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

what is fx swap debt

Inspection of the corresponding time series provides some evidence for these links (Graph 3, left-hand panel). Non-financials’ FX swaps/forwards (red line) co-move with world trade (black). Similarly, there is a visible, if weaker, co-movement between international bonds outstanding (yellow) and longer-term currency swaps (light blue). Off-balance sheet dollar debt may remain out of sight and out of mind, but only until the next time dollar funding liquidity is squeezed. Then, the hidden leverage10 and maturity mismatch in pension funds’ and insurance companies’ portfolios – generally supposed to be long-only – could pose a policy challenge.

  1. About 5% of the $3.4 trillion in US imports were foreign currency-invoiced (Boz (2020)).
  2. This was evident during the Great Financial Crisis (GFC) and again in March 2020 when the Covid-19 pandemic wrought havoc.
  3. 18 In the BIS locational banking statistics, the United States does not report resident banks’ local positions, which prevents measuring US banks’ global dollar asset and liability positions.
  4. Similarly, there is a visible, if weaker, co-movement between international bonds outstanding (yellow) and longer-term currency swaps (light blue).

The second source is the BIS international banking statistics, which cover about 8,350 internationally active banks. 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.

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A swap agreement may also involve the exchange of the floating rate interest payments of both parties. 18 In the BIS locational banking statistics, the United States does not report resident banks’ local positions, which prevents measuring US banks’ global dollar asset and liability positions. The estimate in the right-hand panel of Graph 7 for “Offices inside the US” is inferred from these banks’ net non-dollar positions, and assumes that non-dollar local positions are small. 13 Graphs 5 and 6 plot two estimates for net interbank borrowing (solid and dashed blue lines) and net FX swaps (shaded area and dashed black line). In the locational banking statistics, banks report cross-border inter-office positions.

As noted, as long as one assumes that banks roughly match their FX exposures, BIS international banking statistics offer a detailed picture of the geography of banks’ use of FX swaps/forwards – their main hedging instrument. We focus on the dollar, given its dominance in international finance, generally, and in the market, in particular. While outstanding amounts lump FX swaps with forwards, turnover data show that FX swaps are the instrument of choice. Swaps/forwards and currency swaps amounted to over $3 trillion per day in 2016, over 60% of total FX turnover (Moore et al (2016)). Of that, FX swaps accounted for three quarters, forwards for 22% and currency swaps for the rest. Either company could conceivably borrow in its domestic currency and enter the foreign exchange market, but there is no guarantee that it won’t end up paying too much in interest because of exchange rate fluctuations.

Regardless of whether the off-balance sheet debt is currency-matched or not, it has to be repaid when due and this can raise risk. To be sure, such risk is mitigated by the other currency received at maturity. 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.

Foreign Exchange Swap vs. Cross Currency Swap

11 Institutional investors’ hedging practice can be defended for equities, which vary in price and have no maturity (D’Arcy et al (2009)). Melvin and Prins (2015) describe equity investors’ common practice of adjusting their hedges on the last day of the month at the widely used 4 pm London “fix”. In what follows, we piece together the amount and distribution of this missing debt from three different sources. On the date of publication, Chris MacDonald did not hold (either directly or indirectly) any positions in the securities mentioned in this article. The opinions expressed in this article are those of the writer, subject to the InvestorPlace.com Publishing Guidelines.

what is fx swap debt

This requires a more granular analysis of currency and maturity mismatches than the available data allow. Much of the missing dollar debt is likely to be hedging FX exposures, which, in principle, supports financial stability. Even so, rolling short-term hedges of long-term assets can generate or amplify funding and liquidity problems during times of stress. 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.

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. In addition, some institutions use currency swaps to reduce exposure to anticipated fluctuations in exchange rates. For instance, companies are exposed to exchange rate risks when they conduct business internationally. At maturity, each company will pay the principal back to the swap bank and, in turn, receive its original principal.

What Does $80 Trillion of Hidden FX Swap Debt Mean?

The market turmoil during the GFC and in March 2020 highlighted the central role of the US dollar in the financial system. In each episode, disruptions in dollar funding markets led to an extraordinary policy response in the form of central bank swap lines, whereby the Federal Reserve channelled US dollars to key central banks. Foreign currency swaps are a way of getting capital where it needs to go so that economic activity can thrive. Theses swaps provide governments and businesses access to potentially lower cost borrowing. They also can help them protect their investments from the effects of exchange rate risk.

What Are the Different Types of Foreign Currency Swaps?

Financial customers dominate non-financial firms in the use of FX swaps/forwards. 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.

However, the figure does not factor in any bilateral netting of payment obligations allowable under supervisory and/or accounting methodologies, which could more than halve net interdealer payment obligations. All rights are reserved, including those for text and data mining, AI training, and similar technologies. For all open access content, the Creative Commons licensing terms apply.

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. If they suffered a loss due to fluctuating exchange rates affecting their business activity, the profit on the swap can offset https://www.wallstreetacademy.net/ that. If a currency swap deal involves the exchange of principal, that principal will be exchanged again at the maturity of the agreement. 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.

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. In a cross currency swap, both parties must pay periodic interest payments in the currency they are borrowing.

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