BIS warns of $80 trillion of hidden FX swap debt
Typically, the spreads on currency swaps are fairly low and, depending on the notional principals and type of clients, may be in the vicinity of 10 basis points. Therefore, the actual borrowing rate for Companies A and B is 5.1% and 4.1%, respectively, which is still superior to the offered international rates. Company A now holds the funds it required in real, while Company B is in possession of USD.
- 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.
- Since the overall US holdings of foreign currency bonds were $600 billion at end-2015, a 50% hedge ratio would extrapolate to $300 billion.
- To be sure, the investor may deal with different counterparties and face different operational issues.
- Finally, companies can choose to remain in their domestic market and avoid foreign currency transactions altogether, eliminating the need for currency swaps or other hedging strategies.
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. 8 Only 1% of FX transactions are centrally cleared (Wooldridge (2017)), and most of those remain limited to non-deliverable forwards (McCauley and Shu (2016)). At end-2007, before interest rate swaps were centrally cleared, the inter-dealer share of such positions stood at almost 40%. These three sources, together with BIS data on international debt securities and global trade, provide a sense of the instruments’ use. Triangulating between the various sources also allows a rough cross-check of the approximations made. 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.
Exchange of Interest Rates in Currency Swaps
Experience shows that FX derivatives can also be used to take open positions, including in the form of carry trades. And off-balance sheet debt can cause or amplify strains, especially in the case of FX options (which are beyond the scope of this analysis). The available statistics do not allow us to identify the extent of speculative use. 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.
Company
There is no FX risk, and the agent needs to finance the future obligation (debt) by coming up with the corresponding foreign currency to settle the forward leg (cases 1 and 2) or to repurchase the foreign currency-denominated asset (case 3). The only difference is that in case 3 the agent has the freedom to use the domestic currency cash to buy another domestic currency asset rather than having it tied up in a forward claim. The authors also measure the missing dollar debt for non-banks resident outside the United States and for banks headquartered outside the US.
Unremunerated reserves in the Eurosystem, part 2: Tax incidence and deposit relocation risks
Instead of borrowing from international banks, both companies borrow domestically and lend to one another at the lower rate. The diagram below depicts the general characteristics of the currency swap. The $6.6 trillion in currency swaps that non-bank financial firms have contracted stand at almost 80% of their outstanding international debt securities.
Simultaneously, a Brazilian company (Company B) is seeking entrance into the U.S. market. Financial problems that Company A will typically face stem from the unwillingness of Brazilian banks to extend loans to international corporations. Therefore, in order to take out a loan in Brazil, Company A might be subject to a high interest rate of 10%.
Drilling down to non-financial and financial customers
They know exactly how much money they will receive and have to pay back in the future. 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. These episodes point to a need for statistics that track the geography of outstanding short-term dollar payment obligations. It is not even clear how many analysts are aware of the existence of the large off-balance sheet obligations.
FX swaps have been employed to raise foreign currencies, both for financial institutions and their customers, including exporters and importers, as well as institutional investors who wish to hedge their positions. They are also frequently used for speculative trading, lexatrade review typically by combining two offsetting positions with different original maturities. The fixed-floating interest swap, owing to its ubiquity, provides a solid foundation for understanding how a swap transaction functions, often referred to as a plain-vanilla swap.
All this greatly complicates any assessment of the missing debt’s total amount and distribution, and hence of its implications for financial stability. That said, a fuller assessment would require better data to help evaluate the size and distribution of both currency and maturity mismatches. The analysis also points to deeper and more complex questions about the accounting conventions themselves. At issue is the definition of derivatives and control, which gives rise to the asymmetric treatment of cash and other claims in repo-like transactions. These questions, together with their regulatory implications, would merit further consideration.
This was evident during the Global Financial Crisis (GFC) and again in March 2020 when the COVID-19 pandemic wrought havoc on the world economy. In both cases, swaps emerged 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 funneled US dollar to non-US banks https://traderoom.info/ offshore, which on-lent to those scrambling for dollars. This off-balance sheet dollar debt poses particular policy challenges, as it is not accounted for in standard debt statistics. 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.
As a basic example, let’s assume two companies, company A and company B, have each taken out a million-dollar loan on which they will make yearly interest payments to their respective lenders. Company A entered into a floating-rate loan based on the LIBOR and company B took on a fixed-rate loan of 4%. A swap contract, unlike a standardised futures or options contract traded through a public exchange, is a customised agreement via the over-the-counter market (OTC), used to exchange future cash flows. 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. 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.
This determines what is recognised and not recognised on the balance sheet. Just how large is the missing dollar debt from FX swaps/forwards and currency swaps? At end-June 2022, dealer banks had $52 trillion in outstanding dollar positions with customers. Non-banks had dollar obligations of half of this amount, $26 trillion.4 This sum has been growing strongly, from $17 trillion in 2016 (Graph 2.B). Currency swaps are over-the-counter derivatives that serve two main purposes.
Against foreign currencies, some central banks lend dollars via swaps in the management of their FX reserve portfolio. 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.
