Counterparty Risk Management
In traditional finance swap parties are exposed to the risk of default by their counterparty. Dealers will often lay off this risk by entering into corresponding deals with other participants. In the Swivel method, we isolate counterparty risk in two important ways:
Rather than a daily or other periodic market to market, the premium is paid up front at the outset of the contract. The principal lender either receives the premium and enters the loan, or nothing occurs. There is no exposure to repayment risk.
The principal is held in a time-locked vault contract which automatically returns the underlying ownership and control of the principal balance to the lender at maturity. Again, there is no exposure to repayment risk
In this simple but important innovation, Swivel removes the challenge of counterparty risk, and eliminates the complexity of daily swap valuation and movements of net payment between the parties. Unless either party needs to exit the agreement, there is no need for any activity other than at outset and maturity.
Floating for Floating without Counterparty Risk
Each side of the transaction generates a zero coupon token representing the future value of the floating interest payments and principal repayment, with the discounted value descending over time as the coupon payments are made and passed to the holder of the token.Two things need to be assured for the exchange to be insulated from counterparty risk:
The zero coupon token is associated with a corresponding binding and enforceable legal agreement obliging the issuer to exchange their interest stream for that of their counterparty, and
Enforcement of the terms are guaranteed either by a trusted third-party custodian or a fail-safe vault smart contract
Assuming these conditions are met, the risk then becomes the lesser of the enforceability of the legal contract or the risk of non-compliance by the custodian or failure of the vault contract. None of these increase the direct risk between the parties.