Chapter 20
The STP Flow of Swap and other OTC Drivative Trades
20.1 INTRODUCTION
The examples provided in this chapter are for interest rate swaps and currency swaps, but the text also refers to the other instrument types that were introduced in section 5.3.2 if and where there is variation in the trade flow.
20.2 ORDER PLACEMENT
Orders may be placed by any of the following means:
- By researching best bid and offer prices and telephoning a bank direct
- By researching best bid and offer prices and sending orders through hub and spoke services such as Omgeo Oasys or Autex
- By using any number of Reuters pre-trade services. Reuters is a major force in FX pre-trade services. Because the world’s major FX market makers publish their prices on its services it is able to act as an electronic money broker, finding competitive quotes. It also provides analytical tools and conversational dealing
- By using the services of a money broker
20.3 ORDER EXECUTION
Orders are normally executed as principal by market makers.
20.4 TRADE COMPONENTS AND AMOUNTS
The following is an example of a currency swap that was originally quoted in section 5.3.2.
On trade date 29 January 2008 the USD/GBP exchange rate is 2.00.
Banks A and B agree to swap the 5% fixed rate income streams on USD 100 000.00 with the floating rate LIBOR income streams on GBP 50 000 000 for two years from 1 February 2008. Bank A pays Bank B USD at 5%, while Bank B pays Bank A GBP LIBOR.
The trade components and amounts, from Bank A’s point of view,1 are as shown in Table 20.1.
Table 20.1 Currency swap trade components and trade amounts
| Side of transaction | Trade amount or component | Value |
| Common to both sides | Trade date | 29-Jan-08 |
| Start leg value date | 01-Feb-08 | |
| End leg value date | 01-Feb-10 | |
| Pay side | Notional principal currency | USD |
| Notional principal | 100 000 000.00 | |
| Interest frequency | Annual | |
| Interest basis | Fixed | |
| Interest rate | 5% | |
| Interest margin over/under basis rate | 0% | |
| Interest calculation | Actual/360 | |
| Date of first interest payment | 01-Feb-09 | |
| Rule for determining date of next interest payment if predicted date is a non-working day (note 2) | Leave unchanged | |
| Rule for determining fixing dates (note 3) | ||
| Receive side | Notional principal currency | GBP |
| Notional principal | 50000000.00 | |
| Interest frequency | Semi-annual | |
| Interest basis | Floating | |
| Interest rate | Six-month LIBOR | |
| Interest margin over/under basis rate | 0% | |
| Interest calculation | Actual/365 | |
| Date of first interest payment | 01-Aug-08 | |
| Rule for determining date of next interest payment if predicted date is a non-working day (note 2) | Roll forward | |
| Rule for determining fixing dates (note 3) | Interest payment date – two working days | |
| Notes: | ||
| 1. Interest basis: The different interest calculation methods were examined in section 3.2. | ||
| 2. Rule for determining date of next interest payment if predicted date is a non-working day: This issue is examined in section 23.3. | ||
| 3. Rule for determining fixing dates: Interest rate fixings are described in section 23.3.1. | ||
20.5 TRADE AGREEMENT
The usual model of trade agreement for all types of OTC derivative transaction is based on the mutual exchange of confirmations model. SWIFT format messages are available for OTC derivative confirmations, but due to the complexity of many of the transactions, the sending of printed confirmations that need to be read, interpreted and checked by qualified individuals and then scanned into a database is still extremely common. Refer to section 12.1.2 for more discussion about the process.
20.6 REGULATORY TRADE REPORTING
The regulatory trade reporting requirements for OTC derivatives are somewhat complex, and there may be slight variations between countries. In the EEA they depend on MiFID Level 2 legislation, which was explained in section 8.4.
Broadly speaking, OTC derivative transactions are reportable to the regulators if one or more of the underlying instruments of the transaction are any of the following:
- Purchases and sales of individual equities or individual bonds
- Purchases and sales of listed and OTC derivatives where one of the underlying instruments is an individual equity or individual bond
- Purchases and sales of listed and OTC derivatives where the underlying instrument is an equity index or basket of individual equities.
While, broadly speaking, the following transactions are not reportable:
- Foreign exchange and money market transactions
- OTC derivatives where all the underlying instruments are currencies
- Some securities funding transactions
- The exercise of options and warrants
- Certain primary market transactions in equities and bonds.
This list is provided for guidance only. It was accurate at the time of writing, but may not be accurate at the time of reading. Readers who are in any doubt should consult their firm’s compliance office or national regulator at the time.
20.7 SETTLEMENT
20.7.1 Principles
The key principles involved in settlement of swaps are that:
1. Where the notional principals of both sides of the swap are denominated in the same currency (as in an interest rate swap) then the notional principal is not settled; as settlement would be pointless – all it would do is add additional layers of credit risk, delivery risk and operational risk. If the notional principal amounts are denominated in different currencies (as in a currency swap), then they need to be exchanged.
2. On dates when both parties have to make interest payments to each other, if these payments are denominated in the same currency, then they are netted. The party that has to pay the larger cash flow deducts the value of the smaller cash flow which it is owed and pays the difference to the other party.
3. Firms can agree bilateral netting with each other – so if two firms have to make and receive payments for a number of different swap transactions on the same day, then they can agree that the cash flows of all the swaps are netted.
Multilateral netting is also available through clearing houses. For example, LCH.Clearnet Limited provides the SwapClear™ service. SwapClear is a central counterparty service for interest rate swaps of up to 10 years’ maturity in USD, EUR, JPY and GBP. The service has since been extended to provide clearing facilities for compounding interest rate swaps with the following tenors:
- USD, EUR, JPY and GBP up to 30 years
- CHF, AUD, DKK, CAD and SEK up to 10 years
- HKD, NOK and NZD up to five years.
SwapClear’s objectives are to free up credit lines, risk and use of capital, thus increasing return on investment and trading opportunities. These benefits depend on the individual bank, but are likely to include:
- Lower counterparty risk
- Lower operational risk
- Reduced credit line utilisation
- Reduced regulatory capital requirements
- More secure and standardised collateral handling procedures
- Standardised processing of swaps, simplifying documentation and operations, enabling back offices to handle higher volumes at lower cost
- Fewer payments.
There are no transaction fees for SwapClear. Members pay a fixed annual clearing fee to participate in the SwapClear service.
20.7.2 Practice
For OTC payments and receipts that are not subject to multilateral netting, the party that needs to make a payment sends a SWIFT MT202 message to its settlement agent advising it to make the payment to the trade party’s settlement agent, and the party that is receiving funds sends an MT210 message to its settlement agent advising it that the other trade party’s settlement agent will make payment on the party’s behalf.
The identities of the two parties’ settlement agents are stored in the SSI tables that were examined in section 10.6.
20.8 GENERAL LEDGER POSTINGS
20.8.1 Interest rate swap
Start leg value date postings
The general ledger postings for an interest swap on trade date are as shown in Table 20.2.
Table 20.2 Interest rate swap – start date postings
If the transaction was a currency swap the postings would be as shown in Table 20.3, assuming that the transaction were a (pay) GBP/(receive) USD swap, and 2USD = 1GBP.
Table 20.3 Currency swap – start date postings
During the life of the transaction – periodic interest payments
The entries shown in Table 20.4 need to be passed on the value date that interest payments become due.
Table 20.4 Swap interest payment date postings
| Sign | Ledger account type | Trade amount name |
| Cr | Accrued interest on swaps | Value of interest payment on the receive side |
| Dr | Accrued interest on swaps | Value of interest payment on the pay side |
| Dr or Cr (as required) | Cash at bank | Interest payment on the pay side less interest payment on the receive side |
End leg value date postings
On the value date of the end leg, the postings that were made for the start leg are reversed.
20.9 STOCK RECORD POSTINGS
The stock record is not used for these transactions.
20.10 MARKING TO MARKET
Swap and other OTC derivatives need to be marked to market daily – refer to section 23.8.
20.11 DAILY ACCRUAL OF INTEREST
Swap interest also needs to be accrued during the life of the transaction – see Section 23.9.
1 If this table had been produced from Bank B’s point of view, then of course the sterling cash flows would be the “Pay side” and the dollar cash flows the “Receive side”.