Claudio Borio, Robert McCauley, and Patrick McGuire solved the problem about what I will write about this week by publishing “Dollar debt in FX swaps and forwards: huge, missing and growing” as part of the Bank of International Settlements’ quarterly review (https://www.bis.org/publ/qtrpdf/r_qt2212h.htm). One can interpret the text as a plea for more data, which is reasonable enough. However, the lurid headlines and commentary that the article has attracted elsewhere is somewhat missing the point. I am not attempting to discuss that article in depth, rather offering my interpretation of the underlying issues.(This article also reminded me that my hope that I was finished my “how do banks work?” primer series was incorrect — I needed to do sections on foreign exchange (FX) and interest rate hedging. I will write the FX hedging primer later, so this article will not attempt to explain how they work in too much detail — but I am giving a minimal primer herein.)
What Is a Cross-Currency Basis Swap?
The Borio, McCauley, and McGuire paper referred to “FX swaps.” which I assume are cross-currency basis swaps. The financial press often refers to these as “basis swaps,” which is too vague — a basis swap is a swap that swaps a floating rate for a floating rate. In most cases, “basis swaps” refer to swaps within the same currency (e.g., 3-month USD floating versus 1-month USD floating), and “cross-currency basis swap” for the ones going across currencies only. Since the other basis swaps are boring and the cross currency basis exciting (in 2008, at least), the press often drops the “cross currency” part. In this text, I am not going to refer to same currency basis swaps again, and will use “basis swaps” as a stand-in for “cross currency basis swaps.”
The authors also mention the “close cousin” currency swaps. “Currency swaps” were the first similar cross-currency derivatives traded, but they had one leg of payments with a fixed interest rate. Since that would imply two different swaps to quote for a currency pair — e.g., 5-year CAD fixed versus USD floating, 5-year USD fixed versus CAD floating), the markets moved to basis swaps where both legs float. If one wants to structure trades in the most liquid instruments for ease of pricing and unwinds, one just uses the floating basis swap and separate vanilla interest rate swaps to construct the fixed leg(s). An industrial firm that is not actively trading derivatives might just stick with the simpler fixed-leg currency swap to hedge a bond issue.
The structure of the swap is two party exchanging floating rate loans in the currencies, with loan repayments at the contract termination. (The exchange rate used at termination equals the exchange rate at entry.) This means that these swaps are not like modern interest rate swap contracts: principal is exchanged, and changes in the exchange rate directly affect the economic value of the final exchange.
When I followed the market, the pricing structure of the market centralised versus the USD: pretty much everything was quoted versus the USD. This is great for data collection and pricing. If you wanted to trade two non-USD currencies with liquid derivatives, you set up two swaps, with the USD legs cancelling out. Otherwise, market makers need to come up with a term structure for obscure currency pairs, which is not really feasible.
Cross-currency swaps that have been entered into are ugly from a counter-party risk point of view. (The swaps can also be traded on a forward basis, where principal exchanges occur on future dates. Until the forward date hits, the counter-party risk is close to a similar tenor vanilla interest rate swap, which is relatively small.)
I have seen two incorrect ways of minimising this risk.
- Across the swap, the foreign exchange transfers cancel out. This is true — which is why forward currency swaps are pretty boring. The problem is that the cancellation no longer happens after the first exchange — which is the entire life of a spot swap.
- The parties get a foreign currency asset immediately, and its valuation change cancels out the valuation change in the swap. Although this is again true for the consolidated balance sheet of the participants, having another asset somewhere else does not help the credit risk of the swap instrument itself. The swap counterparty only gets access to the value of that asset if it has not already been liquidated before a bankruptcy proceeding.
I left finance in 2013, and it is unclear to me how well post-Financial Crisis derivatives reforms have addressed counter-party risk of basis swaps. However, even before the Financial Crisis, market participants were aware of counter-party risks, and took steps to combat the problem. However, the Financial Crisis overwhelmed those puny counter-measures (discussed below).
Who Uses Basis Swaps?
Three major users of basis swaps are the following.
- Multinational banks who act as dealers as well as hedge their own operations.
- Borrowers who issue debt in one currency and swap it into another.
- Investors that want to hedge the foreign currency risk of foreign currency assets.
In order to enter into a spot cross-currency basis swap, you need to have the notional amount of the currency you are swapping on hand. The swap dealer is not going to lend it to you. This knocks the “speculators” of financial fan fiction (written by finance professors) out of the spot market — hedge fund balance sheets are too lightweight to support the notional transfers. Speculators trade currency forwards and forward basis swaps — which only have transfers at the expiry date (and often closed early).
As an example, imagine a Canadian province borrowing in Japanese yen (JPY) but really wants to borrow in the Canadian dollar (CAD).
- It issues a bond in JPY.
- It swaps the JPY bond issuance proceeds for CAD in a CAD-JPY cross-currency basis swap, possibly via two swaps using USD legs that cancel out. The currency swap notional exchange at maturity will provide the JPY to make the bond’s principal payment.
- It does vanilla interest rate swaps to adjust the duration of its positions in JPY and CAD (transform between floating and fixed interest rates).
Why would it do this? Presumably because the province wants to lower its cost of borrowing and/or diversify its funding sources. The net effect of all the transactions is to create a “synthetic” CAD-denominated bond with a lower coupon that it could squeeze out in the Canadian market — or at least reduce the funding pressure on Canadian fixed income investors.
Another reason to do such transactions is that you cannot execute them in the local market. For example, when I was in the markets, there was essentially no Canadian primary market for high yield (sub-investment grade) debt. There might be previously investment grade issues that were downgraded, but floating a new bond of any size would be difficult. As such, Canadian high yield investors would buy USD-denominated high yield bonds and hedge into Canadian dollars, while high-yield issuers would issue the bonds in USD and swap the proceeds back into CAD. Currency swaps could be used to execute the hedges, and a large deal could have a decent impact on basis swap pricing.
Notional Size Explosion
Notional sizes of currency derivatives outstanding are really, really big. Lots of zeros everywhere. And they tend to be riskier than interest rate swaps. That said, the notional amount outstanding is fairly meaningless.
- If the notional amount includes options, complicated trade structure with multiple options can have very small maximum gains/losses relative to notional amounts. Currency trading is hyperactive, as the market appears to offer returns uncorrelated to risk assets (which greatly excites asset allocators).
- If a trade is structured with two offsetting USD legs, the notional size of the derivatives is double the size of the “true” swap.
- If a position is closed by entering into an offsetting position, the economic risk of the position is effectively nil, yet the notional size has doubled. Generally speaking, everyone want to reduce notional amounts outstanding. However, dealers invariably offer much worse pricing on closing out a position than another dealer would offer for entering into a new (offsetting) swap. It is easy to grow a derivatives book — but expensive to unwind one.
Currency Hedging Is Good, Actually
Anything involving derivatives raises tut-tut noises from many commentators across the political spectrum. However, cross-currency swaps are how the wholesale market does currency hedges. The other instruments — like currency forwards are effectively appendages of the basis swap market. For example, forward currency quotes deviate from the value predicted by interest rate parity. I believe this deviation was commonly referred to as “the basis,” as it lines up with the spread in the corresponding cross currency basis swap. (Note that I have otherwise ignored that spread in my discussion here; the interest rates used are effectively floating versus floating plus spread.)
Regulators want large financial institutions to hedge currency risk. They need a hedging market to create those hedges. In order for a hedge to work, it has to have a lot of embedded leverage — needs to cancel out valuation changes of a large position without requiring a similarly large investment. This means that regulators have to accept the existence of a big derivatives market with lots of embedded leverage — which drives some commentators up the wall.
Outside of the Financial Crisis — which I will discuss below — you do not tend to hear about the cross currency basis swap market. One reason is that it is largely the domain of entities with big balance sheets, and they tend to keep their yaps shut about their funding methods. The other reason is that it’s fairly quiet most of the time.
A thing that helps the market is that for end users, the macro risk is a “right-way risk” (as opposed to “wrong-way risk”). In a local crisis, the value of risk assets in a country collapse. Since risk asset flows are the major driver of currency values (and not trade flows), this whacks the value of the currency.
What happens when the local currency drops suddenly?
- For local borrowers that hedged into the local currency, the market value of the unhedged bonds they issues rises rapidly. If they were unhedged, they would be in trouble. However, the point of the hedge is cancel that out — they will get a mark-to-market gain on their hedge. Their counterparties would need to post extra collateral (if their derivatives agreement required it), not the local borrowers.
- Borrowers from other countries that tapped into the local currency market might face margin calls. However, the country involved is small, it would only be a small part of a sensible borrower’s funding mix, and it is still a crisis in a foreign country. If things get ugly, it is easier for a central bank to intervene to limit the appreciation of its currency.
- Asset managers with liquid assets in the foreign currency will face margin calls — but they own liquid assets in the foreign currency. They can use those assets to meet margin calls. (E.g., an equity investor could sell equities and use equity futures to replicate the missing broad equity exposure.)
- Banks are supposed to be liquid and able to meet margin calls.
By process of elimination, we are left with a problem group: owners of illiquid assets in the foreign currency.
What About 2008?
A core problem in 2008 was an issue that most observers were unaware of — and ignored in pop histories of the Financial Crisis. The problem was that foreign banks — and we can use basis swap movements to infer that euro area institutions were dominant — had the brilliant plan of investing in toxic credit products denominated in USD, relying on the brilliance of experts in the area of Gaussian copula theory to print trading profits. The plan worked for awhile, but then trouble started.
As an aside, re-read the previous paragraph and compare that to the predictions of doomsters who warned about the American current account deficit causing a financial crisis. How exactly did the current account deficit force people overseas to invest in credit products that had structurers that turned out to be less competent than cows?
Once credit market participants sniffed out the problem, banks that were funding their USD asset positions in USD money markets were forced to rely on funding from their home markets (where they were seen as more secure). The problem is that banks need to be currency-matched, so they needed to swap the foreign currency funding for USD funding. This created a one-sided demand for swap flows in the market, and an unwillingness to extend the flows (due to counter-party risk). The spread on basis swaps blew out, and the market seized up when Lehman was allowed to fail.
Since pretty well every large institutional investor and borrower (including industrial firms) is either directly or indirectly implicated in the cross currency basis swap market, all funding markets froze. This forced the rather active post-Lehman policy response.
The authors of the BIS piece were worried about USD exposures in foreign countries. Although there are data sets of USD-denominated debt, those data sets do not contain any information on currency derivatives. They want to lump those two concepts together, hence they referred to the derivatives as “missing dollar debt” However, that is a misnomer. At most, currency hedges can be described as “missing/hidden contingent (USD) liquidity risks.”
Meanwhile, the “missing USD debt” framing will almost certainly confuse people. The most predictable interpretation is that the “debt” is that it is like an unhedged USD debt — increasingly onerous to foreign entities if the USD increases in value. However, if the foreign entities are borrowing in USD and hedging, currency swap hedges increase in value. The borrowers only face margin calls if their local currency is increasing rapidly in value versus USD.
The problem in 2008 in the swaps market was that big foreign banks were doing stupid stuff in the United States. They were always going to be in trouble, regardless of the state of the currency swap market.
Large borrowers and asset managers need large counter-parties to take on currency hedge risk. Countries have four options: peg currencies (which probably requires the next option as well), impose capital controls to clamp down on cross-border financing, allow currency hedging to operate, or have periodic crises caused by a lack of hedging and a floating exchange rate. Many post-Keynesians want to go back to the 1950s: capital controls and pegged exchange rates. However, this is so far of the political radar in North America that I do not see much need to ponder the possibility.
One natural suggestion is to have the central bank (or central government) monitor and guarantee currency swap activity in a country. The problem is straightforward: it will end up guaranteeing foreign currency obligations, converting a floating currency sovereign into one with contingent liabilities in foreign currencies. This creates an unusual constraint on a sovereign. Keeping the ability to throw foreign subsidiaries and private firms with foreign currency obligations under the bankruptcy bus preserves policy space for the government.
The only realistic possibility I see keep these risks within reasonable bounds is that regulators monitor the market, and understand the positioning of the major players. Given the commercial sensitivity of that information, none of that information would make its way into public data sets. The regulators would then have to use suasion to ensure that sketchier positions are not been funded from overseas, since those positions are the ones most likely to cause grief if there is an unwind.
Any multinational financial crisis in the developed countries will show up in the cross currency basis swap market, since that is where large institutions lay off their foreign currency risk. As such, I cannot say that bad things will not happen in that market. However, my view is that source of the problems are more likely to be caused by activity elsewhere that calls into question the credit worthiness of one or more major players in the market.