When Was the First Swap Agreement and Why Were Swaps Created?
Swap agreements—derivative contracts by which the parties exchange cash flows or liabilities from two financial instruments—originated from agreements created in Great Britain in the 1970s to circumvent foreign exchange controls adopted by the British government. The first swaps were variations on currency swaps.
The British government had a policy of taxing foreign exchange transactions that involved the British pound. This made it more difficult for capital to leave the country, thereby increasing domestic investment.
Key Takeaways
- Swap agreements originated from agreements created in Great Britain in the 1970s to circumvent foreign exchange controls adopted by the British government.
- The British government had a policy of taxing foreign exchange transactions that involved the British pound, which made it more difficult for capital to leave the country.
- IBM and the World Bank entered into the first formalized swap agreement in 1981, when the World Bank needed to borrow German marks and Swiss francs to finance its operations, but the governments of those countries prohibited it from borrowing.
- During the 2008 financial crisis when credit default swaps on mortgage-backed securities (MBS) were cited as one of the primary contributing factors to the economic downturn.
- Swaps were historically traded over the counter (OTC), but they are now mostly traded on centralized exchanges.
Understanding the First Swap Agreement and Why Swaps Were Created
Swaps were originally conceived as back-to-back loans. Two companies located in different countries would mutually swap loans in the currency of their respective countries. This arrangement allowed each company to have access to the foreign exchange of the other country and avoid paying any foreign currency taxes.
IBM and the World Bank entered into the first formalized swap agreement in 1981. The World Bank needed to borrow German marks and Swiss francs to finance its operations, but the governments of those countries prohibited it from borrowing activities.
IBM, on the other hand, had already borrowed large amounts of those currencies, but needed U.S. dollars when interest rates were high for corporate borrowers. Salomon Brothers came up with the idea for the two parties to swap their debts. IBM swapped its borrowed francs and marks for the World Bank’s dollars. IBM further managed its currency exposure with the mark and franc. This swaps market has since grown exponentially to trillions of dollars a year in size.
The history of swaps added another chapter during the 2008 financial crisis when credit default swaps on mortgage-backed securities (MBS) were cited as one of the contributing factors to the massive economic downturn.
Credit default swaps were supposed to provide protection for the non-payment of mortgages, but when the market started to crumble, parties to those agreements defaulted and were unable to make payments. This has led to substantial financial reforms of how swaps are traded and how information on swap trading is disseminated. Swaps were historically traded over the counter, but they are now mostly traded on centralized exchanges.