Negative interest rates

In December 2014 the Swiss National Bank announced the introduction of negative interest rates on sight deposits by financial institutions with the bank. The intention was to reduce the pressure on the pegged rate of Sfr1.20 to €1. In January 2015 the Swiss National Bank abandoned the peg, causing the Swiss franc to soar. In order to prevent further unfavourable outcomes (especially for export-oriented enterprises), the bank tightened its negative interest rates by lowering its three-month London Interbank Offered Rate (LIBOR) to -0.75% and moving the target range for the three-month Swiss franc LIBOR down to -1.25% and -0.25%.

This update discusses how negative interest rates can affect hedging transactions, particularly interest rate swaps linked to the three-month Swiss franc LIBOR.

Does negative interest rate constitute 'interest'?

Switzerland has seen negative interest rates before. In the 1960s and 1970s, when the Swiss National Bank imposed negative interest rates, the measure was restricted to funds from abroad. At the time, the Supreme Court decided that negative interest constituted commission. However, it is unclear whether that view would be upheld today.

Scenario

As an example, a Swiss company borrows Swiss francs at a floating rate of interest based on the three-month Swiss franc LIBOR. In order to protect itself from potentially increased financing costs under floating-rate borrowing, the company enters into an interest rate swap with a swap dealer. On the one hand, the swap contract provides that the swap dealer pays a floating rate of three-month Swiss franc LIBOR plus a spread of 0.5% to the Swiss company; on the other hand, the Swiss company pays a fixed rate of 2% to the swap dealer. The bottom line of the arrangement is that the Swiss company ends up with fixed-rate financing costs of 1.5% = 2%-0.5%.

As the three-month Swiss franc LIBOR has been set to -0.75%, the Swiss company will have to make a payment to the swap dealer to account for the fact that the referenced floating rate has gone negative by an amount in excess of the 0.5% spread. The Swiss company will have to pay the swap dealer 0.25% = -(-0.75%+0.5%) in addition to the fixed-rate payment of 2% that it owes under the swap contract. However, this is true only if the swap contract allows for a negative interest and for a swap to comprise only a unilateral payment (hence, not really a swap of payments).

Swap under ISDA Agreement

Assuming that the 2006 International Swaps and Derivatives Association (ISDA) Definitions apply, the counterparties to the swap contract can decide whether they want to employ the floating negative interest rate method or the zero interest rate method (Section 6.4).

Under the floating negative interest rate method, the swap dealer will pay nothing if the floating rate was negative, and the Swiss company will have to pay the fixed rate plus the negative interest (ie, 2% plus 0.25%). In contrast, no negative interest will have to be paid by the Swiss company if the counterparties have chosen the zero interest rate method.

However, it is wise to be cautious. Under the ISDA Definitions, the floating negative interest rate method applies as the default method (ie, if the parties have been silent on negative interest).

For further information on this topic please contact Ansgar Schott or Markus Winkler at FRORIEP by telephone (+41 44 386 6000) or email (aschott@froriep.ch or mwinkler@froriep.ch). The FRORIEP website can be accessed at www.froriep.com.

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