A swap is a contract between two investors, derived from an underlying asset that each party has, and the other can benefit from. Assets do not change ownership—what is swapped is one or more of an investment's benefits.
Swaps are traded over-the-counter, which means that individual investors do not generally trade them. However, methods are emerging that allow interested investors and traders to add swaps to their portfolios.
Learn more about swaps, how they work, and how they can be invested in with exchange-traded funds.
What Are Swaps?
A swap is an agreement between two parties to exchange an investment asset's benefits at a predetermined date. They are an exchange of a series of payments. Swaps are not limited to one type of investment—a swap can be agreed on for stocks, bonds, exchange-traded funds, commodities, foreign currencies, or even interest rates.
How Do Swaps Work?
Companies use swaps to hedge the risk of financial decisions such as issuing bonds or stocks. If one company wants to issue bonds but isn't comfortable with the interest payments it would need to make on them to the holders, it could look for another company to swap with.
For example, suppose Company X were to issue bonds with a variable interest rate, but it is concerned over rising rates. In that case, it might look for another company that would agree to pay that bond interest for it.
If Company Y were to agree to pay the interest for Company X, it could ask for a fixed-rate interest payment on a set amount of money. If interest rates go up, Company X would benefit more, because it might be paying less interest to Company Y; however, if rates go down, Company Y might benefit, because it would receive more from Company X.
Generally, one side of the contract agreement is set, while the other is variable.
A swap can have multiple financial exchanges during the life of the contract. The contract can be negotiated to last however long a business feels necessary. Sometimes, one side of the swap agreement may want to end the contract before its final expiration.
At that point, both traders can agree on the deliverable, or settle on a cash equivalent for the contract, or even create a new contract position. Prior to 2010, swap contracts did not trade on public exchanges and therefore were not regulated. Both parties were free to make agreements as they saw fit.
Then on July 21, 2010, Congress passed the Dodd-Frank Wall Street Reform and Consumer Protection Act, effectively placing the Securities and Exchange Commission and the Commodities Future Trading Commission in charge of regulating swap trades, which had grown into a multi-trillion market.
What Do Swaps Mean to Individual Investors?
Typically, swap contracts are executed by major financial institutions and established banks. As such, investors who are engaged in swaps need to have a large capital capacity and ability to make the negotiated payments.
ETFs are one of the newer types of investments available—the first one appeared on the U.S. market in January 1993 and is still actively trading today. Swaps have been combined with ETFs to make them available to the general investing community.
In October 2020, the Securities and Exchange Commission (SEC) voted to give investment companies the ability to include derivatives in their funds. This vote allowed companies such as mutual funds and ETFs to have swaps in their funds.
Swap-based ETFs must follow certain criteria, such as having a risk-management program, limits on leveraged risk, and specific recordkeeping to safeguard investors.
Individual investors looking for ways to invest in swaps can find swap-based ETFs, also called "synthetic ETFs." Derivatives and swaps are used in these ETFs to help keep the fund in line with the index the ETF tracks.
Synthetic ETFs don't own any of the underlying assets but are designed in two ways—funded and unfunded.
A funded synthetic ETF gives the pooled holdings to the counterparty. In exchange, the counterparty pays the returns. An unfunded swap-based ETF follows an index but might not hold any of the index's securities.
The unfunded ETF pays the counterparty the returns from the securities in the ETF, and the counterparty pays the returns of the securities from the index.
The passing of the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act has reduced the previous high default risk associated with the unregulated swaps market. Swaps can be solid investments for those who can afford to get into them, because high-value businesses initiate them but there are still risks.
Investors face additional risks besides market risk from the underlying investments. Counterparty risks include risks that the other swap party might default on its obligations.
Conflict-of-interest risk arises if parties involved in the swap take on multiple roles within the fund or swap. The conflict of interest comes from one party having too much invested in the swap.
If there is collateral offered, collateral risks take the shape of a decrease in value or have no bearing on the ETF's objective. If a swap ETF is concentrated in a specific market segment, investors face concentration risk.
- Swaps are an agreement between two investors to exchange cash flows, payments, or liabilities on an asset.
- A swap can be derived from stocks, bonds, commodities, currencies, or any other investment instrument.
- Swaps are traded not on an exchange but between private parties, over-the-counter.
- Swaps are generally not available to average investors unless they are part of an exchange-traded fund or another type of fund.