Interest Rate Swap. Specialist Lawyers in Swaps.
Interest Rate Swap
Interest Rate Swaps (IRS) are among the most complex financial products, generating a high level of litigation with financial institutions. We recommend that all our clients, whether businesses or individuals, review the terms of their contracted swaps and, subsequently, consider renegotiating or litigating with the banking entity.
Swaps: Financial Derivatives. Preliminary Concepts.
A swap is a type of financial derivative of English origin, also known in Spain as a financial swap.
To understand this financial instrument, we must first examine what financial derivatives are.
A derivative is a financial product whose value is based on the price of another asset, which can be of a very different nature, such as interest rates, inflation, shares, indices, commodities, etc. Therefore, these products are always related to another asset called the underlying asset.
This fact allows for a wide variety of possibilities, but to be brief, we will focus on a specific type of derivative: interest rate swaps.
Interest Rate Swap (IRS)
The interest rate swap is commonly known as an Interest Rate Swap (IRS), and it consists of exchanging interest payments accrued on a specific underlying asset, without the transfer of a principal amount. Therefore, within financial derivatives, we find swaps, and within these, IRS.
These instruments are defined by fulfilling the following three characteristics:
- Their value changes in response to changes in a specific interest rate, the price of a financial instrument, the price of listed commodities, the exchange rate, a price or interest rate index, a credit rating or index, or based on another variable, assuming, in the case of a non-financial variable, that it is not specific to one of the parties to the contract (often referred to as the underlying).
- They do not require a net initial investment, or they require an investment that is smaller than what would be required for other types of contracts, where a similar response to changes in market conditions could be expected.
- They will be settled on a future date (International Accounting Standard No. 39, para. 9).
A swap is an atypical but lawful contract under Article 1255 of the Civil Code and Article 50 of the Commercial Code, imported from the Anglo-Saxon legal system, characterized by doctrine as consensual, bilateral (i.e., generating reciprocal obligations), synallagmatic (with independent performances, each acting as the cause of the other), of continuous duration, and involving the exchange of reciprocal obligations.
In its Interest Rate Swap modality, the agreement consists of exchanging, on a nominal and not real (notional) principal, the amounts resulting from applying a different coefficient for each contracting party, called interest rates (although they are not strictly such, as there is no actual capital loan agreement), with the contracting parties merely exchanging partial payments during the contract’s term, according to the respective agreed terms and rates, or, more simply, periodically settling such exchanges by compensation, resulting in a debit or credit balance for one or the other contracting party.
Each swap must be analyzed individually, as they can be more or less complex, but in Article 79 bis.8 of the Securities Market Law (LMV), we can see that swaps are complex products…
Swaps can be used as hedging instruments (protection against market volatility) or as speculative products. In the business sphere, their use as a hedging instrument allows companies to protect their accounts from potential financial losses. One of the many effects of globalization and new technologies has been the increase in these financial risks. These risks to be covered are of very varied natures, including changes in: interest rates, currency exchange, commodity prices, stock prices of listed companies, etc.
Given the risks mentioned, there are two possible options: one is not to address them, maintaining potential gains at the cost of assuming high risk, or to control these risks, which implies a reduction in potential benefits. Therefore, the use of swaps allows for the limitation of financial risks in exchange for a reduction in potential benefits, but with the desired effect of achieving greater financial stability in the company. The problem is that the complexity of these products has generated serious irregularities due to the actions of several banking entities, as we are seeing in the courts.
Swaps have a key characteristic that explains their large number of market transactions: the ability to limit financial risks without the need for a prior and real exchange of monetary flows. For example, if a company wants to cover debt assumed in an expansion process, it can do so without paying any initial amount.
These products are highly complex, so they must be properly structured to produce the desired effects. One of the main aspects is their contracting at market value and without imbalances. That is, the initial value of the swap must be 0 for both parties, and only from the first settlement should amounts begin to accrue favorably or unfavorably to one party or the other. The controversy arises when most clients cannot verify the value of the contracted swap due to its high complexity, and this circumstance can be improperly used by the bank, which is in a privileged position.
If banks had only acted as intermediaries between large, properly advised companies, the vast majority of lawsuits would have been avoided. Instead, in most cases, as the bank acted as a counterparty, swaps have been generalized to non-expert clients, along with the aggravating factor of a conflict of interest, because if their client loses, the bank wins.
On the other hand, swaps are financial instruments without an official organized market where they can be traded and transferred, but this does not prevent their transfer. This characteristic means they are traded in the Over-the-Counter (OTC) market. The fact that the value of swaps is OTC is another characteristic that makes them complex and difficult to value for non-experts. Only the most expert economic agents have access to the OTC market and the forward rate curves necessary to value swaps and their early cancellation. . We must bear in mind that these curves serve to obtain a forecast of rate evolution, which, as we have already seen, is the basis for calculating differentials. Even large companies classified as professionals are at a disadvantage compared to banks when it comes to valuing forward rates.
Within the interest rate swap (IRS) that concerns us, we can differentiate between plain vanilla or coupon swaps and basis swaps. In coupon swaps, one variable interest rate and one fixed rate are used – as reflected in the clause signed in the mortgage contract – and in the latter, only variable rates are used.
Another relevant aspect concerns the notional, also called nominal or principal. In practice, many swaps are signed with a constant principal when the client needed a swap with a variable principal (amortizing swap). That is, when a client contracts a swap to cover a debt that is repaid over time, the swap cannot always be calculated based on the same amount, as it should decrease in parallel with the amount being covered. Therefore, in these cases, the principal must be variable, decreasing as the maturity approaches. If we are facing such a case and the bank does not offer a variable principal, the contract could be challenged for being an unsuitable product.
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