A Guide to Central Bank foreign exchange liquidity swaps

Written by: Notayesmanseconomics

In recent days this rather arcane subject has seen some interest. This is partly because market participants and economists are wondering what policy options the US central bank the Federal Reserve has left in its locker which is likely to reach a height approaching Friday the 26th of August when it Chairman will give a speech to an expectant world audience! Some are suggesting the swap lines mentioned in the title could be opened on a grand scale.

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1. THE BACKGROUND

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Swap lines are actually being used not once, but twice. The European Central Bank has used its swap line with the Federal Reserve to borrow US $500 million on behalf of a bank and this was rapidly followed by the Swiss National Bank borrowing some US $200 million on behalf of a presumably different bank. The reason I say presumably different is that the Swiss National Bank has operations with non-Swiss banks.

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2. DOES THIS MATTER?

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At a time when we have become used to billions and even trillions being the numbers used in world finance the sum of US $700 million which is the total of the two deal may seem insignificant. However this would be a mistake as there is a lot of potential for these two events to turn out to be the tip of a very large iceberg.

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3. WHY DOES IT MATTER THEN?

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To understand the significance of the situation we need to step back into time to 2008 and consider a situation described earlier this year by Lars Nyberg who is a Deputy Governor of the Swedish Central Bank

In Europe, including Sweden, many banks had borrowed dollars on the US market, where large volumes could be obtained at competitive rates. The US market for short-term funding had been highly liquid. However, when the crisis erupted, the flow of dollars quickly dried up.

So the world banking system was in danger of grinding to a halt as liquidity dried up. This was an irony as the reason for borrowing in the US dollar for some was the availability of a liquid pool of funds. There was a further irony in that banks who had no risk themselves to the problem area of US mortgage backed securities found their funding lines cut too as the system was flooded with uncertainty and risk aversion. If in doubt do not lend became the new watchword particularly amongst US money market funds who had become big suppliers of liquidity.

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4. WHAT SHOULD CENTRAL BANKS DO?

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In response to a banking crisis like this a central bank should supply liquidity to stop a system collapsing a bit like the Marrs hit from some years ago “Pump up the volume”.

However if you are the Bank of England for example you rapidly hit a problem. You have control over your own money supply and accordingly can supply as many pounds as you want. So far so good but they want US dollars. Thats what foreign exchange reserves are for you may say but if you think about it then using them is not as easy as you might think. Not all would be readily available as some are invested and you may not want to sell assets such as gold. However you would have some available but a limited supply. So these could help but if say they started to run down and this was observed it could easily lead to increased fears and even make a bad situation worse.

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5. SO WE NEEDED INTERNATIONAL RESCUE?

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Yes we did and as even the Tracy family and their various Thunderbirds would be ill-equipped for such a task the US Federal Reserve stepped up to the plate. On the 18th of September 2008 it announced this.

The Federal Open Market Committee has authorized a $180 billion expansion of its temporary reciprocal currency arrangements (swap lines). This increased capacity will be available to provide dollar funding for both term and overnight liquidity operations by the other central banks.

You may have spotted the use of the word expansion which gave those who had not been following the situation closely some food for thought. The lines had in fact been ready since late 2007.

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6. A STRANGE ADDITION IN APRIL 2009

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Something rather odd was added to the situation here as the Federal Reserve announced the following.

The Bank of England, the European Central Bank (ECB), the Federal Reserve, the Bank of Japan, and the Swiss National Bank are announcing swap arrangements that would enable the provision of foreign currency liquidity by the Federal Reserve to U.S. financial institutions. Should the need arise, euro, yen, sterling and Swiss francs would be provided to the Federal Reserve via these additional swap agreements with the relevant central banks.”

This is odd as the demand has always been for US dollars and there has been no demand for flows in the opposite direction. Perhaps it was to throw those of an inquisitive mind off the scent…

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7. THE GREEK CRISIS LEADS TO A RE-ESTABLISHMENT OF SWAP LINES

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As you can see from the statement below it was the Greek crisis which led to swap lines returning from their brief abeyance.

The swap facilities announced in May 2010 respond to the re-emergence of strains in short term funding markets in Europe

And as they re-emerged blinking in the sunlight we can see that they were not the same.

The swap lines with the ECB, BOE, SNB and BOJ provide these central banks with the capacity to conduct tenders of U.S. dollars in their local markets at fixed local rates for full allotment, similar to arrangements that had been in place previously. The swap line with the Bank of Canada allows for drawings of up to $30 billion.

Yes the swap lines had gone back to being one way. There has been some debate about the recent borrowing by the Swiss National Bank that it might have been a US bank wanting Swiss Francs but as I pointed out the lines are one-way.

The swap lines were renewed at the beginning of this month and will now last until the beginning of August 2012.

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8. WHAT DOES THIS MEAN?

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If we take in the course of events since 2008 and factor in recent events then we can see that it looks like the world banking system is beginning to creak again and we have a US dollar shortage again.

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9. WHAT ARE THE CAUSES

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1. The spread of problems from the periphery of the Euro zone to more core nations such as Spain and Italy has led to a revision of the credit ratings of not only the countries concerned but also their banks. This is not only by the ratings agencies but by individual banks own credit committees who are showing signs of being less willing to lend.

2. This even affects a country such as Germany as investors worry about the size of bail out costs it may end up carrying. The US Money Market Funds are very risk averse and there is some evidence of them moving away even from Germany.

3. Fears of a world economic slowdown are adding to this as there is a tendency for banks to batten down their hatches. As one banks asset is often anothe rbansk loans such actions can rapidly spiral.

4. If we look at the banks themselves then problems are building everwhere we look. As I write this article I am thinking of a UK bank Barclays whose share price has fallen from around 270p to 145p in three months. There is also Bank of America which has fallen from US $11.42 to US $6.15 over the same time period. So the banks are weaker too and of course this partly due to factors one,two and three.

One can see here the danger of a vicious circle where the four factors keep reinforcing each other and that in my opinion is why we have returned to a world where there is the danger of more US dollar shortages.

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FURTHER READING

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  • The Federal Reserve, the Bank of England, the European Central Bank, the Bank of Japan, and the Swiss National Bank announce swap arrangements (Federal Reserve)
  • Is it dangerous to borrow dollars? (Riksbank)

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  • Anonymous

    Hi Shaun
    Thank you for this summary. If the dollar depreciates against the home currency does this increase the stress in funding markets?

  • Anonymous

    Also, there was this story about RBS: http://www.telegraph.co.uk/finance/8719799/Cost-of-insuring-RBS-debt-reaches-historic-high.html

  • Anonymous

    Hi Shire

    Thanks, I felt that it is a subject that (hopefully until now..) had not been explained properly and worse than that some efforts had been somewhat misleading. I do intend to do others as time permits.

    As to your question it depends on various factors. A major one would be if the banks with these risks are currency hedged and in what form. That side of the equation is unknown. With that caveat I believe that it probably does and is another factor in the so-called “currency wars”