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Dollar debt in FX swaps and forwards: huge, missing and growing

Dollar debt in FX swaps and forwards: huge, missing and growing

In this case, company A and B can enter into an interest rate swap agreement. Company A promises to pay company B 4% of 1 million dollars which is the fixed leg of the contract. In return, company B pays the LIBOR of interest on a million dollars, this is the floating leg of the contract. The 1 million dollars is known as the notional amount (or principal amount) in which the swap agreement is based on.

  1. These transactions are functionally equivalent to borrowing and lending in the cash market.
  2. Similarly, Company B no longer has to borrow funds from American institutions at 9%, but realizes the 4% borrowing cost incurred by its swap counterparty.
  3. Other sections of the report focused on findings from its recent global FX market survey.
  4. Such hedging can support financial stability, especially if maturities are matched.
  5. For example, say that European Company A borrows $120 million from U.S.

If a U.S. company with operations in Europe wants to borrow euros but can only get loans in U.S. dollars, for example, making interest payments in euros (where revenues are generated) may help balance out exchange rate losses from a depreciating euro. 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). Just as for the case of the $10.7 trillion worth of on-balance sheet debt, this additional dollar debt contracted through FX derivatives is to some extent supported by dollar revenues and/or assets, ie currency-matched. The previous analysis suggests that the whole amount of that debt could be rationalised by hedging activity, be it trade or asset holdings. Such hedging can support financial stability, especially if maturities are matched.

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. India and Japan signed a bilateral currency swap agreement worth $75 billion in October 2018 to bring stability to forex and capital markets in India.

Reasons for Using Currency Swaps

Having repeatedly urged central banks to act forcefully to dampen inflation, it struck a more measured tone this time around and also picked over the ongoing crypto market problems and September’s UK government bond market turmoil. In practice, the example of the interest rate swap agreement between companies A and B is often more complicated. Company A, in the example above, is no longer at the mercy of the floating LIBOR. However, the swap agreement does not come without risk; there is the possibility of payment defaults – credit risk. With mounting global macroeconomic concerns tied to rising interest rates and inflation, this isn’t easy news to hear. Many investors who are already taking bearish positions may look to such data as the latest reason to sell.

What is a Foreign Exchange Swap and How does it Work?

Company A could hypothetically take out a loan from an American bank at 4% and Company B can borrow from its local institutions at 5%. The reason for this discrepancy in lending rates is due to the partnerships and ongoing relations that domestic companies usually have with their local lending authorities. 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. The crisis that erupted in UK gilt markets in September also underscored that central banks could be forced to step in and intervene – in the UK’s case by buying bonds even at a time when it was raising interest rates to curb inflation.

Drilling down to non-financial and financial customers

2 FX swaps and outright forwards cannot be distinguished in stocks data. 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. This is unlikely to weaken our conclusions, as turnover data show that NDFs account for less than 10% of the average daily turnover of FX swaps, forwards and currency swaps. At maturity, each company will pay the principal back to the swap bank and, in turn, receive its original principal. In this way, each company has successfully obtained the foreign funds that it wanted, but at lower interest rates and without facing as much exchange rate risk. The tom-next foreign exchange swap is perhaps the most well known of these specially-named swap transactions since forex traders who hold positions overnight generally perform that swap when doing their rollovers after 5 p.m.

These episodes point to a need for statistics that track the geography of outstanding short-term dollar payment obligations. Currently, in order to assess the level and maturity structure of foreign currency gross and net debt, analysts tend to rely on benchmark international statistical collections,9 which generally cover only the on-balance sheet positions (McGuire (2022)). It is not even clear how many analysts are aware of the existence of the large off-balance sheet obligations.

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. 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. For example, if a swap involves exchanging €10 million versus $12.5 million, that creates an implied EUR/USD exchange rate of 1.25.

In a currency swap, the two parties agree to exchange notional amounts of currencies at an agreed-upon exchange rate and then, at a specified future date, reverse the transaction at a prearranged rate. The swap rate is the difference between the two exchange rates, and it represents the cost of borrowing one currency compared to the other. Off-balance sheet dollar trading fractals 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. And policies to restore the flow of dollars would still be set in a fog.

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. 1 The quantitative estimates of in this column are an aggregate of FX swaps, FX forwards and currency swaps, since separate statistics are generally not available for outstanding amounts.

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. 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.

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. This feature revisits Borio et al (2017), drawing on the comprehensive data in the 2022 BIS Triennial Survey. First, it updates the stylised facts concerning FX swaps/forwards and currency swaps. Second, it measures the missing dollar debt for non-banks resident outside the United States, and for banks headquartered outside the United States.