Interest Rate Swaps Now Being Monitored More Closely by Treasury
Article by Sean Fitzgerald
In April of 2013, the Financial Stability Oversight Council (“FSOC” or “Council”) released its report identifying potential emerging threats to the stability of the financial system. Among the target initiatives of the FSOC was the implementation of derivative rate swap reform used in Over the Counter trading (“OTC”). An interest rate swap is a contractual agreement between two parties to exchange interest payments. Here’s a hypothetical example of such a two party exchange. Let’s say Joe owns a $1,000,000 investment that pays him LIBOR + 1% every month. (LIBOR, a term you may have heard about in the news, refers to the London Interbank Offered Rate, an interest rate index used by the banking and mortgage industries). As LIBOR goes up and down, Joe’s payment changes. John is the second party and he owns an investment that pays him 1.5% every month regardless of whether LIBOR falls or rises.
Joe decides he would rather lock in a constant payment and John decides that he'd rather take a chance on receiving higher payments. So Joe and John agree to enter into an interest rate swap contract.
Under the terms of their contract, Joe agrees to pay John LIBOR + 1% per month on a $1,000,000 principal amount (called the "notional principal" or "notional amount"). John agrees to pay Joe 1.5% per month on the $1,000,000 notional amount. Joe has now reduced his risk should LIBOR take a fall. John, on the other hand, has increased his risk. Should LIBOR fall dramatically, John is now receiving less on his investment and still owes Joe the 1.5%. Should Joe go bankrupt, Joe doesn’t owe John any more, but John still owes Joe. They don’t net out.
This is what has been going on with large banks over the last decade. The only problem was that some of the institutions that were considered “too big to fail” did just that and teetered on the brink of bankruptcy or went over the edge causing huge financial losses. In response, the Federal Reserve, the Federal Deposit Insurance Corporation (“FDIC”) and the Comptroller of the Currency began to implement rules to improve the safety and transparency of the derivatives market. By the end of 2013, there were 22 swap execution facilities (“SEF”s) registered with the Commodity Future Trading Commission (“CFTC”). The CFTC finalized its guidance on how to apply derivatives reforms to cross-border transactions.
In February 2014, the CFTC implemented mandatory trade execution for certain interest rate and credit default swaps that are subject to the CFTC’s clearing mandate. As recently as this month, the Department of Treasury reported that the European Commission (“EC”) and CFTC staff intend to continue discussing the technical aspects of any rule proposals, including possible CFTC rule proposals on regulatory treatment of foreign SEFs.
Although derivative swaps are still a risk but continue to be traded by banks, there are steps which are currently being taken to reduce the risk associated with derivatives as well as to fight market abuse associated with derivative swaps and benchmark manipulation. What the future will bring for derivatives is still uncertain. However, there appears to be a concerted effort on the part of financial institutions to mitigate the risk of trading on derivatives and finalize the remaining cross-border rules proposals related to OTC derivatives reforms.