who is trading and what affects the costs? – Bank Underground

Ioana Neamțu, Umang Khetan, Jian Li and Ishita Sen

What do the 2023 Silicon Valley Bank collapse and the 2022 UK pension fund crisis have in common? Interest rate risk. Several sectors in the economy run significant asset-liability mismatch that makes them vulnerable to rapid interest rate changes: pension funds and insurers have short-term cash flows and long-term liabilities, while banks follow a lend-long-borrow-short approach. While interest rate derivatives enable risk transfers to hedge these exposures, research on this market is limited, leaving important questions on the extent of risk sharing and the consequences of imbalances unanswered. We construct the largest data set on interest rate swaps using confidential Bank of England data to unlock insights into how investors use these instruments, and their relative importance in determining swap prices.

Firms can hedge the interest rate risk through an internal rebalancing to match the duration of their assets and liabilities, or they can buy synthetic instruments that reproduce the same duration structure. Interest rate swaps are the instrument of choice, with a market worth US$500 trillion in outstanding gross positions in 2022. In our recent paper first we uncover persistent demand imbalances, sectors emerging as natural counterparties and discuss the role of dealers in intermediating these transactions. Second, we employ a structural model to quantify the effects of demand pressures on asset prices, and evaluate how potential shocks to hedging demand or supply can affect costs and gains to the broader financial system.

Why does the interest rate swap market matter?

Rising interest rates and recent market disruptions led to increased attention towards the distribution of interest rate risk across the system: from the effects on mortgage owners and small corporations to the largest players such as banks, hedge funds or pension funds. On one hand, derivatives provide hedging opportunities to businesses which by the nature of their operations are exposed to interest rate risk. On the other hand, derivatives can also be used by speculative market players to bet on expected movements in interest rates.

One of the simplest ways to hedge or speculate on interest rate risk is to enter into an interest rate swap (IRS) agreement where a firm is willing to exchange, usually several times per year, a fixed payment with a variable payment which depends on a prevailing interest rate (eg, SOFR or SONIA). The swap cash flows are based on an outstanding amount (notional), and leftover maturity, that sometimes exceeds 50 years. The net notional or position of a firm’s exposure measures the difference between the total amount underlying firms’ gross received fixed and paid fixed-rate positions.

Fluctuations in the interest rate affects firms’ income streams in different ways depending on their business model, and so hedging against interest rate risk may mean different things for different entities. For example, pension funds will need to pay their policyholders (liabilities) a fixed income in the future, so they want to insulate their assets against interest rate movements.  Pension funds are then expected to want to receive fixed IRS positions, and increase duration. By contrast, a bank wanting to close the mismatch between their assets and liabilities with swaps might seek to pay fixed rate, and decrease duration. This complementary nature makes these sectors natural counterparties in the swaps market.

Key facts about the interest rate swap market

Facts 1 and 2 – Sectoral participation and net positions: We identify four main end-user segments in the swaps market: funds (including hedge funds and asset managers), pension and liability-driven investment funds and insurers (PF&I), banks, and corporations. Their positions match their underlying balance sheet needs: PF&I typically receive fixed payments, whereas banks and corporations generally pay fixed rates – see Chart 1. This aligns with the anticipated hedging needs of these sectors and suggests a complementary risk-sharing relationship.

Chart 1: This chart shows monthly net outstanding positions held in GBP in £ billion for five end-user sectors and the dealer sector

Note: A positive (negative) value on y-axis indicates net receive (pay) fixed position.

Fact 3 – Maturity segmentation: There is a significant maturity-based market segmentation, as can be seen in Chart 2. PF&I tend to hold long-term swaps (10 years and above), while banks predominantly engage in short to intermediate maturities (three months to five years). This segmentation is consistent with the preferred habitat investor hypothesis, which assumes that different investors have different maturity demand based on the duration gap of their assets and liabilities.

Chart 2: This chart shows monthly net outstanding positions in US$ billion, split by maturity groups three months to five years in the left panel, and 10 years and above in the right panel

Fact 4 – Firms’ responses to interest rate changes: We test how different sectors change their net positions in response to changes in interest rates. PF&I increase their net receive positions when rates fall, while banks and corporations increase their net pay positions. This behaviour reinforces the notion that PF&I and banks are natural counterparties in the swaps market.

Fact 5 – Dealer imbalances: Despite the offsetting positions between sectors, dealers still bear significant imbalances. Dealers typically receive fixed rates in short maturities and pay fixed rates in long maturities, resulting in a net negative duration. The role of dealers as intermediaries highlights their critical function in maintaining market stability.

Asset pricing implications

The swap spread is the difference between the swap rate and a similar maturity bond yield, and it captures the difference in the perceived risk of default between buying a swap and a (risk-free) government bond. An important puzzle in the asset pricing literature has been the existence and persistence of negative swap spreads. Building on our findings that dealers absorb large imbalances from end-user demand for swaps, we investigate how demand and supply affect swap spreads.

To further understand the impact of these dynamics on asset prices, we apply the preferred habitat investors model to interest rate swaps and calibrate it using our database. The model accounts for the specific demand preferences of different sectors and the role of arbitrageurs (including dealers and certain funds) who trade across maturities to exploit price differences. The model helps quantify the influence of demand pressure on swap spreads and provides insights into how sector-specific demand shocks propagate through the financial system.

What affects swap spreads?

Our calibration indicates that demand pressures, particularly from sectors trading in short-to-intermediate and long maturities, have a significant impact on swap spreads when keeping supply preferences fixed. For example, panel (a) of Chart 3 captures how increased hedging demand from banks can substantially raise long-term swap spreads, making it cheaper for PF&I to hedge their positions. We obtain the opposite result, but with different magnitudes, when we assume that PF&I increase their hedging. The increase in hedging demands can come from heightened regulation, responses to changes in interest rates, or reactions to other types of market shocks, such as the Silicon Valley Bank crisis. The sectoral spillover effects to pricing arising from changes to swap demand highlight broader implications of regulatory changes or market shocks, and help explain the existing shape of the swap curve.

Chart 3: Panels (a) and (b) plot counterfactual swap spreads when assuming demand shocks to banks or PF&I

To sum up

Our study sheds light on the interest rate risk sharing through interest rate swaps, and some of its asset pricing determinants. By leveraging Bank of England confidential trade-level data, we provide a comprehensive analysis of how different sectors interact in the swaps market and the resulting asset pricing implications. Our calibration results emphasise the dealers’ role in facilitating risk transfers and the significant impact of sector-specific demand shocks on swap spreads. Quantifying the relative importance of demand needs on swap spreads should provide valuable insights to policymakers and market participants alike, when trying to understand its asset pricing drivers. For instance, a policymaker could analyse the spillover effects of increasing hedging requirements for pension funds or of increasing funding costs for dealers.

Ioana Neamțu is a Senior Researcher in the Bank’s Banking Capital Division, Umang Khetan is a PhD Candidate at University of Iowa, Jian Li is an Assistant Professor in Finance at Columbia Business School and Ishita Sen is an Assistant Professor in Finance at Harvard Business School.

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