The UK’s Financial Services Authority has softened its stance on the nascent liquidity swaps industry.

The City watchdog has released new guidance saying that the practice between banks and insurers does indeed have some benefits.

Liquidity swaps are complex asset trades between banks and insurers aimed at meeting tough new global liquidity rules for banks, such as Basel III.

It is a process where insurers exchange high-quality liquid assets such as gilts with less liquid assets such as asset-backed securities held by banks. The deal allows the bank to boost its stock of liquid assets to use as collateral while the insurer receives a fee for lending out the more liquid asset, and thus the insurer gains a higher return than that achievable from merely holding on to the gilts.

Last July, the FSA instigated a consultation with the financial services sector, warning that liquidity swaps “could have the effect of increasing inter-connectedness between the insurance and banking sectors and, in turn, create a transmission mechanism by which systemic risk across the financial system may be exacerbated”.

However, the FSA has now relented on this view. Paul Sharma, the FSA’s director of policy, said: “We see a role for these transactions on a sensible scale, provided the risks are properly identified and managed by both parties.

“We recognise that these transactions enable the temporary transfer of liquid assets to firms that need them, whilst at the same time providing the lending firm with secured exposures and potentially an enhanced yield.”

The FSA had delayed several liquidity swaps, including a £1bn seven-year deal between specialist life insurer Phoenix Group and a UK high street bank and a multi-year trade between Lloyds Banking Group and the life assurance arm of Scottish Widows, during the consultation process.

In its guidance, the FSA says that it will continue to monitor the practice and its implications for financial stability. Companies will be required to notify the FSA of any significant transactions prior to the start date in order for regulators to assess any inherent risks.

Although some of the drafting is still ambiguous, it should now be easier to structure liquidity swaps – also known as collateral swaps – to meet the FSA’s concerns.

The transactions carry greater risks for insurers as they are taking on more complicated assets and it also increases the links between banks and insurers during any crisis period.

The move is seen as significant as the UK is seen as a world leader in liquidity regulation and this new guidance could, in time, be used as the global benchmark.

The FSA says the new guidance on liquidity swaps will come into force at the end of this month.