Extending Safe Harbor to Swaps #1-4

Through the 1980s the market in a new type of derivative called a swap was growing.  The first swap was a currency swap:  IBM was receiving regular payments in Swiss francs which it needed to convert to dollars, while the World Bank was receiving dollar payments and had obligations in Switzerland.  The two parties contracted to exchange their Swiss francs for dollars and vice versa.

The most common swap contract both in the 80s and today is the interest rate swap, where one party pays a floating interest rate (which can change and is based on a money market rate) on a regular basis over a period of years and receives regular payments from the other party based on a fixed rate that is set at the start of the contract.  Such contracts are very useful for banks that have sold fixed rate loans and wish to protect themselves against the possibility that the money market rate rises.

The defining characteristic of a swap contract is the trade of a fixed stream of payments for a stream of payments that will be determined by future prices or events in financial markets.  Swaps were considered a new category of financial contract that did not fall directly under the jurisdiction of any of the existing self regulatory organizations supervised by the SEC.

Instead of extending the purview of one of the existing self regulatory organizations to cover swaps, a consortium of dealer banks chose in 1985 to create a new trade group to coordinate swap policy, the International Swap Dealers Association or ISDA.  Thus, through the 1980s the swaps market was unregulated:  they were not, for the most part, considered securities by the SEC, and the CFTC allowed them to fall through the forward contracts exemption of the Commodities Exchange Act.  Their unregulated status was confirmed in 1993 by formal CFTC exemption from regulation. [1]

The repo amendment to the Bankruptcy Code had established the principle that the imprimatur of a self regulatory organization was not necessary for a financial contract to receive safe harbor; exemption from bankruptcy was possible even for unregulated financial contracts.  Thus when the financial industry sought safe harbor privileges for swaps contracts they did not seek the status of a national securities association for the ISDA – which would have granted swaps the same privileges as other securities under the 1982 amendment.[2] Instead the ISDA lobbied Congress to pass an exemption from the Bankruptcy Code specifically for swaps.  The ISDA and other lobbyists argued that the law favored exchange traded derivative contracts by granting them privileges that were not available to over the counter derivatives like swaps.[3] In short, they called for unregulated financial derivatives to receive the same treatment as regulated financial derivatives.

In 1990 the swaps amendment to the Bankruptcy Code was passed.  As with the repo amendment the safe harbor protection for swaps employed extremely broad language:  the amendment extended to any contractual right arising “under common law, under law merchant, or by reason of normal business practice, whether or not evidenced in writing.”[4] From 1990 on swap market participants were, thus, permitted to seize the margin posted by a bankrupt counterparty, to sell off the counterparty’s positions and to set off the value of the bankrupt’s margin against the obligations owing to the swap participant.  The broad terms of the amendment granted a large class of financial contracts special status in bankruptcy.

After the 1990 amendment was passed, the swaps market grew steadily for the next decade and a half.  In 2008 the dollar amount of interest rate and currency swaps had grown to more than 400 times what it had been in 1987. [5] The swaps market also grew as new products were developed that simulated the returns of tradition financial contracts.  Credit default swaps are synthetic bonds:  one party receives regular interest payments in exchange for paying out the value of an underlying bond if it goes into default.  These swaps can function as bond default insurance, since the other side of this trade makes regular payments in exchange for a guarantee that the face value of the bond will be paid even after the bond goes into default.  Equity swaps are synthetic stocks:  one party receives a payment (or periodic payments) based on the performance of a stock or stock index and makes payment(s) based on the money market interest rate.  The other equity swap counterparty then gets the return of a short seller, he will lose the value of any increase in the value of the stock and gets the proceeds from investing the cash gained by selling borrowed stock in a money market account.  Total return swaps are similar but can be used to simulate the returns of any asset.

While these swaps are often called synthetic assets, there is an important difference between a synthetic asset and a real asset:  real assets require an upfront payment to purchase the asset, whereas synthetic assets have no upfront payment and involve instead a promise to make payment in the future.  Thus while an investor in a real bond must come up with, say $10,000, to purchase the bond, the investor in a synthetic bond pays nothing unless the underlying bond defaults – at which point the investor will have to pay the $10,000.  In theory, then, synthetic assets are infinitely leveraged investments (that is, the investor puts no money down at all).  In practice every investor – with the exception of the dealer banks – is required to post margin when entering into a synthetic investment and this reduces, but by no means eliminates, the degree of leverage involved in the transaction.  It remains unclear to what degree the dealer banks post margin on their trades – which leaves open the possibility that their positions in the swaps market are extremely leveraged.

Another concern raised by swap market developments is that when one considers the variety of swaps that have been created to date – currency swaps, interest rate swaps, credit default swaps, total return swaps, equity swaps – one realizes that there are few financial contracts that cannot fit under the umbrella term “swap”.  It is true that traditional investments like stocks, bonds and mortgages require a large upfront payment, rather than the large tail end payment that is common in the swaps market;  however, given that extremely asymmetric payments are an integral part of the swaps market, it’s far from clear why the time sequence of asymmetric payments should be sufficient to preclude the reclassification of traditional investment vehicles as swaps.  Furthermore, if the distinction is that with stocks and bonds one party has no future obligation to make payments, then the simple expedient of either allowing settlement to take place one week after the trade date or of offering to sell the stock or bond on an installment basis (adjusted, of course, by the money market rate) will turn the traditional asset into a swap.[6]

Given the fact that the overarching term “swap” can apparently encompass most financial contracts, the legal definition of a “swap” is a matter of some importance.  This definition was amended by the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, discussed below.

[1] However in a regulatory action in 1994 against Bankers Trust Securities Corp. the SEC did claim that some swaps were securities.  This position was very much the exception rather than the rule.  (Carolyn Jackson, 1999, “Have you hedged today?” 67 Fordham Law Review, p. 3223)

[2] The definition of a security in the Securities Acts of 1933 and 1934 is broad enough to include swaps, if the swaps dealers had wanted the designation.  (Olander and Spell, “Interest rate swaps,” 45 Maryland Law Review, 1986, p. 53)  However, since that would subject them to regulation by the SEC, they argued that swaps were not securities and the Gramm-Leach-Bliley Act  (2000) explicitly amended the Securities Acts to exclude swaps from the definition of securities.

[3] “Over the counter” refers to trade that takes place in a decentralized manner and is coordinated by dealers.  Karen Ramdhanie, “Derivatives contracts of insolvent companies,” 18 New York Law School Journal of International and Comparative Law, 1999, p.299

[4] Hance, p. 746.

[5] Data from ISDA http://www.isda.org/statistics/pdf/ISDA-Market-Survey-results1987-present.xls.

[6] Note that even spot transactions have a settlement several days in the future, so all financial transactions are in some sense forward transactions.  Furthermore, the definition of swaps contract has always explicitly included spot foreign exchange agreements.  The text of the law with revisions indicated is available here:  http://www.law.ttu.edu/lawlibrary/library/research/BAPCPA_Library/code-01.htm#101.50


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