Direct vs Intermediated Swap
A direct swap is a bilateral OTC contract between two end-users. An intermediated swap runs through a swap dealer (typically a major bank) that enters back-to-back swaps with each side. The intermediary takes a small bid-offer spread in exchange for matching counterparties, bearing credit risk, and providing standardised ISDA documentation. Post-Dodd–Frank, many standard swaps are now also cleared through a central counterparty (CCP), adding a third structural layer.
Try it yourself
It is comparativeadvantage, not absolute advantage, that makes a swap pay, and a dealer's spread splits the gain three ways. Set each firm's cost in both markets. The quality spread differential QSD = |fixed gap − floating gap| is the total gain available, and it is shared by Firm A, Firm B, and the dealer.
Floating gap (B − A) = 50 bp vs 100 bp = 50 bp
QSD = |200 bp − 50 bp| = 150 bp
Discuss.Load "Classic QSD" and confirm Firm A is cheaper in both markets yet the swap still pays. Why does absolute advantage not matter? Now drag B's floating spread until both gaps are equal and the QSD collapses to zero. If real capital markets are efficient, should a persistent QSD survive arbitrage (Hull 2022, §7.4)?
Convention: floating quoted as BBSW + spread (bp). Total gain QSD = |fixed gap − floating gap|. The dealer spread is capped at the QSD; A and B split the remainder, so A + B + dealer = QSD exactly. Per-annum rates, notional and tenor aside. Illustrative split; the real division is negotiated.
Why it matters
In a direct swap, A pays B fixed and B pays A floating. They share the full quality spread differential but each bears the other's default risk. In an intermediated swap, the bank steps in. A pays the bank fixed at one rate, and the bank pays A floating. The bank does the mirror trade with B at slightly worse terms. A and B never face each other legally or operationally. The bank earns the spread between the two fixed legs and absorbs the credit risk. Most vanilla swaps in Australia run this way through ANZ, CBA, NAB, Westpac, or international dealers.
In an intermediated interest rate swap, the role of the dealer bank is to:
Formulas
Worked examples
Total QSD between Company A and Company B is 1.2%. The intermediating bank charges 0.2% p.a. for the bank's services and risk-taking.
After paying the bank fee, the remaining 1.0% gain is split. With a symmetric split, each company saves 0.5% per annum relative to direct borrowing in its less-preferred market. The bank books 0.2% across its two legs, typically as 0.1% on each side of the back-to-back trade. On a A$10m notional this is A$20,000 per annum of bank revenue, less the bank's hedging and capital costs.
Common mistakes
- ✗Direct swaps are always better because there is no fee. Not necessarily. The bank's fee compensates for matching counterparties, credit assessment, collateral management (under the ISDA Credit Support Annex), and default protection for both end-users. Without intermediation, A and B must each evaluate the other's credit and post bilateral collateral.
- ✗Intermediation eliminates counterparty risk. It transforms but does not eliminate it. End-users now face the bank instead of each other. Post-GFC reforms push standardised OTC swaps into central clearing via CCPs (e.g. LCH SwapClear, ASX OTC Clear), which adds an extra layer of credit mutualisation.
- ✗Every intermediated swap goes through a CCP. Only standardised ones. Bespoke or long-dated swaps, certain corporate end-user trades, and some EM-currency swaps still settle bilaterally with collateral under ISDA's Variation and Initial Margin requirements.
Revision bullets
- •Direct: bilateral, full QSD split between parties
- •Intermediated: bank takes the middle, charges spread
- •Counterparties never face each other in an intermediated swap
- •Bank absorbs credit risk and provides ISDA documentation
- •Standard swaps often centrally cleared post-Dodd-Frank
- •Most Australian corporate swaps are intermediated
Quick check
In an intermediated interest rate swap, the role of the dealer bank is to:
Connected topics
More in Swaps
In learning paths
Sources
- Hull, John C. Options, Futures, and Other Derivatives. 11th ed. Pearson, 2022. ISBN 978-0-13-693997-9.Describes the role of financial intermediaries in arranging interest rate swaps, the bid-offer spread, and the standard back-to-back structure.
- International Swaps and Derivatives Association. 2002 ISDA Master Agreement. ISDA, 2002.Standard legal framework governing virtually all OTC derivatives trades, including the netting and Credit Support Annex provisions that underpin intermediated and bilateral swaps.
- Australian Securities Exchange. ASX OTC interest rate clearing service. ASX, accessed 2026.Local central counterparty for Australian dollar interest rate swaps, illustrating the post-GFC shift toward CCP intermediation of standardised OTC contracts.
- Bank for International Settlements. OTC interest rate derivatives turnover in April 2025. BIS, 2025.Documents the dominance of dealer-intermediated trades in the OTC swaps market and the share of turnover that is centrally cleared.