There are two main types of cross currency swap structures in the market. Dealer-to-client and dealer-to-dealer. While both involve the exchange of currency amounts at the start and end of the swap, their mechanics and risk management approaches differ significantly.
Let's start with how dealer-to-client cross currency swaps work. In a dealer-to-client to cross currency swap, the transaction consists of three key phases. The first phase is the initial principle exchange with a two parties physically exchange currency amounts at the agreed spot FX rate. During the second phase, both counterparties exchange interest rate payments at fixed intervals, but the notional amounts remain unchanged. Interest payments can be fixed or floating in either currency, meaning the swap can take one of four forms, both rates fixed, both floating, or a combination where one is fixed and the other floating.
In the third and final phase at swap maturity, the currencies are exchanged back at the same FX rate agreed at the start of the swap. Since the final exchange occurs at the original FX rate, the principle amount is fully hedged against FX risk. The structure makes cross currency swaps an effective tool for clients hedging foreign currency debt issuances, or investments as their loan or investment amount does not fluctuate with FX movements. Now let's turn to the dealer-to-dealer market, which has some important differences. The dealer-to-dealer market, which primarily involves banks and financial institutions, operates with a slightly different structure designed to minimize counterparty credit risk. While it retains the initial and final principle exchanges, there are two key differences.
The first difference is that unlike dealer-to-client swaps, dealer-to-dealer swaps typically involve floating rates on both currencies. These are known as cross currency basis swaps and are often used for interbank funding and hedging purposes. The biggest distinction, however, is that the US dollar notional amount is adjusted periodically to reflect changes in the FX spot rate over time. But why are notional adjustments used in dealer-to-dealer swaps? It's to reduce counterparty risk. If the currency received from the counterparty strengthened significantly, the exposure to that counterparty increases potentially creating large credit risks. Suppose two counterparties enter into a five year euro US dollar cross currency swap exchanging US dollars for euros at the start. Over time, the US dollar strengthens significantly against the euro. The counterparty set to receive US dollars at maturity now faces a larger exposure, since the value of their expected US dollar payment has increased. To mitigate this risk, the swap is periodically adjusted, meaning the party that initially received US dollars returns part of it to keep exposures in check. From that point on, interest will still be exchanged, but now based on the newly adjusted US dollar notional, if adjusting the notional amount helps manage risk, then why don't clients use this structure as well? Unlike dealers, clients typically hedge loans or investments where the notional amount remains fixed regardless of FX fluctuations. For example, a company that borrows in a foreign currency wants to hedge the full loan amount without having to adjust it every few months. Likewise, an investor holding a foreign currency bond typically prefers a stable hedge that doesn't reset periodically. Because of this, clients need a structure where the notional stays unchanged, even if FX rates move. While this structure works well for clients, it creates challenges for banks when hedging dealer to client swaps in the interbank market. Since the dealer to dealer swaps do adjust notionals while dealer to client swaps do not, dealers must manage this mismatch carefully, often using additional trades or risk management techniques. This adds an extra layer of complexity for banks requiring careful risk management to ensure both sides of the trade remain balanced.
