Definition and legal foundations of swaps
Ein Swap is a financial derivative in which two contracting parties exchange payment flows or security positions under pre-determined conditions. Swaps are predominantly used in over-the-counter (OTC) trading and are of central importance to the international financial market. Legally, a swap constitutes a reciprocal contract that creates obligations under the law of obligations as well as specific risks for the contracting parties.
Distinction from other derivatives
Swaps are characterized, in contrast to options and futures, by individualized contractual structuring. While futures and options generally use standardized contracts, swaps are typically governed by bilateral, freely negotiable agreements regarding payment flows, maturities, reference values, and other terms.
Legal nature and contract type of swaps
Legal basis for claims
Swaps are classified under German law and international standards as reciprocal contracts (§§ 320 ff. BGB). The parties undertake to provide either recurring or one-time services, such as interest payments or currency exchanges. The legal structure follows the model of a civil law exchange contract, with performance and counter-performance being causally linked.
Conclusion of contract
The conclusion of swap contracts is generally informal. In practice, however, especially international swaps are executed on the basis of the International Swaps and Derivatives Association (ISDA) master agreements. The ISDA Master Agreement is the globally recognized standard, regulating fundamental obligations, liability issues, and particularly the settlement in case of non-performance.
Types and legal specificities of swaps
Interest Rate Swaps
In an interest rate swap, the parties exchange interest payments on an agreed notional amount, usually swapping a fixed for a variable interest rate. Interest rate swaps are not subject to explicit statutory regulation in Germany but are addressed within the scope of the law of obligations. Legal issues relate in particular to validity, contestability, and, for banks, additional regulatory requirements under the German Banking Act (KWG).
Currency Swaps
A currency swap involves the exchange of payments in different currencies, often combined with the exchange of interest payments. This raises specific legal issues regarding exchange rate risk, cross-border money transfers, and fulfillment in various jurisdictions. Typically, the law of the Federal Republic of Germany or English law applies, supplemented by international law provisions.
Credit Default Swaps (CDS)
Credit Default Swaps are contracts for protection against the default risk of a debtor. Legally, CDS are sometimes regarded as insurance, sometimes as pure financial derivative contracts. The precise structuring is decisive—for this, there are extensive regulations on admissibility, disclosure, reporting obligations, and compliance with regulatory requirements, especially under MiFID II, EMIR, and the German Securities Trading Act (WpHG).
Contents of contract, obligations and risks
Contract contents
In particular, a swap contract determines the following elements:
- Term and maturity
- Type and amount of the payment flows to be exchanged
- Provisions on payment default and non-performance
- Collateral agreements (collateral management)
- Termination and dissolution modalities
Risks
Swaps entail various risks that should be stipulated in the contract:
- Credit risk: risk of a contracting party’s default.
- Market risk: change of key market parameters (e.g. interest rates, exchange rates).
- Liquidity risk: difficulties in selling or closing out a swap.
- Legal risk: ambiguities or changes in the relevant jurisdiction.
Proper risk documentation and adequate protective measures (such as margin calls or clearing mechanisms) are imperative.
Regulatory requirements and supervision
European and German regulatory law
Swaps are subject to various European and German regulatory provisions, in particular the Regulation on OTC derivatives, central counterparties, and trade repositories (EMIR). EMIR obligates affected parties, among other things, to report to trade repositories, provide collateral, and comply with clearing obligations.
Banks and financial service providers engaging in swap transactions generally require authorization under the German Banking Act (KWG). In addition, they are subject to specific conduct, organizational, and transparency obligations under the German Securities Trading Act (WpHG) and the Markets in Financial Instruments Regulation (MiFIR).
Civil law framework
Under German law, swaps are primarily governed by the general law of obligations of the German Civil Code (BGB) and specific provisions of commercial law. In addition, particularly in cross-border swap transactions, parties must observe the provisions of international private law to determine the applicable contract law.
Tax treatment of swaps
Swaps are treated differently for tax purposes depending on their type and the parties involved. For companies, swap results typically constitute business income or expenses and are recorded in accordance with tax law principles (in particular § 6 EStG, accounting rules under HGB and IFRS). Special provisions for individuals are set out in the Income Tax Act (EStG), and in some cases, profits from swaps are taxable as income from capital assets (§ 20 EStG).
Insolvency law consequences with swaps
In the event of insolvency, the legal classification of the swap contract becomes particularly important. Under the German Insolvency Code (InsO), the key issue is whether and how swaps may be unwound, especially in consideration of netting clauses and close-out netting, which are regulated, inter alia, in the ISDA Master Agreement. The effectiveness of such clauses is regularly influenced by national insolvency provisions.
Case law and disputes related to swaps
German and international case law deals, among other things, with the validity of swap contracts, prospectus liability, the duty to provide information when concluding the contract, and the immorality of swaps. A prominent aspect is the advisory duty of banks towards clients regarding the risks of swap transactions, on which the Federal Court of Justice (BGH) has ruled in numerous decisions.
Summary
Swaps are a central element of modern financial law and are subject to a multitude of civil law, regulatory, and tax provisions. Legally sound structuring of swap contracts requires careful consideration of contract contents, regulatory requirements, insolvency scenarios, and tax aspects. Their complex legal structure therefore always demands detailed review and documentation of all business transactions.
Frequently asked questions
What legal frameworks apply to swaps in Germany?
Swaps are financial derivatives whose legal framework in Germany is defined in particular by the Securities Trading Act (WpHG), the German Civil Code (BGB), the German Banking Act (KWG), as well as the EU Markets in Financial Instruments Directive (MiFID II). Swaps are generally regarded as financial instruments within the meaning of § 2 Sec. 4 WpHG and are thus fundamentally subject to supervision by the Federal Financial Supervisory Authority (BaFin). Providers of swaps in Germany typically require a KWG license as a financial services institution if they offer or broker such transactions commercially or on a significant scale. Furthermore, customer and investor information must be disclosed in accordance with the Securities Prospectus Act and the relevant European requirements under MiFID II. The EMIR Regulation (EU 648/2012) is also relevant, in particular imposing requirements for reporting and clearing.
When is a swap contract deemed legally effective?
The validity of a swap contract is determined by the general rules of German civil law (§§ 145 ff. BGB). A swap contract comes into effect through offer and acceptance and generally does not require a particular form unless special legal provisions apply. For transactions involving consumers or in cross-border cases, special rules may apply concerning information and documentation. A crucial point is the clear definition of the contractual content and mutual obligations. Problems may arise particularly regarding transparency and comprehensibility for non-institutional counterparties; failure to fulfill information duties may result in contestability on legal grounds of mistake, fraudulent misrepresentation, or immorality (§ 138 BGB).
What obligations do contracting parties have regarding advice and information when concluding a swap?
Under German law—and in particular according to the decisions of the Federal Court of Justice (BGH)—a provider of a swap is subject to comprehensive information and advisory obligations, especially if one of the contracting parties is a consumer or not a professional market participant. The information duties arise from the WpHG, the Financial Investment Brokerage Ordinance, and relevant European regulations (MiFID II). All essential risks, mechanisms, and costs associated with the swap must be transparently presented. Breaches of the duty to provide investor-appropriate and objective advice can lead to claims for damages and, where appropriate, to rescission of the transaction.
What legal risks are associated with swaps in the event of insolvency of a contracting party?
In the event of insolvency of one of the swap parties, insolvency law provisions, in particular those of the Insolvency Code (InsO), apply. Swaps may be classified as ‘unfulfilled mutual contracts’ within the meaning of § 103 InsO, which is relevant for the insolvency administrator. The administrator has the right to choose whether or not to fulfill the contract. For transactions already settled, rights to segregation, separation, or restitution may exist. Furthermore, many swap contracts include so-called ‘netting’ clauses (especially close-out netting), the legal effectiveness of which, particularly in the insolvency context, is regularly reviewed by German courts—particularly in cross-border situations. The effectiveness of such clauses is specially protected under § 104 InsO (financial derivatives transactions).
What are the special features of international swap transactions regarding applicable law and jurisdiction?
International swap transactions are often subject to the parties’ free choice of law under Article 3 of the Rome I Regulation (Regulation (EC) No. 593/2008). Standard contracts such as the ISDA Master Agreement frequently stipulate English law or the law of the US State of New York, even if a party is based in Germany. If no choice of law clause is agreed, the applicable law is determined according to the rules of the Rome I Regulation. As regards jurisdiction, freedom of contract generally applies (Art. 25 Brussels Ia Regulation). In the event of a dispute, questions of jurisdiction can be complex, especially where assets in different jurisdictions are involved or simultaneous avoidance or insolvency proceedings are pending.
What tax aspects must be observed in connection with swaps?
Swap transactions can have various tax implications. The income from swaps is generally treated as income from capital assets (§ 20 EStG) or, where applicable, as other income for tax purposes. For companies, treatment as current operating expense or income according to commercial and tax accounting rules (§ 5 EStG, §§ 252 ff. HGB) may be relevant. In addition, VAT issues must be considered, whereby certain financial futures transactions may be exempt from VAT under § 4 No. 8 UStG. For cross-border swaps, it is necessary to analyze whether and how withholding taxes, double tax treaties (DTA), or controlled foreign corporation (CFC) rules under the Foreign Tax Act (AStG) apply.
