Market Crash Alert: Why BIS Is Warning of HUGE FX Swap Debt

In fact, as of the end of 2021, no new transactions in U.S. dollars use LIBOR (although it will continue to quote rates for the benefit of already existing agreements). Currency swaps have been tied to the London Interbank Offered Rate (LIBOR). LIBOR is the average interest rate that international banks use when borrowing from one another. During the financial crisis in 2008, the Federal Reserve allowed several developing countries that faced liquidity problems the option of a currency swap for borrowing purposes.

In a foreign currency swap, each party to the agreement pays interest on the the other’s loan principal amounts throughout the length of the agreement. When the swap is over, if principal amounts were exchanged, they are exchanged once more at the agreed upon rate (which would avoid transaction risk) or the spot rate. For their part, several large European banking systems also draw dollars from the FX swap market to fund their international dollar positions (top centre panel). Pre-GFC, German, Dutch, UK and Swiss banks, in particular, had funded their growing dollar books via interbank loans (blue lines) and FX swaps (shaded area).

  1. In the fixed-for-floating rate swap, fixed interest payments in one currency are exchanged for floating interest payments in another.
  2. Much of the missing dollar debt is likely to be hedging FX exposures, which, in principle, supports financial stability.
  3. This determines what is recognised and not recognised on the balance sheet.
  4. During the financial crisis in 2008, the Federal Reserve allowed several developing countries that faced liquidity problems the option of a currency swap for borrowing purposes.
  5. Ideally, we would exclude from our analysis non-deliverable forwards (NDFs), which entail just a fractional payment, but they are not identified individually in the stocks data.

If they suffered a loss due to fluctuating exchange rates affecting their business activity, the profit on the swap can offset that. Other banks and large institutions use swaps for hedges or relatively cheaper financing. But when done through unregulated banks (shadow banks), the risks of these hedges can outweigh the value they provide. The outstanding amount has quadrupled since the early 2000s but has grown unevenly (Graph 1, left-hand panel).

It’s just another thing to worry about, for those already concerned about these troubling markets. Once a foreign exchange transaction settles, the holder is left with a positive (or “long”) position in one currency and a negative (or “short”) position in another. 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. To do this they typically use “tom-next” swaps, buying (or selling) a foreign amount settling tomorrow, and then doing the opposite, selling (or buying) it back settling the day after. The forward rate is the exchange rate on a future transaction, determined between the parties, and is usually based on the expectations of the relative appreciation/depreciation of the currencies.

Reasons for Using Currency Swaps

We focus on the dollar, given its dominance in international finance, generally, and in the market, in particular. A foreign exchange swap (also known as an FX swap) is an agreement to simultaneously borrow one currency and lend another at an initial date, then exchanging the amounts at maturity. It is useful for risk-free lending, as the swapped amounts are used as collateral for repayment.

FX swaps and forwards are treated together since, as noted above, after the spot exchange only the forward position survives. That said, BIS statistics on FX turnover show that FX swaps are the modal instrument (see below). The missing dollar debt from FX swaps/forwards and currency swaps is huge, adding to the vulnerabilities created by on-balance sheet dollar debts of non-US borrowers. It has reached $26 trillion for non-banks outside the United States, double their on-balance sheet debt.

Market Crash Alert: Why BIS Is Warning of HUGE FX Swap Debt

The reporting population outnumbers that of the derivatives statistics, but the value overlap is great given the concentration of international banking. We use the apparent currency mismatches visible on-balance sheet to infer the amounts of swaps and forwards. Assuming that the net FX position is zero, as typically encouraged by bank trade bitcoin options and futures supervisors, we estimate the net use of swaps as the net positions in a given currency. Moreover, as mentioned before, the resulting net positions are likely to underestimate the gross debt positions, especially for dealer banks. This requires a more granular analysis of currency and maturity mismatches than the available data allow.

The mark-to-market loser regularly hands over cash or securities (“variation margin”) to the mark-to-market winner. Due to recent scandals and questions around its validity as a benchmark rate, LIBOR is being phased out. According to the Federal Reserve and regulators in the UK, LIBOR will be phased out by June 30, 2023, and will be replaced by the Secured Overnight Financing Rate (SOFR). As part of this phase-out, LIBOR one-week and two-month USD LIBOR rates will no longer be published after December 31, 2021. Upgrading to a paid membership gives you access to our extensive collection of plug-and-play Templates designed to power your performance—as well as CFI’s full course catalog and accredited Certification Programs.

What is a Foreign Exchange Swap?

Interest payments are generally not netted because they are in different currencies. The first foreign currency swap is purported to have taken place in 1981 between the World Bank and IBM Corporation. Then, they can unfold the swap later when the hedge is no longer needed.

For instance, the Reserve Bank of Australia swaps US dollars for yen (Debelle (2017)). We estimate that such operations by reserve managers sum to at least $300 billion. Apart from speculative use, the non-financial sector employs FX forwards and currency swaps to hedge international trade and foreign currency bonds, notably those issued to cheapen funding costs. Since most international trade contracts are short-term, forwards serve as hedges. When hedging bond issues in foreign currency, firms and governments typically match the bond maturity and that of the currency swap (McBrady et al (2010), Munro and Wooldridge (2010)). The second source is the BIS international banking statistics, which cover about 8,350 internationally active banks.

Short-Dated Foreign Exchange Swap

At end-2016, three quarters of positions had a maturity of less than one year and only a few percentage points exceeded five years. Turnover data show that the modal forward (a customer-facing instrument) matures between one week and one year while the modal swap (an inter-dealer instrument) within a week (BIS (2016)). The long-term share has risen since the 2000s, as capital markets have boomed. The off-balance sheet US dollar debt of non-banks outside the United States substantially exceeds their on-balance sheet debt and has been growing faster. 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). Foreign exchange swaps and cross currency swaps are very similar and are often mistaken as synonyms.

Most maturing dollar forwards are probably repaid by a new swap of the currency received for the needed dollars. This new swap rolls the forward over, borrowing dollars to repay dollars. Before turning to a more detailed analysis of the inter-dealer market based on the BIS international banking statistics, we discuss non-financial and financial customers’ use of the various instruments. The maturity of the instruments is largely short-term (Graph 1, centre and right-hand panel).

In a transaction arranged by investment banking firm, Salomon Brothers, the World Bank entered into the very first currency swap in 1981 with IBM. IBM swapped German Deutsche marks and Swiss francs to the World Bank for U.S. dollars. See also Aldasoro et al (2017) for evidence of differential pricing in dollar funding markets; Japanese banks pay a premium to borrow via repos from US money market funds. These three sources, together with BIS data on international debt securities and global trade, provide a sense of the instruments’ use.

Fourth, non-bank private sector entities can provide hundreds of billions of dollars. In June 2014, the then largest US bond fund, PIMCO’s Total Return Fund, reported $101 billion in currency forwards, no less than 45% of its net assets (Kreicher and McCauley (2016)). Since the overall US holdings of foreign currency bonds were $600 billion at end-2015, a 50% hedge ratio would extrapolate to $300 billion. The outstanding amounts of FX swaps/forwards and currency swaps stood at $58 trillion at end-December 2016 (Graph 1, left-hand panel). One reason is that forwards and swaps are treated as derivatives, so that only the net value is recorded at fair value, while repurchase transactions are not. Since the value of the forward claim exchanged at inception is the same, the fair value of the contract is zero and it changes only with variations in exchange rates.

At end-2007, before interest rate swaps were centrally cleared, the inter-dealer share of such positions stood at almost 40%. Post-GFC, these European banks’ aggregate dollar borrowing via FX swaps declined, along with the size of their dollar assets. In particular, German, Swiss and UK banks reduced their combined reliance on FX swaps from $580 billion in 2007 to less than $130 billion by end-Q1 2017. The most common[citation needed] use of foreign exchange swaps is for institutions to fund their foreign exchange balances.