In the financial world, a swap is essentially an exchange of payment obligation between two parties, say floating-rate interest for fixed-rate interest. During the 1980s, this exotic financing instrument and related "derivatives" came into their own as a way for Corporate America to manage its financial risk. In a remarkably short period, value of swaps outstanding has grown to $5 trillion--one of the true financial-market success stories.
Because swaps interlock, a default by one major user might trigger a broad financial meltdown. When Drexel Burnham Lambert Inc. and Bank of New England Corp. failed, many regulators and swap dealers breathed easily only after the institutions' portfolios of derivatives were unwound without huge losses. Now, the bankruptcy filings of Olympia & York Developments Ltd. show the huge real estate developer has about $1 billion in swaps outstanding.
Swaps dealers predictably downplay any problems and resist incursions into their practices by regulators. Undue regulations, they argue, will simply drive business offshore to less-policed environs or, worse yet, kill off one of the most innovative markets.
There's merit to that argument. Yet the swaps market does need a lot more sunlight and a little more policing. Under an edict approved last March by the Financial Accounting Standards Board, banks and brokerage firms will be asked--for the first time--to record their exposure from all derivatives transactions on their balance sheets, effective in 1993.
If swaps dealers don't want additional regulation, they must improve the credit quality of their transactions. A few firms, led by Merrill Lynch & Co. and Goldman, Sachs & Co., are spinning off their swaps operations into new units that allow the credit-rating agencies to assess the swap businesses on their own. Others should follow their lead. And as the swaps industry matures, dealers should explore establishment of a clearinghouse that, like a stock exchange, would stand behind the trades of its members. The industry's continued growth may well depend upon whether its players accept the responsibilities that come with their newfound influence.