Liability Swap: Meaning, Benefits, Limitations

What Is a Liability Swap?

A liability swap is a financial derivative consisting of an interest rate swap (IRS) or currency swap used to change the interest rate exposure or the currency risk exposure assumed by a party to the transaction arising from liability from exposure to a particular interest rate structure or foreign currency exposure.

The terms and structure of a liability swap are essentially the same as they are for an asset swap. The difference is that with a liability swap the parties' respective liability exposures linked to a given liability are being exchanged, reducing the parties' risk exposure to the interest rate or the currency, while an asset swap exchanges exposure to an asset. The term "swap" can refer to the derivative itself or the derivative plus the package in which it is traded.

Understanding Liability Swaps

Most swaps involve cash flows based on a notional principal amount. Usually, the principal does not change hands. One cash flow is fixed, while the other is variable, that is, based on a benchmark interest rate, floating currency exchange rate, or index price.

In effect, with an interest rate swap, one stream of fixed interest payments is exchanged for a different stream of floating interest payments. In a currency swap, the parties are exchanging the principal amount of a loan and its interest in one currency for the principal and interest in another currency, initially at the current market or spot rate. Swaps can be outstanding for long periods, creating certainty in the number of payments that an entity will have to make at the end of the swap.

Swaps do not trade on exchanges, and retail investors usually do not engage in swaps. Instead, swaps are customized over-the-counter (OTC) contracts negotiated between businesses or financial institutions as private parties. Liability swaps are used to exchange a fixed (or floating rate) debt for a floating (or fixed) debt. The two parties involved are exchanging cash outflows.

For example, a bank may swap a 3% debt obligation in exchange for a floating rate obligation of the London Interbank Offered Rate (LIBOR) plus 0.5%. LIBOR may currently be 2.5%, so the fixed and floating rates are the same right now. Over time, though, the floating rate may change. If LIBOR increases to 3%, now the floating rate on the swap is 3.5%, and the party that locked in the floating rate is now paying more for that liability.

If LIBOR moves the other way, the party will be paying less than it was originally (3%). It should be noted that since December 2021, the financial markets have been engaged in a transition away from using LIBOR. The United States, for example, will be using the Secured Overnight Financing Rate (SOFR). The concepts beyond the use of LIBOR remain the same for the use of SOFR.

Principal amounts are not typically exchanged, and the liabilities don't change hands. Therefore, changes in the interest rate over time are dealt with by making netting settlements at regular intervals or when the swap expires. As the counterparties set the terms of the swap, they create the transaction terms to which both parties agree.

Benefits of Liability Swaps

Businesses and financial institutions use liability swaps to alter whether the rate they pay on liabilities is floating or fixed. They may wish to do this if they believe interest rates will change and they want to potentially benefit from that change.

Parties may also enter into a liability swap so that the nature of the liability (fixed or floating) matches up more closely with their assets, which may produce fixed or floating cash flows. Swaps can also be used to hedge.

Businesses also use liability swaps to obtain the benefits of hedging a risk exposure. A hedged risk often carries a lower interest rate and receives certain types of preferred accounting treatment.

Limitations of Liability Swaps

Liability swaps are neither perfect nor risk-free. In the first place, swaps are highly illiquid financial instruments. Unlike exchange-traded futures which are easily traded or liquidated, swaps are contracts negotiated and entered into by private parties. The legalities involved in exchanging the "ownership" interests in such a contract are complex and probably not worth the trouble.

As with any contract between private parties, swaps also feature counterparty risk. In an exchange environment, such as in interest rate futures contracts, there is a third-party, such as a clearinghouse, that assumes the counterparty risk of both sides to a transaction. While ISDA provides certain functions to swap market participants, as seen below, it is not a clearinghouse and does not assume counterparty risk.

Foreign currency futures and interest rate futures, when traded on an exchange, are highly liquid and have little to no counterparty or default risk. Swaps do feature default and counterparty risk.

International Swaps and Derivatives Association

The International Swaps and Derivatives Association (ISDA) has, since 1985, worked to improve the swaps marketplace, particularly by developing the ISDA Master Agreement, the primary standardized document used to draft agreements for the terms of any given over-the-counter (OTC) derivatives transaction.

Because OTC derivatives are traded between private parties, the use of a standardized agreement brings consistency, transparency, and higher liquidity to the swaps market. ISDA also works to reduce counterparty credit risk, which is a risk-managed in exchange-traded instruments through the use of a clearinghouse or similar institution.

Example of a Liability Swap

As an example, Company XYZ swaps a six-month SOFR interest rate plus 2.5% liability for ABC's six-month fixed rate of 5% liability. The notional principal amount is $10 million.

Company XYZ now has a fixed liability rate of 5%, while Company ABC is taking on the SOFR plus 2.5% liability. Assume the six-month SOFR rate is currently 2.5%, so the floating rate is also 5% currently.

Assume that after three months, SOFR has increased to 2.75%, and the floating rate is now 5.25%. Company ABC is now worse off than it was before because it is now paying a higher floating rate than the fixed-rate it originally had. That said, companies don't typically enter swaps to make or lose money, but rather to exchange rates based on their business needs.

If SOFR drops to 2.25%, the floating rate will be 4.75%, and Company ABC will be paying a lower rate than the 5% it was originally paying.