Foreign exchange swaps: Hidden debt, lurking vulnerability

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. In addition to hedging exchange rate risk, this type of swap often helps borrowers obtain lower interest rates than they could get if they needed to borrow directly in a foreign market. In a currency swap, or FX swap, the counterparties exchange given amounts in the two currencies.

1. They are also frequently used for speculative trading, typically by combining two offsetting positions with different original maturities.
2. Thus, central bankers at the BIS appear concerned about the potential ramifications of too much money trading hands in the shadows.
3. The purpose of currency swaps is to reduce currency risk, achieve lower financing costs, or gain access to a foreign currency.
4. 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.
5. In a currency swap, the parties agree in advance whether or not they will exchange the principal amounts of the two currencies at the beginning of the transaction.
6. Many investors who are already taking bearish positions may look to such data as the latest reason to sell.

The third source includes ad hoc surveys on institutional investors’ and asset managers’ use of derivatives. Behn, M, G Mangiante, L Parisi and M Wedow (2018), “Does the G-SIB framework incentivise window-dressing behaviour? Evidence of G-SIBs and reporting banks”, ECB Macroprudential Bulletin 6, October. Pricing is usually expressed as London Interbank Offered Rate (LIBOR), plus or minus a certain number of points, based on interest rate curves at inception and the credit risk of the two parties. Still, questions remain on whether China will recognize the Hong Kong court order for Evergrande’s liquidation — since most of the company’s assets are in the mainland.

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This is a staggering amount of money, with some estimates putting the amount at roughly 14% of all financial assets globally. The outstanding amount has quadrupled since the early 2000s but has grown unevenly (Graph 1, left-hand panel). After tripling in the five years to 2007, it fell back sharply during the GFC, even more than international bank credit. This most likely reflected a reduction in hedging needs, as both trade and asset prices collapsed. For instance, given the hundreds of billions of swaps of yen for dollars by Japanese banks, the Japanese authorities have encouraged their banks to extend the maturities of their swaps (Nakaso 2017). Schrimpf, A and V Sushko (2019a), “Sizing up global foreign exchange markets”, BIS Quarterly Review, December, pp. 21–38.

Currency Swap Considerations

This makes it difficult to anticipate the scale and geography of dollar rollover needs. Foreign currency swaps can involve the exchange of fixed rate interest payments on currencies. Or, one party to the agreement may exchange a fixed rate interest payment for the floating rate interest payment of the other party. A swap agreement may also involve the exchange of the floating rate interest payments of both parties. Imagine down the line company A prefers a fixed rate and company B a floating rate.

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If the currency declines in value, so does the interest payments on the loan (on a relative basis, keeping the ROI of an investment intact). This off-balance sheet dollar debt poses particular policy challenges because standard debt statistics miss it. The lack of direct information makes it harder for policymakers to anticipate the scale and geography of dollar rollover needs.

LONDON, Dec 5 (Reuters) – The Bank for International Settlements (BIS) has warned that pension funds and other ‘non-bank’ financial firms now have more than $80 trillion of hidden, off-balance sheet dollar debt in the form of FX swaps. 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. Consider a company that is holding U.S. dollars and needs British pounds to fund a new operation in Britain. Meanwhile, a British company needs U.S. dollars for an investment in the United States. Currency swaps don’t need to appear on a company’s balance sheet, while a loan would.

Interest payments go to the swap bank, which passes it on to the American company and vice versa. A currency swap involves two parties that exchange a notional principal with one another in order to gain exposure to a desired currency. Following the initial notional exchange, periodic cash flows are exchanged in the appropriate currency.

McGuire, P and G von Peter (2009), “The US dollar shortage in global banking”, BIS Quarterly Review, March, pp. 47–63. 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. China’s property sector is the bedrock of its economy, but massive piles of debt on the balance sheets of its major developers have led to serious defaults. However, a separate Dish debt exchange announced on January 12th is still active.

And, in each, the investor must pay foreign currency to settle the maturing debt. 6 Non-banks in the United States had $866 billion in foreign currency debt in 2021 (US Treasury et al (2022)). About 5% of the $3.4 trillion exponential function python in US imports were foreign currency-invoiced (Boz (2020)). Compared with $26 trillion in dollar debt, any borrowing of dollars in swaps/forwards to hedge these payables may be considered as a rounding error.

An investor or bank wanting to do an FX swap from, say, Swiss francs into Polish zloty would swap francs for dollars and then dollars for zloty. 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 that. 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. An American multinational company (Company A) may wish to expand its operations into Brazil.

Who uses currency swaps?

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. FX swap markets, where for example a Dutch pension fund or Japanese insurer borrows dollars and lends euro or yen in the “spot leg” before later repaying them, have a history of problems. FX swap markets, where for example a Dutch pension fund or Japanese insurer borrows dollars and lends euro or yen in the “spot leg” before later repaying them, have a history of problems. FX swaps are frequently employed to offset exchange rate risk (FX risk). Cross-currency basis swaps, however, can be used to offset both exchange rate and interest rate risk. Another aspect worth highlighting is the principal for cross-currency basis swaps is returned at the same FX rate derived from the FX spot market at the start of the contract.

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 https://traderoom.info/ the forward over, borrowing dollars to repay dollars. 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). The forward creates an obligation to come up with foreign currency (a liability), matched by the right to receive the domestic currency (an asset), both equal to the current value of the foreign currency asset. Precisely because the instruments are off-balance sheet, a systematic analysis is not possible. Still, we just saw how large non-US banks’ dollar borrowing (on net) via FX swaps is and how the figures are an order of magnitude larger for gross positions. The net-gross distinction is bound to be especially large for banks acting as market-makers, which have both long and short positions in the instrument. Currency swaps are typically held by the two parties to the contract, although in some cases, one or both parties may choose to sell or transfer their position to another party.