Interest Rate Swaps (IRS): Hedging Opportunity or Speculative Trap?

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Interest rate swaps (IRS) are derivative products known as hedging instruments. In a rising-rate environment, they offer the opportunity to determine and fix future costs on a credit agreement. They can also prove to be a dangerous speculative instrument. This is a brief analysis of how they work and of the legal issues they raise in Belgium.

1. What is an interest rate swap?

An IRS allows businesses to protect themselves against interest rate variations. A swap is an agreement between two parties to exchange, in the future, their conditions of access to the money or financial markets. Typically, A undertakes to pay B a fixed rate (say 2%) for a set period (say ten years), while B undertakes to pay A a variable rate (say three-month EURIBOR) over the same period. The financial flows are computed on a notional amount agreed between the parties. Various features (callable options, caps, floors, tunnels, twins) can make an IRS relatively complex.

Hedging instrument or speculative instrument?

Depending on the case, a swap is a hedge or a speculative position. Hedging presupposes a pre-existing underlying risk to be tempered, whether a credit agreement or an investment: a business may swap a variable rate for a fixed rate against rising rates, or the reverse against falling rates. Where the swap is used speculatively, the position is taken for its own sake, without regard to any other legal or economic relationship.

Regulatory attention after the fall in interest rates

After the 2007-2008 crisis, these products were criticised for worsening the position of certain businesses and public entities: many had hedged against rising rates, not falling ones, and suffered heavy losses when rates collapsed. In its report of 19 May 2015 on interest rate derivatives hedging variable-rate credit to SMEs, the Belgian FSMA found that several institutions could not demonstrate that their clients had understood the characteristics of IRS or measured their potential impact in a falling-rate context, and that the contracts were unsuited to the clients’ needs. The FSMA required a coupling of IRS and credit for all retail clients within the meaning of MiFID.

IRS disputes generally concern compliance with MiFID rules, since swaps are financial instruments under Article 2, 1° d) of the Act of 2 August 2002 on the supervision of the financial sector. Other disputes concern the debt of local authorities, particularly in France, and turn on the principle of speciality governing their missions and powers.

2. Two recent Belgian decisions on IRS

2.1. A speculative IRS and the principle of legal speciality: more than EUR 70 million

A judgment of the Liège Court of Appeal, ruling after cassation, analysed a swap agreement backed by a credit, concluded between the Société Wallonne du Logement (Walloon housing company) and a financial firm. The Mons Court of Appeal had initially found that the firm had breached its duty to inform, inducing an error that led to the nullity of the swap.

Before the Liège court, the housing company argued that the swap was speculative and therefore void for breach of its legal and organic speciality. The court restated the distinction between the hedging swap, backed by a credit, and the speculative swap, by which the parties bet on rate variations as they would with any other derivative. As a rule, a speculative swap is not backed by a credit. But a credit-backed swap is not automatically a hedge: where the risk is not contained by predefined limits agreed by the parties, the speculative character returns.

In this case, the housing company intended to obtain a hedge capping its interest cost at 6.50%. Yet the formula fixing the rate contained no cap. The rate reached at one due date remained definitively owed until the end of the contract, even if rates later fell, and the rate owed for one period was added to the rate owed for the next: the cumulative “snowball” effect. The court held that this was not a hedging instrument.

Finally, the court applied the principle of legal and organic speciality: public law entities exist and act only within the purpose assigned to them by law. The missions of the housing company, defined in the Housing Code, do not allow it to use its funds for speculative operations. The swap agreement therefore breached the speciality principle and was void; the parties had to be restored to their prior position.

2.2. Failure to gather information on the client’s investment objectives

In a judgment of the Brussels Court of Appeal, the court found that a bank had provided investment advice on IRS contracts without first gathering information on the clients’ investment objectives, risk capacity, and level of experience and knowledge of the instrument. Article 27, § 4 of the Act of 2 August 2002 was breached for lack of a suitability test; the client-profile questionnaire had only been submitted after the disputed contracts were concluded. The court further held that the swaps were unsuitable in a context of uncertain markets and long-term commitments not matched by credits of similar duration and notional amounts. As compensation, the bank was ordered to reimburse the amounts paid under the disputed swap agreements.

This article is a translation. Only the French version is authoritative. It is provided for information purposes and does not constitute legal advice.