What Is a Swap Bank?
A swap bank is an institution that acts as a broker between two counterparties who wish to enter into an interest rate or currency swap agreement and possibly remain anonymous. It brings together both sides of the deal and typically earns a slight premium from both counterparties for facilitating the swap.
- A swap bank is an institution that acts as a broker to two unnamed counterparties who wish to enter into an interest rate or currency swap agreement.
- Counterparties prefer to use a swap bank as an intermediary as it reduces their risk.
- Swap banks also provide clients the benefits of anonymity and their expertise in swap agreements.
Understanding Swap Banks
A swap is a derivative contract through which two parties exchange financial instruments. These instruments can be almost anything, but most swaps involve cash flows based on a notional principal amount to which both parties agree. Usually, the principal does not change hands. Each cash flow comprises one leg of the swap. One cash flow is generally fixed, while the other is variable, that is, based on a benchmark interest rate, floating currency exchange rate, or index price.
Swaps do not trade on exchanges, and retail investors do not generally engage in swaps. Rather, swaps are over-the-counter (OTC) contracts between businesses or financial institutions. However, smaller institutions may still have access to this market through a swap bank.
Generally speaking, companies do not directly approach other companies in an attempt to create swap agreements. Instead, swap banks coordinate the swap agreements for companies. In most cases, the identities of the counterparties are unknown to each other, and often to the swap bank, as well.
Benefits of a Swap Bank
There are three major benefits to using a swap bank when entering into a swap agreement. They are anonymity, reduced risk, and greater expertise.
- Many companies wish to remain anonymous so as not to give away their competitive advantage. In other words, they may not want others to know what they are doing in terms of financing, risk control, and possibly where they deploy their capital. By using a swap broker, they can keep their identities hidden for the cost of a small premium.
- One of the biggest risks in a swap transaction is counterparty risk, or the risk that the other side will not deliver on its obligations, including default. All of the swap's cash flows often flow through the swap bank, which collects and forwards periodic payments. This often includes credit services from assessing the counterparty's creditworthiness to guaranteeing timely payment of cash flows.
- Because swaps can be complex, companies that do not have the proper resources, either in expertise or experience, benefit from the swap bank's specialized knowledge. It allows for better terms for the small or inexperienced counterparty. And it gives them access to a large universe of potential counterparties, which is especially useful for the infrequent or first-time swap customer.
The swap bank transfers these benefits to the swap counterparties, but itself takes on risk for its fees. This includes interest rate risk. Should rates change during the time when it has only completed either the receiving or paying a portion of the swap, the bank would be at risk for the remaining duration. Credit risk is the biggest threat to the swap bank leaving it on the hook if one party defaults. And finally, it may be difficult to find a counterparty for any given swap. This is called mismatch risk.