Financial literacy: Plain language for securities. Swap: A contract for the exchange of cash flows

What you need to know about swaps – another risk hedging tool by exchanging payments

The National Securities and Stock Market Commission (NSSMC), together with LIGA.net, has prepared a series of publications to explain the essence and specifics of financial instruments and mechanisms of their use in a simple and accessible manner.

In previous publications, we have discussed the general principles of derivatives and the specifics of forwards, options and option certificates. The topic of today’s publication is the swap, another derivative that has long been used in global financial practice to hedge risks.

Economic essence

A swap is a derivative contract whereby two parties exchange cash flows or liabilities from two different instruments. Simply put, it is a contract to hedge risk by exchanging payments. Such a contract can be concluded both on and off the organized market.

The definitions of swaps provided in the Law of Ukraine on Capital Markets and Organized Commodity Markets (hereinafter – Law 3480) and the Tax Code of Ukraine are general in nature and only define the perimeter for structuring the instrument configuration required by the parties.

What swaps are there?

Today, there is a very large number of options for using swaps. Here are examples of the main types of swaps.

An interest rate swap is an agreement between two parties to exchange different interest payments (calculated at fixed and floating interest rates) in the same currency during the term specified in the contract. The amount of the interest payment is calculated based on the amount, interest rate and the relevant interest period.

A currency swap is an agreement that provides for the exchange of cash flows denominated in different currencies agreed upon by the parties.
A commodity swap is used to exchange cash flows that depend on the price of a commodity. Since the price of commodities is variable, a fixed price of a commodity (for today) is exchanged for a floating price.

Equity swap is an agreement to exchange future cash flows between two parties, where one party generates a cash flow based on equity and the other party generates a notional fixed cash flow based on, for example, LIBOR.

Debt-equity swap – an agreement that provides for the exchange of cash flows generated by equity and debt capital by the parties.

Total return swap – an agreement under which the return on a certain asset is exchanged for a fixed interest rate. The party paying the fixed rate assumes the risk of a particular asset (including shares). For example, an investor may pay a fixed rate to a party in exchange for access to shares, realizing capital gains and receiving dividends, if any.

A credit default swap is a transaction entered into to hedge credit risk (a counterparty’s failure to fulfill its obligations), although the buyer of the protection may not bear the credit risk or bear it indirectly. This instrument belongs to the third wave of derivatives – credit derivatives – and will be discussed in the next publication.

Is there any experience of using swaps in Ukraine?

Undoubtedly, there is such experience and it was gained in the banking system, as it is banks that are able to effectively manage interest rate and currency risks.

Historically, the first swap in Ukraine was a currency swap. Even before the first regulations governing swaps were drafted, banks entered into offsetting contracts to buy and sell in a currency pair. Obligations under the counterparties were fulfilled either by exchanging full cash flows or by netting the counterclaims and paying the difference to the winning party.

Thus, banks used their existing opportunities to enter into foreign exchange purchase and sale agreements to structure currency swaps. In other words, the banks structured the derivative with the help of other transactions, which is a good example of financial engineering: when market participants have knowledge of and need for certain financial products, they can artificially construct such an instrument with the help of other simpler instruments.

When the regulator of the relevant market notices such engineering, the best response is to adopt appropriate regulations to regulate such transactions. Thus, the following NBU resolutions regulate swaps in the banking market:

• NBU Resolution No. 222 dated 31.03.2016 on Approval of the Regulation on Conducting Foreign Currency Purchase and Sale Transactions by the National Bank of Ukraine on Swap Terms;
• NBU Resolution No. 67 dated 28.05.2020 on Approval of the Regulation on Conducting Interest Rate Swap Transactions by the National Bank of Ukraine in the Interbank Market.

A good example of a currency swap is the agreement between the central banks of Ukraine and Poland (entered into force on March 21, 2022) with the following characteristics: currency pair – UAH/USD, term of the agreement – 1 year with the possibility of extension, volume – up to USD 1 billion in equivalent. USD equivalent.

In addition to banks, a currency swap may be of interest to companies that enter into foreign economic contracts and will have receipts or obligations to convert the counterparty’s currency, as such companies have the opportunity to hedge currency risk (changes in the exchange rate that will lead to losses).

For example, Company A has attracted a foreign currency loan for 1 year in the amount of USD 1 million, and Company A will spend the funds in hryvnia, which necessitates the sale of foreign currency proceeds. At the same time, realizing the need to repay the loan in foreign currency, Company A must repay USD 1 million in a year at an uncertain rate. If the dollar appreciates, Company A will have to pay more hryvnia than it received when it sold $1 million. To transfer the currency risk to another entity, Company A may enter into a currency swap that provides for the repurchase of $1 million under specified conditions. Typically, the repurchase rate is determined by reference to the interest rates of the respective currencies and the respective maturity.

Another very interesting instrument is an interest rate swap, the idea of which is to exchange cash flows from a fixed interest rate for a floating interest rate:

• one party, the fixed rate payer, undertakes to make payments at a fixed interest rate on specified dates during the swap period;
• the other party, the floating rate payer, undertakes to make payments based on a specified benchmark rate, such as LIBOR.

The monetary value of the exchanged payments is calculated based on the amount specified in the swap, which is called the notional amount. The amounts of payments exchanged between the parties are calculated at the agreed periodic interest rate multiplied by the notional amount of the contract. Thus, the parties exchange only interest payments, and the notional amount acts as a scaling factor that helps convert the interest rate into cash flow.

The modern practice of using interest rate swaps in Ukraine began with the adoption of the NBU Resolution on Approval of the Regulation on Conducting Interest Rate Swap Transactions by the National Bank of Ukraine in the Interbank Market No. 67 dated 28.05.2020. Since then, 12 auctions have been held with contracts at different rates and notional amounts.

Such an instrument (interest rate swap) may be of interest to those who use interest-bearing instruments such as deposits, loans, bonds, etc.
However, it should be noted that the active use of such an instrument as a swap should be preceded by the harmonization of tax legislation with the provisions of Law 3480. First and foremost, we are talking about VAT taxation of these transactions. For example, when interest payments are exchanged (interest rate swap), there are no counter credits/deposits, and therefore, such interest payments are not interest paid as a fee for the use of funds or property borrowed for a fixed or indefinite period. Such an approach may result in additional VAT charges. In order to avoid such discrepancies, the legislation needs to be constantly harmonized.

Conclusions./h3>
Hedging risks with swaps is an effective and useful mechanism that is understood by our international partners. Despite the legalization of swaps in Law 3480 and the existence of a definition in the Tax Code, such swaps are not widely used in Ukraine today, but with the development of financial markets, the use of such contracts is becoming relevant, especially for foreign partners planning to invest in the Ukrainian economy.

In the next publication, we plan to familiarize you with credit derivatives (credit default swaps and credit notes).

The text was prepared by the NSSMC specially for LIGA.net