Swap Structure

An interview with Ralph Axel

Have interest rate swaps (IRS) become the modern repurchase agreements (repos)? In the latest essay in the ongoing series on Market Microstructures, I argue that shifts in the liquidity market have fundamentally altered the function of IRS in the global financial system. Today, IRS are used to fill funding gaps and compensate for failures in the repo market. 

The following interview with Ralph Axel, an interest rate strategist at Bank of America (BofA), builds on this analysis, providing insights into the fixed-income market. Extensive experience in sales and trading desks has given Axel a thorough understanding of market structures, models, and risks. Below, we delve into the market structure of interest swaps, its connection with the wholesale money market, and regulator responses. 

An interview with Ralph Axel

ELHAM Saeidinezhad: Bank of America, which is a big player in the fixed-income market, is known for being one of the largest dealers in IRS—financial contracts in which parties exchange fixed interest payments with floating ones based on a notional amount. They create markets in IRS and sell them to participants such as asset managers and primary dealers, and they also make markets in fixed-income futures, and Treasury securities.

Let’s examine the market structure for IRS. What is the dominant force that is fundamentally altering the market structure?

Ralph axel:  In recent years, the Commodities Futures Trading Commission (CFTC) has discussed introducing new regulatory rules. These are aimed at examining the creation of new products for trading and defining capital requirements for swap dealers and major swap participants. The discussions are ongoing, with the CFTC working to ensure that new products benefit the market, while also considering the capital requirements of those involved in transactions. The CFTC aims to promote efficient markets while strengthening participant’s balance sheets.

ES: These rules are separate from those introduced after the 2007-08 Great Financial Crisis (GFC), which were focused on increasing transparency in the market in the aftermath of GFC. Regulators have now shifted their attention.

RA: Since the financial crisis of 2008, increasing transparency has been a crucial goal. In order to achieve this, regulators have implemented margin rules for high-quality collateral and clearing rules to push trades towards central counterparties (CCPs). These measures help create visibility, which was sorely lacking in 2008. It took a lot of work to know where IRS were located, who was facing whom, and what collateral types were used. Clearing and margin requirements have been at the forefront of regulators’ efforts to improve risk reporting, measurement, and tracking.

Recently, regulatory focus has shifted towards strengthening swap participants’ balance sheets through higher capital requirements and closer examination of new products that may be considered swaps.

ES: As someone who follows the markets closely, do you think these regulations are necessary?

RA: These additional swap regulations aim to address issues in the repo market, albeit indirectly. I will later explain how the IRS and repo markets are connected. Going back to your question on regulation, in the repo market, current regulatory proposals that aim to push for repo clearing seem unnecessary.  In the swap market, the existing mandates introduced in Dodd-Frank and Basel III have already led to a smooth transition into swap clearing. Clearing swaps involves directly or indirectly submitting the swaps transactions to a Derivatives Clearing Organization (“DCO”) registered with the CFTC. In the government fixed-income market, for instance, the Government Securities Clearing Corporation (GSCC) has played a key role in this, handling government securities swaps with ease. In general, this process has been successful and has led to the development of relatively robust swap markets.

ES: What is driving regulators to impose more restrictions on the IRS market? I am specifically thinking about capital requirements and new product rules that the industry has criticized.

RA: The new regulatory interventions, although happening in the swap market, are not intended so much to fix the IRS structure but to stabilize the repo market. The repo market is a crucial wholesale funding market that helps to move cash around the financial system. The swap market plays a major role in enabling the flow of funds through the repo market. Therefore, regulators pay close attention to the happenings in this market.

In the repo market, regulators, particularly the US Securities and Exchange Commission (SEC), advocate for the central clearing of the repo and US Treasuries to promote transparency. Similarly, the CFTC also pushes for increased swap clearing to enhance transparency in the IRS market. In addition to these mandates, the CFTC has implemented new capital requirements to improve the risk management and risk-absorbing capacity of the swap dealers and major swap participants. These regulatory developments positively impact both the repo and IRS markets.

ES: You mentioned that swaps are crucial infrastructures supporting the repo market. The relationship between wholesale funding and swap markets is fundamental to the functioning of the financial system. Strangely, this connection is often disregarded in academic discussions. How do swaps make it easier to facilitate wholesale funding?

RA: It is possible to observe a connection between the IRS market and the repo market by examining the business model of major swap participants. These entities, including asset managers and primary dealers, frequently use repos to raise funds and manage liquidity. In fact, asset managers constitute almost a quarter of the participating firms in the repo market, while primary dealers account for nearly 50 percent of the participation. These entities use interest rate-sensitive fixed-income securities, such as US Treasuries, as high-quality collateral to obtain cash in the repo market.

Asset managers need to access funding through fixed-income securities. However, their funding depends on these securities’ price, which exposes them to price risks. To mitigate this risk, IRS can be used as a hedging solution. In the meantime, the repo market determines the funding costs for these firms, which are represented by the interest rates. At times, the repo market may offer unattractive or high rates, which interest rate swaps can mitigate. This process, known as interest rate management, enables asset managers to exchange these rates for more desirable and attractive rates. It is important to note that the conditions of the IRS market can impact the functioning of the repo market.

But again, from an operational standpoint, it is striking how well the wholesale funding functions when you look at repo markets. 

ES: The repo market is currently functioning well. However, as you previously mentioned, asset managers could use swaps to manage their funding costs if the repo market were to offer unattractive rates. This is a crucial function of swaps in the funding market.

RA: An IRS is a financial instrument that helps entities manage their interest payments, including those related to activities in the repo market. Additionally, swaps help asset managers manage cash flow. For instance, asset managers can use IRS if they need to adjust their portfolio’s duration. Duration refers to the average time it takes to receive all of a bond’s cash flows, weighted by the present value of each cash flow. It is the payment-weighted point in time at which an investor can expect to regain their original investment. Liquid swap markets partially exist because swaps provide these essential funding-centric services.

ES: Interestingly, IRS are often overlooked as a funding strategy. 

RA: Yes, non-practitioners sometimes do not recognize the IRS market’s full potential. Typically, swaps are used either to hedge or speculate, which are their more classic functions. Hedging is an important because it can be used by both financial and non-financial corporate entities. For instance, if IBM plans to issue a bond within the next year and wants to avoid a situation where interest rates rise by 100 basis points, it can hedge today using the swaps market. This enables companies to plan more precisely for the future, leading to a smoother business cycle, even outside financial markets.

ES: Should we expect spillover effects between the repo/US Treasuries and swaps markets due to regulatory developments such as clearing mandates?

RA:  It is important to note that anything that limits the accessibility of high-quality collateral, including US Treasuries, for entities such as asset managers will increase the cost of repo funding. This increase in cost will also have implications in the IRS market. This is because the cost of managing the interest rate risks associated with these fundings will also increase. Similarly, any factor that increases the hedging costs will also cause an increase in the funding costs. Therefore, it is crucial to be meticulous when creating clearing/regulatory rules that affect the expenses of derivatives and repos. The functioning of the swaps and repo market are closely related.

ES: The costs from the swap market, where interest rate management takes place, spill over to the repo market, where access to funding is provided, and vice versa. Regarding the new regulations on clearing mandates, are practitioners concerned about the costs that the restrictions may bring?

RA: A more important question that needs to be addressed—who bears the costs? Specifically, when it comes to clearing, regulators must clarify who is responsible for bearing the costs. Are clearing house owners or capital owners on the hook? Additionally, how is the cost distributed among the participants? These are important questions.

ES: Our focus has been on asset managers, but the Silicon Valley Bank (SVB) failure shows that banks also extensively use IRS. Can you explain banks’ applications for swaps?

RA: The banking system holds approximately 17 trillion in deposits and frequently adjusts its fixed and floating rate exposures on both the asset and liability sides. Banks may opt for a fixed-to-floating rate swap through the IRS market to match their overall balance sheet interest rate exposure more effectively. The system is functioning well as these entities can trade swaps in a relatively liquid manner without encountering significant difficulties in determining market pricing, executing trades, determining trade size, and exiting positions without disrupting the markets.

During the pandemic in 2020, swaps functioned properly while the cash market (i.e., the US Treasury market) needed the intervention of the Fed. Because people could not exit the market smoothly and functionally, the Fed had to buy many Treasuries. The current swap market is not in an emergency that requires fixing. However, it should be improved, simplified, and made fairer over time.

ES: During the pandemic, you mentioned that investors faced difficulty in selling US Treasury holdings while they more smoothly unwound their swap positions. Although financial theories offer various ways for investors to exit swap contracts, what are the most commonly used methods in practice?

RA: If a client has a swaps position initiated a few months or years ago, they usually approach a “swap dealer.” Like the BofA trading desk, these dealers could be large or smaller swaps dealers. These dealers have standardized pricing methods, crucial for clearing and enabling clients to exit their positions. The client would provide their swap’s payment schedule and maturity date, and the dealers would make a market in the swap. The client could enter or exit the swap, just like trading any other financial asset.

ES: Earlier, you mentioned that the swap market was resilient during the pandemic because participants could smoothly enter or exit swap positions. Liquidity is a service offered by swap dealers such as BofA, vital in making the market for interest rate swaps. Can you tell us more about their business model and whether there will be any significant changes to their transactions or model due to regulatory changes in the near future?

RA: We have trading desks for various financial instruments like IRS, repos, treasury securities, mortgages, corporate investments, high yield, commodities, and currencies. Each desk has a different business model. Generally, businesses require a certain amount of capital to operate, which can generate a certain return, making it attractive or unattractive. Sometimes, a business may not have a high return on equity, but it’s still important to keep it running as it provides a vital side service to other attractive businesses. Decision are made not only based on a business’s its return on equity but also on how it fits into the overall capital market operations. Swaps and cleared products are crucial to meet the demands of our client base. Interest rate risk and sensitivity are inherent in the fixed-income market, which makes swap dealers a fundamental part of the financial market infrastructure.

ES: Standardization is a significant side effect of clearing mandates. Does standardization make the market-making more accessible, attractive, or challenging?

RA: Standardization is very important. The value of any market lies in how usefully it facilitates trade. You can trade less standardized assets. But as you move away from the standardized products, the markets become less deep. And the pricing becomes more volatile, and liquidity deteriorates. We see that in many markets—Treasuries, mortgages, etc.—that started standardization before the swaps market. That is why important markets, such as mortgage-backed securities (MBS) and Treasury markets, are highly standardized.

As you move away from standardized products, markets become less deep, and your pricing and liquidity are lower. This is why the IRS market is also growing highly standardized. We only have a financial system because the market can fulfill a need. We have a swaps market because so many entities have financial risk and the need to manage interest rates. They need to exchange fixed payments for floating payments. Everyone benefits if you have a IRS market that exchanges fixed for floating rate payments. But as it becomes more specialized, the number of people open to using the market declines—it becomes less valuable.

ES: I want us to focus on the hedging momentarily. Some practitioners differentiate between hedging and risk management. In academic and policy discussions, they are often used interchangeably. Are there any differences between these two terms?

 RA: Risk management is a broader concept than hedging. Usually, when hedging, there are very specific instruments whose risk profile is changed. Let’s say a bank has a mortgage-backed security sensitive to interest rates. That’s a specific interest rate exposure, so they might trade a swap specifically geared towards reducing the interest rate exposure on that mortgage-backed security. Risk management more broadly incorporates more generic ideas. 

Borrowing costs are a function of the overall interest rate level and its specific credit profile. As a corporation borrowing money in capital markets doesn’t know precisely what its borrowing costs will be next year, it can’t perfectly hedge. Likewise, as its credit profile can change in a year, it can’t really hedge—it can only hedge the approximate overall level of interest rates. Risk management tends to be performed by corporations that wants to manage overall exposure to borrowing costs by locking in their costs through a fixed tenure swap. That’s different from hedging the interest rate risk on a specific security.

ES: I am also curious about the role of CPPs in all of this, including hedging. A CCP becomes a counterparty to trades with clients that are different market participants. Recent reports from the CFTC display concern for the behavioral diversity among CCP clients—hedge funds, asset managers, insurance companies, pension funds, and so on. Should we be concerned about this?

 RA: I think the more, the merrier. If you only had banks in the swap market, they would likely all go the same way—if they are generally making thirty-year fixed-rate loans, they all have similar risk exposure. They will all want to go in the same direction in the swap market to offset it. That would create a lopsided demand; you wouldn’t have many players or entities wanting to take the other side of that trade. When banks, hedge funds, insurance companies, asset managers, and corporations take different risks in different directions, the chances of a balanced market is much greater. Diverse entities spread risks, which is extremely important.

ES: We started our conversation by discussing regulations and collateral (margin) rules. I want us to go return to that point. One of the things that the CFTC is trying to understand is whether there is a causal relationship between margin requirements and the liquidity of the IRS market—whether margin requirements create funding issues in the market. What do you think about this relationship between margin requirement and liquidity?

 RA: We have seen some problems with margin requirements. In the UK, pension funds struggled to meet margin requirements because the market had huge moves. The prices of assets declined significantly, and they were asked to put more margin in to protect against default. Suddenly, these funds were not able to make their margins. It’s thus important to have somewhat predictable margin requirements. If volatility picks up suddenly, you have margin requirements that were not projected or planned. That can be disruptive; if you can’t meet your margin requirements, you must unwind your position in the clearing house.

That forced liquidation, sometimes called fire sales, is a risk. You can have caused liquidation problems for other reasons, like suddenly needing to meet liabilities. We want to minimize fire sales because they significantly impact the prices and liquidated assets and carry chain effects. We must figure out ways to reduce the risk of fire sales and forced liquidation by making margining more transparent and predictable. It’s very tough to do that because margin requirements move with volatility, but it is important to make margining less disruptive.

ES: Finally, I want to discuss the hierarchy of financial instruments, where cash is at the top. CFTC reports mention that market practitioners prefer to hold cash as collateral and seem pretty puzzled about it. Is this the case, and if so, why?

 RA: Cash doesn’t have price risk, and everything else does. If you post treasuries and their price decreases, you might need to post more. That’s the main problem with non-cash—it has this exposure that can make it less valuable. The problem is that to get cash, you often have to borrow it; entities rarely have lots of cash sitting around because it’s an expensive thing to do. So, practitioners face a tough choice on the right collateral to use.

Treasury bills have minimal price risk, while thirty-year bonds have a lot of price risk. Then you might have other types of securities, like government bonds issued by Germany or Canada, and so on. These might have the same property of moneyness as T bills or cash. It is undoubtedly essential to have some flexibility in the collateral types used. 

One of the great things about insurance companies in the United States is that they naturally hold a lot of corporate bonds of various types. It’s beneficial that many insurance companies have collateral arrangements that allow them to post those corporate bonds. If something happens with a margin call for an insurance company, they typically will be able to adjust the margin to, let’s say, an increased margin requirement because they’ll post more of the assets that they already own, they don’t have to go out and find these assets to post.

Rate Transformation

Interest rate swaps are modern repos

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