The simplest possible description
Two parties agree to exchange interest payments on a notional amount. One pays a fixed rate; the other pays a floating rate, now typically SONIA in sterling. The notional itself never changes hands — only the net difference in payments, periodically.
A company with floating-rate bank debt that wants certainty pays fixed and receives floating, converting its exposure. A pension fund with fixed liabilities does the reverse. Nothing is borrowed or lent; only the interest rate characteristic is swapped.
Why the notional figures are misleading
The global interest rate derivatives market is quoted in hundreds of trillions of notional. That number is close to meaningless — the actual credit exposure is the net present value of the difference in payments, orders of magnitude smaller. Journalists and politicians have been alarmed by the wrong number for thirty years.
LIBOR and its replacement
Swaps referenced LIBOR, a rate derived from banks' estimates of their borrowing costs. Traders manipulated it, several were prosecuted, and the benchmark was retired. Sterling markets now use SONIA, based on actual overnight transactions rather than estimates.
The transition required repapering a vast stock of existing contracts and is one of the larger pieces of financial plumbing work ever undertaken. It is a good illustration of benchmark risk: an instrument is only as sound as the reference rate someone else calculates.
The mis-selling episode
Between 2001 and 2012, UK banks sold interest rate hedging products to small businesses — often as a condition of lending, frequently structured in ways the customers did not understand. When rates fell to near zero, these products generated large ongoing costs and enormous break fees.
The FCA required a redress scheme; banks paid out billions. It remains the clearest example of a legitimate institutional instrument causing serious damage when sold to parties without the capacity to assess it.
How you would actually trade it
Not accessible to individuals, and not useful to them. The relevant exposure for most people is indirect: a fixed-rate mortgage is a retail-packaged version of the same hedge, and your pension scheme almost certainly uses swaps to match its liabilities.
Businesses considering hedging bank debt should take independent advice rather than relying on the lending bank's own product desk, and should ask specifically for the break cost under a range of rate scenarios before signing.
What goes wrong
- Break costs. Exiting early when rates have moved against you can cost a substantial fraction of the notional.
- Basis risk where the hedge references a rate that does not exactly match the exposure.
- Collateral calls. Cleared swaps require variation margin in cash, which is where the 2022 LDI crisis originated.
- Benchmark risk, as the LIBOR transition demonstrated.
- Complexity and suitability — structured variants with caps, floors and knock-ins have a long history of being sold to parties who could not price them.
This entry describes how a market works. It is not a recommendation, a price forecast, or advice about whether this belongs anywhere near your money. How entries are written.