A swap is a contract between two investors that involves "swapping" or exchanging cash flows, for example one party will receive a fixed interest rate and pay the other party a variable rate. These cash flows are derived from some underlying asset or assets, but these assets, however, do not change ownership.
Swaps are traded "over the counter" (OTC). This means that retail investors don't typically trade them, unless they are used as part of fund vehicle that they are invested in. Still, methods are emerging that allow 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 (ETFs).
What Are Swaps?
A swap is an agreement between two parties to exchange an asset's benefits on a specific 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, ETFs, commodities, foreign currencies, or even interest rates.
How Do Swaps Work?
Firms use swaps to hedge the risk of financial choices such as issuing bonds or stocks. If one firm 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 firm to swap with.
For instance, suppose Firm X was to issue bonds with a variable rate, but it is worried about rising rates. In that case, it might look for another firm that would agree to pay that bond interest for it.
If Firm Y were to agree to pay the interest for Firm X, it could ask for a fixed-rate interest payment on a set amount of money. If rates go up, Firm X would benefit more because it might be paying less interest to Firm Y. If rates go down, Firm Y might come out ahead because it would receive more from Firm X.
Often, one side of the contract agreement in a swap is set, while the other side is variable.
A swap can have many financial exchanges during the life of the contract. The contract can be drawn to last however long a business wants. There are times when one side of the swap contract may want to end it before it expires.
At that point, both traders can agree on the deliverable, 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 were not regulated. Both parties were free to create contracts as they saw fit.
On July 21, 2010, Congress passed the Dodd-Frank Wall Street Reform and Consumer Protection Act. This act put 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 Investors?
Most often, swap contracts are made by major financial institutions and banks. As such, investors who are dealing in swaps need to have a lot of capital and be able to make the agreed payments.
ETFs are one of the newer types of investments available. The first ETF came to the U.S. market in 1993 and is still trading today. Swaps have been combined with ETFs to make them available to the general investor.
In October 2020, the SEC voted to give investment firms 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 record keeping to safeguard investors.
Single 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.
These ETFs don't own any of the underlying assets but can be either funded or 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. Then, the counterparty pays the returns of the securities from the index.
The passing of the 2010 Dodd-Frank Act has reduced the previous high default risk that came with the unregulated swaps market. Swaps can be a solid place to invest for those who can afford to get into them because high-value firms initiate them. Even so, there are still risks.
People face other risks besides just market risk from the underlying investments. Counterparty risks include risks that the other swap party might default on what it owes.
A conflict of interest arises if parties involved in the swap take on more than one role 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, 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 a contract 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 over the counter between private parties.
- Average investors don't have access to swaps unless they are part of an ETF or another type of fund.