Currency Swaps: Definition, How and Why They’re Done

That is, the agent finances the security at purchase by immediately selling it while committing to buy it forward at an agreed price. (Here we abstract from the haircut so that the security is altogether self-financing.) Current accounting principles require that this be reported on a gross basis, so that the balance sheet doubles in size. Yet the position is functionally equivalent to that of an FX swap or forward.

  1. In order to collect or pay any overnight interest due on these foreign balances, at the end of every day institutions will close out any foreign balances and re-institute them for the following day.
  2. And it exceeded both global external portfolio investment ($81 trillion) and international bank claims ($40 trillion) at end-2021.
  3. (Here we abstract from the haircut so that the security is altogether self-financing.) Current accounting principles require that this be reported on a gross basis, so that the balance sheet doubles in size.
  4. At end-June 2022, the missing debt amounted to as much as double the on-balance sheet component (Graph 2.B), which was estimated at “only” $13 trillion (Graph 2.A).

Moreover, it has grown smartly since 2016, despite the often significant premium demanded on dollar swap funding (Borio et al (2016)). For banks headquartered outside the United States, dollar debt from these instruments is estimated at $39 trillion, more than double their on-balance sheet dollar debt and more than 10 times their capital. The first section recalls the relationship between FX swaps, currency swaps and forwards as well as their accounting treatment, explaining how the missing debt arises. The second takes a bird’s eye view of the aggregate market, including its instruments, currencies and counterparties.

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Thus, one can relate non-financial FX swaps/forwards and currency swaps, in an admittedly stylised fashion, to international trade and bond issuance, respectively (Table 1). If firms use $5.1 trillion of short-term FX forwards to hedge global trade of $21 trillion, then the ratio implies that importers and exporters hedge at most three months’ trade. Similarly, if firms and governments use $2.4 trillion of currency swaps amaroq announces changes to its trading liquidity enhancement agreements to hedge $4.8 trillion of international bonds, then they hedge half or less. This feature revisits Borio et al (2017), drawing on the comprehensive data in the 2022 BIS Triennial Survey. First, it updates the stylised facts concerning FX swaps/forwards and currency swaps. Second, it measures the missing dollar debt for non-banks resident outside the United States, and for banks headquartered outside the United States.

For all the differences between 2008 and 2020, swaps emerged in both episodes as flash points, with dollar borrowers forced to pay high rates if they could borrow at all. To restore market functioning, central bank swap lines funnelled dollars to non-US banks offshore, which on-lent to those scrambling for dollars. A currency swap, sometimes referred to as a cross-currency swap, involves the exchange of interest—and sometimes of principal—in one currency for the same in another currency.

In the process, it also shows what would happen if FX swaps were treated the same as repurchase agreements (repos) – two transactions that can be considered to be forms of collateralised lending/borrowing. The table shows the corresponding balance sheets, with the subscript X denoting foreign currency positions. In a cross currency swap, both parties must pay periodic interest payments in the currency they are borrowing. Unlike a foreign exchange swap where the parties own the amount they are swapping, cross currency swap parties are lending the amount from their domestic bank and then swapping the loans. Now assume that the agent decided to avoid the FX risk by keeping the cash in domestic currency and financing the foreign security in the foreign repo market (case 3).

Currency swaps were originally done to get around exchange controls, governmental limitations on the purchase and/or sale of currencies. Although nations with weak and/or developing economies generally use foreign exchange controls to limit speculation against their currencies, most developed economies have eliminated controls nowadays. For example, say that European Company A borrows $120 million from U.S. Company B. Concurrently, U.S Company A borrows 100 million euros from European Company A. However, in 2023, the Secured Overnight Financing Rate (SOFR) will officially replace LIBOR for benchmarking purposes.

FX swaps and forwards: missing global debt?

In the locational banking statistics, banks report cross-border inter-office positions. These positions should sum to zero for each banking system but often do not. FX swaps were a key part of non-US banks’ total US dollar funding, amounting to an estimated $0.6 trillion, roughly 6% of the total in March 2017 (Graph 4). The rest, about $9.4 trillion, mostly took the form of deposits from US and non-US non-banks (red and blue areas), and dollar debt securities (yellow area).

Exchange of Interest Rates in Currency Swaps

Embedded in the foreign exchange (FX) market is huge, unseen dollar borrowing. In an FX swap, for instance, a Dutch pension fund or Japanese insurer borrows dollars and lends euro or yen in the “spot leg”, and later repays the dollars and receives euro or yen in the “forward leg”. The $80 trillion-plus in outstanding obligations to pay US dollars in FX swaps/forwards and currency swaps, mostly very short-term, exceeds the stocks of dollar Treasury bills, repo and commercial paper combined. The churn of deals approached $5 trillion per day in April 2022, two thirds of daily global FX turnover. Financial customers dominate non-financial firms in the use of FX swaps/forwards. The first source is the BIS derivatives statistics, which draw on reports from 73 global dealer banks.

We sort banking systems into US dollar net borrowers and lenders via FX swaps (Graphs 5 and 6). Focusing on the dominant dollar segment, we estimate that non-bank borrowers outside the United States have very large off-balance sheet dollar obligations in FX forwards and currency swaps. They are of a size similar to, and probably exceeding, the $10.7 trillion of on-balance sheet debt. On the other side of the ledger, as much as two thirds of the dollar-denominated bonds issued by non-US residents could be hedged through similar off-balance sheet instruments. That fraction seems to have fallen as emerging market borrowers have gained prominence since the GFC.

The third relates aggregate market data to the hedging of trade and the asset-liability management of non-banks. The fourth delves into banks’ role, tracing banking systems’ post-GFC reliance on the market for funding. The more detailed analysis focuses on the dollar segment, given the currency’s outsize role in the foreign exchange and other financial markets.

Foreign exchange swap

Many swaps use simply notional principal amounts, which means that the principal amounts are used to calculate the interest due and payable each period but is not exchanged. Foreign currency swaps can be arranged for loans with maturities as long as 10 years. Currency swaps differ from interest rate swaps in that they can also involve principal exchanges. For most investors, it’s unclear what the ultimate impact of an FX swap crisis would be. Some might say that if the global market for FX swaps tanks, then it’s all over anyway. Others might suggest that central banks have dealt with these scenarios in the past.