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.
There’s a potential $80 trillion of capital that’s being held in shadow banks and non-US banks, essentially hidden from the ledgers of the BIS. This is a staggering amount of money, with some estimates putting the amount at roughly 14% of all financial assets globally. McGuire, P and G von Peter (2009), “The US dollar shortage in global banking”, BIS Quarterly Review, March, https://www.forex-world.net/ pp. 47–63. The exchange between them is based on a $1.2 spot rate, indexed to LIBOR. The two companies make the deal because it allows them to borrow the respective currencies at a favorable rate. ETFdb.com data show that, out of the top 22 exchange-traded funds that invest in Japanese equities, those with „hedged“ in the fund title had combined assets of $29 billion.
FX swaps and forwards: missing global debt?
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. It’s just another thing to worry about, for those already concerned about these troubling markets. The parties swap amounts of the same value in their respective currencies at the spot rate.
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. US non-banks have sold only $600 billion in non-dollar-denominated debt to non-residents (US Treasury et al (2016)). Many leveraged accounts (eg Commodity Trading Advisor funds) sell dollars in the futures market rather than in the OTC market.
- For most investors, it’s unclear what the ultimate impact of an FX swap crisis would be.
- If they need to borrow money in a particular currency, and they expect that currency to strengthen significantly in the coming years, then a swap will help limit their cost in repaying that borrowed currency.
- Even so, rolling short-term hedges of long-term assets can generate or amplify funding and liquidity problems during times of stress.
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. Expectations stem from the interest rates offered by the currencies, as demonstrated in the interest rate parity. If currency A offers a higher interest rate, it is to compensate for expected depreciation against currency B and vice versa. Interest rate payments are usually calculated quarterly and exchanged semi-annually, although swaps can be structured as needed. Interest payments are generally not netted because they are in different currencies.
Canary in the coal mine: Bank liquidity shortages and local economic activity
Currency swap maturities are negotiable for at least 10 years, making them a very flexible method of foreign exchange. Currency swaps are used by various financial institutions and multinational corporations that have exposure to multiple currencies. Some examples include multinational corporations, banks, investment funds, governments and central banks, and international organizations like the International Monetary Fund (IMF). One purpose of engaging in a currency swap is to procure loans in foreign currency at more favorable interest rates than might be available borrowing directly in a foreign market. A foreign currency swap can involve exchanging principal, as well. Usually, though, a swap involves notional principal that’s just used to calculate interest and isn’t actually exchanged.
26 Such investors might be able to settle the existing contract by obtaining dollars through the spot market against incoming currencies, putting upward pressure on the dollar exchange rate. 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.
22 This also assumes that dealers – and not customers – have matched positions in which the dollar serves as the vehicle currency, eg a swap from yen to dollars matched with one from dollars to euros. Accounting conventions leave it mostly off-balance sheet, as a derivative, even though it is in effect a secured loan with principal to be repaid in full at maturity. 10 Dafermos et al (2022) argue that repos allow more leverage than swaps. Even so, the larger stock of swaps/forwards entails more dollar obligations than dollar repos. 6 This relates to counterparty risk, in the form of the market value of the instrument (replacement cost) and potential future exposures, which are included in both cases. A common reason to employ a currency swap is to secure cheaper debt.
As part of this phase-out, LIBOR one-week and two-month USD LIBOR rates will no longer be published after December 31, 2021. 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. 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.
Who uses currency swaps?
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.
Figures for internationally active banks’ net on-balance sheet open currency positions are derived from the BIS international banking statistics. 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 https://www.dowjonesanalysis.com/ 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.
Five European supranationals and agencies together had over $400 billion in dollar debt in June 2017. We estimate that these alone have provided $300 billion in swaps against the euro. Assume that an agent wishes to purchase a foreign currency asset, A, and hedge the corresponding FX risk. The agent begins with holdings of local currency C, and no debt, ie C equals net worth, E (left-hand panel). For most investors, it’s unclear what the ultimate impact of an FX swap crisis would be.
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The extent of the strains took many by surprise, as did the underlying demand for US dollars, especially as this came from European banks. Had the amount of FX swaps and the banks in need been more broadly known, the surge would have been less unpredictable or at least more easily understood. The funding disruptions were so serious that they prompted major central banks to put in place FX swap arrangements to channel https://www.forexbox.info/ the necessary US dollar funding to those that needed it most. In the fixed-for-floating rate swap, fixed interest payments in one currency are exchanged for floating interest payments in another. In this type of swap, the principal amount of the underlying loan is not exchanged. The fixed-for-fixed rate currency swap involves exchanging fixed interest payments in one currency for fixed interest payments in another.
The parties involved in currency swaps are usually financial institutions, trading on their own or on behalf of a nonfinancial corporation. Currency swaps and FX forwards now account for a majority of the daily transactions in global currency markets, according to the Bank for International Settlements. To be sure, we are not arguing for a specific treatment of repos and swaps. Nor are we saying that the treatment needs to be identical, at least if the uses of the instruments and broader implications for financial stability are considered. The bottom panels of Graph 5 show aggregates for the non-US banks that, on net, lend dollars through FX swaps in order to square their books. 6 Non-banks in the United States had $866 billion in foreign currency debt in 2021 (US Treasury et al (2022)).
