What is a Debt Swap?

A debt swap is a financial transaction in which one person or entity swaps debt with another. There are a number of types of swaps which can occur in the financial world beyond debt swaps, including currency swaps, interest rate swaps, debt/equity swaps, and credit default swaps. The purpose of all such transactions is to make a profit on some aspect of the transaction. These transactions are often facilitated through an intermediary such as a bank, since they can be difficult for the parties involved to coordinate on their own.

One example of a debt swap is a swap which may be used to provide financial assistance to a struggling nation. In this case, a rescuing nation or agency like the World Bank will arrange a debt swap in which it acquires debt from the struggling nation at a discount in order to convert the debt to equity in the local currency. Debt/equity swaps of this nature are very common tools for rescuing countries in debt.

Corporations can use debt swaps when they restructure. In a debt/equity or equity/debt swap, shareholders or creditors of a corporation can be provided with an incentive to trade their equity for debt such as bonds, or to trade their debt for equity such as stocks. In the process, the company's financial situation is shifted, which can rescue it from financial problems or allow it to make a merger or to engage in other business activities. Usually, the deal is sweetened. For example, when shareholders are asked to swap their shares for bonds, it will not be done at a one-to-one ratio, because this provides no incentive to swap.

Another type of debt swap is utilized in conservation activities. In a debt for nature swap, a nation agrees to swap preservation of the natural environment for some of its debt. This benefits the nation because it brings its overall debt level down, and it benefits the environment by creating more protected habitat for animals and plants. Debt for nature swaps may be organized by conservation organizations or by governmental organizations concerned with environmental preservation.

Debt swaps were developed in the 1980s, along with a range of other financial products. In the 2000s, some of these financial products proved to be faulty. Credit default swaps, for example, proved to be part of the confluence of circumstances which led to the 2008 financial crisis. Financial regulators proposed a tightening on debt swaps and similar products with the goal of preventing similar problems in the future while still allowing people to trade financial products.