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Bond MarketCurrency Swap Facility Comment

Currency Swap Facility Comment

I have something written on currency swaps, but it is probably too complex. I want to make a brief and hopefully simple comment on the topic. (The fact that I am writing an article a day tells us something about markets.)

The term “currency swap” is the term that we usually see, although there are a few variants. The variants are differentiated by the way in which interest rates are calculated. The cross-currency basis swap is the floating rate/floating rate version of a “currency swap,” and is the 800 pound gorilla of cross-currency funding trades. This is the wholesale hedging tool, and other foreign exchange hedging instruments are priced off these swaps. Although “cross-currency basis swap” sounds cool, I will just “currency swap” in this article, since I am not concerned about the interest rate terms.

Although a currency swap is typically packaged as a derivative, it is the economic equivalent of a pair of loans. For simplicity, I will use a Canadian dollar (C$ or CAD) versus U.S. dollar (U$ or USD) example, and will use a nice round C$2 = U$1 exchange rate.

Let’s say I am a Canadian bank, and you are an American bank, and I want U$100 million of your yummy U.S. dollars for one month. We then enter into a swap to achieve this.

As loans, the structure is:

  1. I lend you C$200 million for one month at some CAD interest rate.

  2. You lend me U$100 million for one month at some USD interest rate.

We can alternatively think of this as swapping currencies.

  1. I swap you C$200 million for U$100 million now.

  2. I swap you U$100 million for C$200 million one month in the future.

  3. We have some interest rate payments to settle — which are small relative to principal.

If you think hard about this package of transactions, we see that neither party is greatly affected by the unknown future CAD/USD exchange rate. Even if the U$100 million I receive drops in value versus CAD, I am exchanging it back at the original exchange rate. This means that the package does not face exchange rate valuation risks, which allows people in funding groups that are not allowed to take foreign exchange risk (the division of rates and FX risk is called “separation of church and state”) to do the transactions.

We can now turn to why the major developed central banks announced swap line programmes with the Fed. Due to the dominance of the U.S. dollar and the attractiveness of U.S. capital markets, foreign banks have U.S. subsidiaries and USD assets. However, their funding base mainly comes from locals. This means that they are stuffed to the gills with non-USD funding, but have positions in USD assets to fund. They do not take meaningful foreign exchange risk, trading their local currency for USD outright. (The only banks that mismatch currencies on their balance sheets are ones in pegged currencies — which is why devaluations in pegged regimes tend to blow out banking systems.)

When times are good, the foreign banks either issue USD liabilities to fund their assets, or swap their local currency funding to USD (in a variety of ways, but the alternatives end up being equivalent to currency swaps).

Unfortunately, times are not always good. When there are worries about banking systems, investors that provide funding pull back from funding foreign banks. They generally have local currency liabilities (which is why they have fixed income portfolios), and they know that the local central bank will backstop the local banks. This means that it suddenly becomes hard for foreign banks to fund their positions in USD. Either funding is cut off due to credit/counter-party concerns, or is exceedingly expensive. In other words, the circular flows in cross-country finance are no longer flowing.

In order to restore the circular flows, foreign central banks do a currency swap with the Fed, and they then pass along the USD to the local banks that need it. The central banks restore the circular flows, and this hopefully buys time for the private sector to find a way for the foreign banks to finance their USD positions (or exit them).

Despite theories to the contrary, this has nothing to do with the level of currencies, nor is it a sign of weakness of the United States. Although it indicates concerns about the financial system, you had to be living under a rock to not notice that such concerns exist. The benign interpretation is that these facilities have been loudly announced now to prevent bearish speculation about the future — i.e., the announcement effect is enough to eliminate the need for actual intervention.

Central bank intervention makes people angry. But people need to accept that these swap lines are part and parcel of a deregulated global financial and trading system. You either have capital controls, or you have central banks acting as swap dealers of the last resort, or you have periodic meltdowns of the currency system. Pick your poison.

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(c) Brian Romanchuk 2023


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