Yves here. Anyone who remembers the crisis will recall that one of the critical elements that turned what should merely have been a housing crisis into a global financial crisis was that accounting rules allowed banks to record certain types of assets at zero risk weights, such as AAA rated CDOs with some additional insurance from an AAA guarantor…like AIG or the monolines, all of which went bust.
There are three reasons to scrutinize FX swaps (note this is the 50,000 foot statement of these issues). First, as this article points out, the peculiar accounting for FX swaps results in some of what is essentially debt to go unrecorded.
Second, currency mismatches were a big problem in the crisis, as European banks that held dollar assets (and a lot of that was US mortgage market related) found they had trouble rolling their dollar funding of it. The Fed had to throw open currency swap lines so that the ECB could swap its Euro emergency loans to these banks into the needed dollars.
Third, as we pointed out, foreign exchange swaps look to have played a significant role in the recent repo market strains. Our view has been that concern about the repo market interest spikes has been way way overdone; there’s no indication that the increases resulted from banks being reluctant to lend to counterparties, but instead to the Fed not understanding the implications of various changes it and Congress had made to how banks manage their liquidity, which got exposed when the Fed finally started tightening via shrinking it balance sheet. And to make matters worse, the Fed’s responses were late, clumsy, not well explained, and hence had the effect of making non-insiders suspicious.
John Dizard in the Financial Times pointed out that the reason big banks like JP Morgan who made clear they had ample liquidity but couldn’t be bothered to provide it to the repo market was that they were making more in foreign exchange swaps. From a September post, quoting Dizard:
Why have the Fed’s large interventions since September 17 not calmed the money markets? Perhaps it is because that liquidity is being sopped up by the demands of the FX swaps market.
Ralph Delguidice, a money market observer and global macro strategist at Pavilion Global of Montreal, points out that for a yen/dollar FX swap, “a dealer receives a total of about 230 basis points for what is a synthetic yen-dollar repo. That includes the three-month dollar Libor rate, the negative rate on Japan Libor, a charge by the dealer called the ‘basis’, and the negative yield on the JGBs which are the best place for the dealer to park the yen they receive in return for dollars.
“Compare that to dollar repo which was 190 earlier this week, and Treasury bills, which are about 150. You can see why the dealers are incentivised to lend dollars in the FX swap market rather than the domestic money market.”
Note finally that the Bank of International Settlements has been worried about hidden foreign exchange swaps debt since at least 2017. The fact that they have not gotten to the bottom of it is a cause for concern. Opacity and hidden leverage are prescriptions for disruption or worse.
The bottom line is foreigners’ “hidden” dollar borrowings via foreign exchange swaps look to be bigger than their visible on-balance sheet borrowings. This is not a pretty picture, and among other things, means that credit rating agencies and other financial analysts have a big blind spot.
By Claudio Borio, Head of the Monetary and Economic Department, Bank for International Settlements,Patrick McGuire, Head of International Banking and Financial Statistics, Monetary and Economic Department, Bank for International Settlements, and Robert McCauley, Corte Real Advisor. Originally published at VoxEU
Foreign exchange swaps and forwards are a key instrument in the global financial system for hedging, position-taking and short-term funding. They involve the exchange of notional amounts at a future date and, as funding vehicles, they are akin to other forms of collateralised borrowing (e.g. repo). The amounts involved are huge, but the instruments remain mysterious in some ways: because of an accounting peculiarity, they are treated very differently from other forms of collateralised debt. This column examines their geography and draws implications for both academics and policymakers. It finds that non-US residents’ US dollar forward payment obligations arising from foreign exchange swaps and forwards are likely to be even larger than the corresponding on-balance sheet US dollar debt. It also highlights the favourable regulatory treatment that these instruments receive, and argues that they represent a critical pressure point in international financial markets.
Foreign exchange (FX) swaps and their close cousins, FX forwards, are an important and growing segment of global financial markets.1 The latest BIS Triennial Survey indicates that, at $4.3 trillion, they accounted for some 65% of the average daily turnover in global FX trading in April 2019. In fact, they have been its fastest-growing component, accounting for roughly 75% of the increase in aggregate turnover since April 2016, the date of the previous survey (BIS 2019a, Schrimpf and Sushko 2019a). The amount outstanding at end-June 2019 was as high as $72 trillion, with FX swaps an estimated three-quarters of this total.2 For perspective, this figure was equivalent to 84% of global GDP, exceeded that of global cross-border portfolio stocks ($59 trillion) and international bank claims ($35 trillion), and was almost triple the value of global trade ($25 trillion). Not surprisingly, the US dollar reigns supreme. It is almost always one of the two currencies exchanged: 89% and 90% in terms of outstanding and turnover, respectively.
FX swaps and forwards play a key role in funding. Whenever an agent wishes to acquire, say, a US dollar asset on a hedged basis, they can do so in four ways: borrow dollars on an uncollateralised basis, enter a repo, enter an FX swap or, equivalently, combine a spot purchase of dollars with a forward sale, possibly with two different counterparties. The last three transactions are, in effect, forms of collateralised borrowing. It is only when an agent already has revenue streams and wishes to hedge them that they can simply use a forward. In this case, while not a financing vehicle, the forward is a form of debt. Of course, the instruments can also underpin speculative positions.
FX swaps and forwards differ from most other types of derivatives in one crucial respect: the notional amount is exchanged. They generate a debt obligation for the full face value of the contract. As a result, while notional amounts for other derivatives simply act as a reference for the much smaller amounts actually exchanged, the same is not true for FX swaps and forwards. Notional amounts must be paid and thus matter a great deal; in fact, there is nothing notional about them.
The special character of these instruments does not stop here (Borio et al. 2017). Their accounting treatment differs fundamentally from that of other forms of collateralised debt. Compare an FX swap with a repo. When an agent borrows against a security in a repo, the security stays on the balance sheet: the balance sheet is grossed up, as it includes the new borrowing and whatever is acquired through it. By contrast, if the same agent enters into an FX swap, using another currency as collateral, the new currency simply replaces the old one on the asset side of the balance sheet: the size of the balance sheet does not change.3 One transaction shows up as additional debt; the other is not treated as debt at all – the debt remains ‘hidden’. Why are instruments that are economically (roughly) equivalent treated so differently? Because accountants consider cash to be special.
This asymmetric treatment has important implications. One has to do with our understanding of the geography of FX swap and forward debt; the other with their regulatory treatment and financial stability implications more broadly. Consider each in turn.
The gGeography of FX Swap and Forward debt: US Dollars Outside the US
Out of sight may not quite be out of mind, but a lack of transparency does complicate things. When the Great Financial Crisis (GFC) broke out, the FX swap market came under substantial strain (Baba et al. 2009, McGuire and von Peter 2009), as funding in the wholesale unsecured segment froze. The extent of the strains took many by surprise, as did the underlying demand for US dollars, especially as this came from European banks. Had the amount of FX swaps and the banks in need been more broadly known, the surge would have been less unpredictable or at least more easily understood. The funding disruptions were so serious that they prompted major central banks to put in place FX swap arrangements to channel the necessary US dollar funding to those that needed it most.
McGuire and von Peter (2009) took a first stab at estimating non-US banks’ US dollar borrowing via FX swaps and forward debt more generally. Their key assumption was that banks generally avoided taking significant FX exposures, largely reflecting prudential regulations and risk management practices. In other words, they assumed that banks used FX swaps to ‘fill the gap’ in the net currency exposure shown on their balance sheets. Based on the same methodology, estimates of this gap derived from the BIS international banking statistics suggest that non-US banks’ net dollar borrowing via FX swaps was less than $1 trillion at end-June 2019. However, rough estimates based on some ancillary assumptions detailed in Borio et al. (2017) and derived from the BIS OTC derivatives statistics indicate that the corresponding gross amount exceeded $30 trillion, more than double their gross on-balance-sheet dollar debt ($13 trillion).4
What about the amount of US dollar debt in the form of FX swaps/forwards by non-banks (financial and non-financial entities) outside the US? Here, obtaining an estimate requires a triangulation between the aggregate amount of FX swaps/forwards outstanding and banks’ positions. Using the same ancillary assumptions, we estimate that, at end-June 2019, the amount was some $18 trillion or so. This was actually larger than the equivalent amount of on-balance sheet debt, estimated at $11.9 trillion.5
FX Swaps, Regulation, and Financial Stability
As a rule, prudential regulation generally follows accounting, with first-order implications for the treatment of FX swaps/forwards. Compare, again, an FX swap with a repo. While the corresponding cash flows are captured and treated equivalently in liquidity regulation, the picture is quite different for the leverage ratio in particular. As a first approximation,6 FX swaps are exempt; repos included in full. This is surprising, given that the two instruments are roughly equivalent from an economic perspective.
The implications can be substantial. 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.
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. Indeed, a key function of FX swaps is to facilitate hedging. We are simply saying that such a large difference is odd. The difference has implications for regulatory arbitrage, for market dynamics around reporting dates and for business models more generally.7 Appropriately, the Basel Committee on Banking Supervision (BCBS) is monitoring banks’ behavioural responses to regulations, including potential regulatory arbitrage transactions and balance sheet optimisation techniques (BCBS 2019c).
Looking forward, regardless of their regulatory treatment, FX swaps are likely to come under strain again should global financial markets face stress at some point. Their role in US dollar short-term funding is so large and important that it could not hardly be otherwise. Almost three quarters (72%) of the average daily turnover in April 2019 was in maturities up to one month, adding to rollover pressure.8 Any financial stress in this market could easily also engulf the shorter-term repo market: both compete for spare dollar funding, which is quite concentrated these days (Dizard 2019). And this at a time when the authorities are grooming secured interest rates to become the new reference (Schrimpf and Sushko 2019b). In fact, the direction of contagion could go either way. The surprising ructions of September 2019 in the US dollar repo market had only a limited effect on the FX swap segment (BIS 2019b). But, in periods of extreme stress, even fully collateralised markets can seize up, as the events of the GFC showed.
FX swaps/forwards are a critical segment of global financial markets. Despite their role, the geography of their utilisation remains opaque. And, largely because of accounting conventions, their regulatory treatment differs markedly from that of instruments that, economically, are also forms of secured debt. Both of these aspects deserve more attention than they have generally received so far.
Our analysis has implications also for academic work on bank funding and lending patterns. That work generally has to rely exclusively on on-balance sheet data, for which the BIS international banking statistics are a key source. Authors should be aware and acknowledge that they are capturing only part of overall activity, often not even the larger one if the focus is on the US dollar. Here as elsewhere, ‘caveat emptor’ applies.
Authors’ note: The views expressed are those of the authors and do not necessarily represent those of the Bank for International Settlements.
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. Currency swaps are FX swaps with a maturity longer than one year in which coupons are also exchanged. Our aggregate also includes non-deliverable forwards (NDFs), or forwards where the notional amount is not exchanged, making them materially different from swaps and deliverable forwards. It is not possible to exclude NDFs from the outstanding amounts, although turnover data for these instruments suggest that they are a single-digit share of the market. Figures for the average daily turnover and amounts outstanding of FX swaps and forwards are taken from the BIS Triennial Survey and the semi-annual OTC derivatives statistics, respectively. Figures for internationally active banks’ net on-balance sheet open currency positions are derived from the BIS international banking statistics.
2 The estimate of outstanding FX swaps (separate from outright forwards) is derived from the Triennial survey, where turnover figures for these instruments are reported separately. In what follows, whenever we refer to funding via FX swaps, we have in mind combinations of spot and forward transactions.
3 Outright forwards combined with a spot transaction with a different counterparty would be recorded similarly.
4 In addition to market-making activities (see below), the gross figure is boosted by the vehicle currency role of the US dollar. For instance, a European institution seeking to invest in a Thai baht asset may swap euro for dollars and then dollars for baht, i.e. both borrow and lend dollars via FX swaps.
6 This relates to counterparty risk, in the form of the market value of the instrument (replacement cost) and potential future exposures, which are included in both cases. But these are tiny in comparison to the principal amounts. For details, see BCBS (2019a).
7 For instance, it is well known that banks “window-dress” their balance sheets around reporting dates (BIS 2018, Behn et al. 02018). Indeed, the Basel Committee on Banking Supervision has issued guidance to address this problem (BCBS 2019b, 2018). Not least because of the regulatory treatment, the adjustment takes place largely via repos.
8 Of course, some authorities have been very alert to such risks. 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).