Photo: Ryan McGuire. Source: Gratisography
When I was growing up, swapping was a term of art that the big kids used when they cheated the little kids out of their stuff. I remember going to birthday parties where we swapped pieces of cake. Somehow, my big brother always ended up with the biggest slice.
In banking, swaps are a way for the big broker-dealer banks to “help” smaller institutions manage their interest rate risk, currency risk, credit risk, and almost everything else. If you can measure it, you can swap it. The bigger the market, the better for the market-makers. They charge a spread between the bid and the offer, and make money on the deal-flow, just like a casino.
Not that much has changed.
You can’t swap things like fiduciary duty and professional standards. Dealers aren’t supposed to use off-balance sheet transactions to help their clients mask their true financial condition, the way Goldman Sachs helped Greece qualify for entry into the Euro-zone. They aren’t supposed to collude with each other to manage the underlying index, the way Barclay’s Bank manipulated Libor, or the CBOE may have manipulated the VIX. They aren’t supposed to front-run their customer’s order flow, the way curreny traders at JP Morgan, Citigroup, and Standard Charter bank did in their chatroom group called “The Bandit’s Club.”
Option trade volume around VIX calculation time. Source: Griffin & Shams
Swaps create financial interconnections and facilitate trade, making almost everyone better off. But because they’re complicated contractual agreements that remain off the balance sheet, they can be abused fairly easily. That’s why there are rules about fair dealing and fraud that have to be followed.
Otherwise, they just give bigger pieces of cake to the big kids.
Douglas R. Tengdin, CFA