One of the most common financial products used by a credit union for hedging interest rate risk is an interest rate swap. According to the Bank for International Settlements, as of 12/31/2019 the total notional amount outstanding of interest rate swaps exceeded $341 trillion. Interest rate swaps are widely used across many industries and are highly effective at managing interest rate exposure. However, like all financial instruments there are advantages and disadvantages to using interest rate swaps. Below is a summary:
Advantages to Interest Rate Swaps
Effective risk management tool – As long as a credit union understands their interest rate exposure and the risk they want to manage, interest rate swaps are an effective tool for managing interest rate risk.
Flexibility – The terms and structures that can be built into an interest rate swap are numerous. They can be arranged for any period of time and with flexibility on the underlying rate index. They can include optionality, and they can be structured to provide liquidity if that is desired.
Liquidity – Plain vanilla interest rate swaps – swaps having standard terms and referencing a transparent market index – are highly liquid. When entering into a plain vanilla swap, the price transparency through independent sources, such as an independent swap advisor, should give credit unions comfort that they are receiving a fair price. Also, interest rate swaps can be terminated anytime. However, when terminating a swap prior to its maturity, it is done so at a value reflective of the current market. An early termination will result in either receiving a payment from, or making a payment to, the swap dealer.
Disadvantages to Interest Rate Swaps
Legal documentation – Several documents are required when entering into an interest rate swap. Depending on a credit union’s comfort level with the terms of the documents, there may be a need to retain counsel or an advisor that specializes in interest rate swaps to assist with the document review and negotiation.
Counterparty credit risk – The majority of interest rate swaps are traded over-the-counter, which simply means that the swap is a contract between the credit union and a swap dealer. That being the case, the credit union assumes credit exposure to the swap dealer. This risk can be mitigated by requiring the swap dealer to post collateral. Event driven requirements that can cause the swap provider to post collateral include – 1) a credit rating downgrade below a certain credit rating, or 2) the fair value on the interest rate swap becomes negative beyond a certain threshold amount.
Collateral requirements – Similar to how a credit union can negotiate to protect themselves from an adverse credit event of the swap dealer, the dealer will often do the same with respect to their credit exposure to the credit union. The credit support annex is one of the documents associated with an interest rate swap and dictates the collateral requirements. It generally requires a credit union to post collateral in the event the fair value of the swap drops below a certain threshold value, or if the credit union experiences a significant negative credit event such as a credit rating downgrade.
In summary, interest rate swaps are an effective risk management tool, and something many credit unions should consider having in place to help manage interest rate risk. But understanding the advantages and disadvantages is imperative to ensure a hedging program is designed that best meets a credit union’s needs. Credit unions should consider working with their ALM advisor or an other third-party consultant well-versed in interest rate swaps to be sure any interest rate swaps entered into effectively meets their hedging objectives.