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Interest rate swaps - UK focus

Updated: May 20


Introduction

In the past month the current situation in the UK has been under the spotlight, mainly in view of the British pension funds getting margin calls, which led to an unstable economic view and the resignation of the shortest-serving UK’s prime minister, Liz Truss. The funds were hit with margin calls given their overly risky approach on the market caused by the use of certain financial instruments such as interest rate swaps.

Swaps are forward derivative contracts. The underlying object is the exchange of cash flows, which are calculated according to the specific terms of the agreements. One of the most diffused and widely used swap contracts are interest rate swaps.

An interest rate swap, more specifically, is an arrangement where two contracting parties agree to exchange future payments to each other, that vary on the basis of different, predefined interest rates applied to a predefined principal amount, for a time horizon determined at the time the contract is signed. The contractual terms do not provide for an exchange of capital, but only for flows corresponding to the differential between the two interests.

Some of swaps’ peculiar characteristics are:

  • The contract has deadlines exceeding one year.

  • It is traded OTC.

  • The due dates for payments are determined on an interim basis as 3,6,9 or 12 months, unless the parties provide otherwise.

  • The contract may be assigned to another party.

  • 26% taxation on capital gains from 2014.

The purpose of this practice is to cancel the risk associated with fluctuations in interest rates or exchange rates between currencies, or to obtain a lower interest rate than without the swap.



Different Types

There are various types of swap contracts:

  • Coupon swaps: also called vanilla swaps, are contracts whereby two parties exchange a fixed-rate and a floating-rate interest stream in the same currency (floating-to-fixed swap).

  • Basis swaps: contracts wherein two parties exchange interest flows both at floating rates in the same currency (floating-to-floating swaps).

  • Cross-currency interest rate swap: contracts through which two parties exchange two predetermined interest streams in two different currencies (fixed-to-fixed swap).

The variable interest rate changes as its underlying rate changes, which in this precise case is LIBOR, an acronym for London Interbank Offered Rate. LIBOR is an interbank rate that is calculated daily by the Reuters agency on behalf of the British Bankers' Association and represents the rate at which banks lend to each other in the London money market, with transactions normally taking place after the markets close. It is also a basic indicator for international markets and Euro-currency loans. In particular, various other interest rates are linked to it, including those of variable-rate mortgages and the reference rates of derivative contracts, which include IRS. For banking transactions exclusively in euros, EURIBOR is used, which, different from LIBOR, is calculated by the federation of European banks.

(GBP LIBOR interest rates chart - maturity 3 months from Global Rates)




Why IRS?

The purposes for entering into an IRS contract are 2:

1) Purpose of coverage:

When a person has long-term variable-rate debts, he can enter into an IRS contract to hedge himself from the risk of rising market interest rates; in fact, the buyer who pays a fixed and receives a variable rate on the notional principal will gain in a situation of rising rates. The difference received in his favor allows him to neutralize what he owes on the variable rate, thus protecting himself from the risk of interest rate fluctuations by immediately establishing what rate he will pay for the duration of the swap contract.

2) Speculative purposes:

This type of approach works in the opposite way to the previous one: a person anticipating a reduction in market rates might in fact buy fixed-income bonds, which acquire value due to the reduction in interest rates. The same person, with these assumptions, could sell an IRS contract, thus taking a short position. Those who take the short position on this type of contract pay the variable rate which is lower and receive the fixed rate, thus benefiting from a falling rate scenario by collecting a positive differential.


Here is a short example to better understand IRS: The company Alfa takes out a loan from a credit institution for 100,000 euros at a fixed rate of 8% for five years. Another Beta company takes out a loan with another credit institution with the same characteristics as the previous one, but with a variable six-month LIBOR rate. Expecting a reduction in interest rates, company Alfa wishes to change the rate from fixed to variable; while on the basis of different valuations, company Beta considers it more convenient to borrow at a fixed rate. By entering into an interest rate swap, the two companies will be able to reverse their debtor position with respect to the interest rate of the loan granted by the credit institution. The company Alfa agrees to pay the counterparty the interest on LIBOR, while the company Beta agrees to pay the fixed interest rate of 8%. At the end of each period defined in the contract, the actual flow of payment will be the difference between the two interest rates, so if LIBOR falls to 6%, company Alfa will collect €2000 from company Beta; conversely, if LIBOR rises to 10%, company Alfa will pay €2000 from company Beta. However, the two companies remain obligated to the lending institutions and the differential establishes the effective amount of interest due to each company. The same contract can also be concluded at the credit institution that granted the financing.


UK focus

This type of contract has been the subject of discussion within the English landscape regarding the English economy. As far as the policies of Liz Truss's UK government was concerned, a fiscal maneuver wreaks havoc on UK government bonds and the pound.

On the 23rd of September, an expansion tax plan was announced to favor the wealthiest. In fact, in England, incomes over GBP 150000 would be taxed at a 45% rate. With the then announced new maneuver it was lowered to 40%. In addition, the cap on the variable part of bank managers' salaries imposed by the old EU rules was abolished. Finally, the maneuver wanted to increase corporation tax from 19% to 23%. All this is estimated to cost a collective £45 billion in debt. On top of that, there were measures for the livelihood of businesses and homes due to rising energy prices.


To all this the markets reacted with a sharp fall in the exchange rate and the London’s stock market, and a surge in government bond yields (Gilts). This reaction forced the Bank of England (BoE) to intervene to safeguard the stability of bonds, starting with pension funds, which were in margin call due to the large amount of Gilts and IRS they held, thus damaged by the depreciation of UK’s Treasury bonds. On 28 September, the BoE announced and initiated the temporary repurchase of Gilts until 24 October. In addition, the BoE postponed the start of sales of securities on the market to reduce its balance sheet in the coming months. Some order was restored to the Gilts market after the BoE's initial purchase, less so the effect on sterling. This affair provides important information so that the same mistakes are not made by new governments that currently or in the future will rise to govern their countries. The BoE, up to the 23rd of September, had been implementing a policy of Quantitative Tightening aimed at reducing the inflationary soaring also recorded in the English territory. This shift in fiscal policy conditions had led to a real risk for pension funds, which in England manage around £3,000 billion, a large part of the savings of British citizens. However, the link between the bleeding financial situation and pension funds is not clear; to understand the role of pension funds and why they are among the players most at risk in this negative financial spiral, we must first understand how they work.


Pension funds guarantee a stable contribution to their savers, this operation needs steady income in the coffers of pension funds. The funds in fact implement various investments and largely allocate British savings in government bonds. They differentiate their investments between a "safe and solid" part with low risk but low interest, principally Gilt, and another part with riskier bonds with obviously higher interest. By doing so, the funds are able to obtain a “medium” return which allows them to satisfy the periodic contributions promised to the savers. However, these transactions involve specific risks (in particular, the risk related to the change in interest rates in the case of Gilt and market risk in high-risk bonds).

To contain these risks, the funds use derivatives that act as “insurance” for their investment (This is where interest rate swaps come into play on a large scale). These contracts must be backed by the funds with their assets (principal cover with Gilts) given in the form of collateral. This procedure protects against investment risks but leaves the funds exposed to the risk of Margin Calls. That is, if your collateral assets depreciate, you will be required to cover the shortfall with additional assets or liquidity. And that is exactly what happened to the British pension funds. Once this risk (margin call) was realized, the funds had to sell additional government bonds to cover the derivative contracts that were to protect their investments in order to guarantee the returns to the savers of the funds (in government bonds themselves).

The situation was in such severe conditions that at least three UK pension funds had been hit with margin calls of as much as £100m.


On the 25th of October, 5 days after Liz Truss' resignation, Rishi Sunak was appointed as UK’s Prime Minister, hoping to reestablish stability.




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