Liquidity Swaps - An Overview (article)

Although a range of structures may be used, the core element of such transactions is an exchange of assets between a bank, as borrower, and insurer, as lender. In its simplest form, the parties may enter into a securities lending arrangement, with:

- the insurer lending high-quality liquid assets (such as gilts) to the bank in return for a fee; and

- the bank’s obligation to return equivalent securities being “secured” by the posting of collateral, typically in the form of more illiquid / lower quality assets (such as ABS or loan receivables).

Clearly, from the lender’s perspective, the collateral arrangements (which may vary in their legal form) are of central importance, with the (typically) illiquid and potentially volatile nature of the assets demanding a prudent and rigorous approach to collateral composition and valuation. Equally, the arrangements may need to be tailored to address concerns the borrower may have over risks associated with potential over-collateralisation.

FSA approach

Earlier this year the FSA issued final guidance on liquidity swaps and similar arrangements.

Whilst recognising their potential benefits and “seeing a role for these transactions on a sensible scale”, the FSA has a number of concerns about their increased use and the management and mitigation of associated risks.

http://www.law-now.com/cmck/pdfs/nonsecured/liquidswapoverview.pdf