Let's explore the advantages and disadvantages of equity swaps, which can be powerful tools for achieving targeted market exposure, but also come with certain trade-offs.
Starting with the advantages, one key advantage of equity swaps is leverage. Since an equity swap is an ISDA documented OTC over the counter derivative contract, and does not involve an outright position in the underlying equity, it doesn't tie up the user's balance sheet in the same way as directly holding the shares would. This makes equity swaps a simple and cost effective way to achieve leverage, where the initial margin required by clearing houses is significantly less than the notional size of the position.
Another advantage is their cost efficiency. Equity swaps are favored by counterparties like hedge funds because they enable them to achieve the economic benefits of owning shares without incurring the operational costs associated with direct ownership. For instance, holding shares directly often involves high custodian fees, maintaining records, monitoring corporate actions, and managing regular reconciliations. Functions that require dedicated operations teams and back office infrastructure.
By using equity swaps, investors can streamline operational processes and optimize strategy execution, especially in strategies involving high transaction volumes such as statistical arbitrage or short-term long short equity trading.
In many jurisdictions, equity swaps may also have favorable tax treatment compared to outright share purchases. For instance, stamp duty is generally applicable to the purchase of ordinary shares, but not to equity swaps as they are financial contracts rather than direct share purchases.
While equity swaps offer many advantages, they also involve many important trade-offs that investors must consider. For example, while equity swaps enable leverage, they also come with financing costs.
These costs are typically linked to the floating reference interest rates such as SONIA or SOFR, plus or minus the spread. In a rising interest rate environment, the cost of financing a swap increases making the position more expensive to maintain. Another consideration is the lack of ownership rights. The counterparty holding the long equity swap does not own the underlying shares, meaning they cannot vote in corporate actions like annual general meetings, AGMs, or extraordinary general meetings, EGMs.
If voting rights are required, the swap must be exchanged for physical, which involves terminating the swap and receiving the underlying shares. This may trigger additional costs such as stamp duty or other transaction taxes.
And finally, as with all OTC derivatives, equity swaps expose each party to counterparty credit risk.
If the underlying share price rises, the equity payer must make a payment based on the increase, exposing the equity receiver to credit risk, the risk that the payment is not made.
Conversely, if the share price falls, the equity payer benefits, and the equity receiver bears the credit risk. However, this risk is mitigated through collateralization. Margin requirements are adjusted regularly to reflect price movements in the underlying shares, producing the net credit exposure for both parties.
