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Context: Interest rate swaps allow corporates to manage risks stemming from exposure to the fixed and floating rates they pay on debt obligations, including bonds. The price they pay for swaps is a major consideration for companies selecting the banks who become their counterparties in the transaction.
- In picking counterparties, most treasury teams pay special attention to those banks in their revolving credit facility (RCF), which need to earn a share of the wallet the corporate spends on capital markets transactions. Finally, as with any OTC derivative, swaps expose the corporate to some level of counterparty credit risk.
Swaps can be syndicated like a bank loan. Syndication allows the corporate to dole out pieces of the swap in varying amounts to its banks at the lowest bid price; the swap syndicator is usually the bank with the lowest price. Fees on swaps are not publicly disclosed, meaning a corporate can compensate banks without sharing the information with other members of group. In bond and bank deals, by contrast, much of the fee structure is in the public domain.
- Amol Dhargalkar, global head of the corporates sector at Chatham Financial, said that while selecting banks has always been an important part of using swaps, “the volatile rates market has made it more relevant this year, especially as firms increase the use of derivatives like cross-currency swaps which tend to be more credit intensive.”
- The question below is also timely given that many NeuGroup members with investment-grade credit ratings find themselves overexposed to fixed-rate debt. That’s a concern because although rates have remained higher for longer, many observers expect them to drift lower.
- “We are actively layering into fixed for floating swaps but have recently changed how we manage counterparty risk (i.e., collateralized vs. uncollateralized),” the member who posed the question told NeuGroup Insights. “In addition, we are leaning in on new swaps given our view of the short-term rates cycle and the corresponding impact to long-term swap rates.”
Member question. “I’m curious how others think about spreading interest rate swaps share of wallet and counterparty exposure among their bank group. It seems that you would want to avoid using the entire bank group as it dilutes the economics and creates an administrative burden to manage 20+ derivative counterparties.
- “I presume price is a major component; but does anyone have more structure or a policy related to the level of dispersion from the best or average spread they are able and willing to accept? Also, are there other quantitative (e.g., probability of default, loss given default, etc.) or qualitative (e.g., coverage, other share of wallet, etc.) factors that are heavily weighted when evaluating which counterparties to target?”
Peer answer 1: “We try to spread swaps across a subset of our banking partners (maybe eight to nine banks). We primarily select them based on share of wallet objectives and credit strength. The counterargument to consolidating among a smaller group of banks is diversifying counterparties to avoid too much counterparty exposure.
- “We do a competitive bid process on swaps to floating where we ask the banks to bid solely on the credit and execution charge and then award it to the lowest bidder. Credit and execution charge is largely going to be based on your rating and the tenor of the swap.
- “We try to mix up the bid groups to spread the business/risk across the banks so the same bank isn’t winning every time. For intraday hedges, we don’t bid them out as there’s potential to move the market so we work those bilaterally.”
Peer answer 2: “For us, it is almost all based on pricing. We don’t work with all the banks in our credit facility banking group, though; we have scorecards that inform us what subset of banks have performed better than others and those are the ones who are typically invited into a bid.
- “We have ratings-based credit support annexes (CSAs) in place, so counterparty exposure doesn’t play into the decision much. We will include a bank on a bid we might not otherwise include them on if they have been helpful with a specific project/analysis, but that doesn’t happen on a frequent basis.”
Peer answer 3: “We also spread ours across a smaller group of our credit facility, focused mainly across our tier 1 and 2 banks given their higher commitments, with pricing being the biggest component followed by current derivative portfolio/past business and potential for posting collateral (we have a ratings-based CSA).
- “Similar to the others, we’ll bid across a few different partners each go-round but switch up the banks so that they’re getting a chance to bid/win and we can provide feedback. If someone is way out of line, it’s an easy conversation and move on.
- “If there are banks close to each other and we want to give some business to the bank with a slightly higher charge, we may give them some color and a chance to rebid/tighten pricing. The bidding banks chosen are typically based on prior pricing, need to return business from helping on something specific elsewhere in treasury, or someone who has been proactive in providing color/analysis on a specific trade.”
Summing up. After reviewing the peer answers, the questioner told NeuGroup Insights, “We are going to identify a clearable level based on a RFQ process with the relationship banks in our RCF and then will choose which banks we will include, based on advisory, other wallet and credit (assuming they are within the clearable levels).
- “We have quantified what the financial impacts are from the best price and are comfortable with some level of tolerance to avoid concentrating wallet and counterparty risk.
- “We have also quantified what our counterparty exposures limits are based on potential future exposures and have run scenarios of how many counterparties we would need to use in order to appropriately spread the fully ramped total exposure.
- “Our view is mitigating counterparty risk and a growing ask for capital commitments cost money, but we are balancing that cost with other factors.”
Last word. Mr. Dhargalkar said Chatham typically sees clients minimize dispersion across the entire bank group but try to achieve a sufficient sample size to create pricing competition and have “lender banks participate in the wallet.” He added, “On average, depending on the size of the total hedge, we see roughly no less than $100 million allocated per bank as a rule of thumb, so that can drive the number of total banks.
- “Typically, companies will have a hierarchy towards which banks they want to include in the bidding (e.g., banks that stepped up in recent debt deals) and then use pricing as the next filter.”
