.

To reduce credit and payment risks in swap transactions, the International Swap Dealers Association has incorporated credit risk control for members during the existence of transactions in the revised "Interest Rate and Currency Swap Agreement." Standardized agreements employ a series of clauses regarding statements, agreements, defaults, terminations, illegal events, credit change events, and bank capital changes, defining the rights and obligations of both parties concerning credit.

Simultaneously, to mitigate payment risks for counterparties, the standard agreement stipulates the method of offsetting payments in the "Master Agreement." On the transaction payment date, the parties offset the income and expenditure from all swaps of the same currency against each other, with the party with the larger payment amount paying the difference after offsetting.

The "Interest Rate and Currency Swap Agreement" is a legally binding document with certain constraints on swap transactions. Market participants utilizing this agreement can reduce financial and credit risks in swap transactions through the aforementioned risk management clauses. However, from a market perspective, given the lack of standardized agreement accounting systems and financial disclosure mechanisms for over-the-counter instruments, traders, despite being more cautious and focused on counterparties' financial conditions, find it difficult to effectively avoid losses caused by counterparty risks during the transaction process.

3. In the currency composition of interest rates and currency swaps, the proportion of swaps denominated in USD and swaps with USD participation has noticeably decreased.

As of the end of 1988, interest rate swap amounts denominated in USD totaled $728.2 billion, accounting for 72% of the total outstanding notional principal amount for the same year, while interest rate swaps denominated in other currencies comprised only 28%. In 1989, interest rate swap amounts denominated in USD constituted 66% of the total outstanding notional principal amount, with interest rate swaps denominated in other currencies, including JPY, GBP, and DEM, accounting for 34%.

By the end of 1990, interest rate swaps denominated in USD accounted for only 55% of the total outstanding notional principal amount, while other currency-denominated interest rate swap amounts reached 45%. Among these, interest rate swaps denominated in CHF, GBP, and CAD experienced the fastest growth.

By the end of 1991, interest rate swaps denominated in USD and other non-USD currency-denominated interest rate swaps accounted for 49% and 51% of the total outstanding notional principal amount, respectively. The dominant position of interest rate swaps denominated in USD had reversed. Among these, significant increases were observed in interest.

Disclaimer: Investment involves risk. The content of this article is not an investment advice and does not constitute any offer or solicitation to offer or recommendation of any investment product.

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