FX Swaps: Implications for Financial and Economic Stability

Contributor Notes

Authors’ E-Mail Address: bbarkbu@imf.org; long@imf.org

The proliferation of foreign exchange (FX) swaps as a source of funding and as a hedging tool has focused attention on the role of the FX swap market in the recent crisis. The turbulence in international money markets spilled over into the FX swap market in the second-half of 2007 and into 2008, giving rise to concerns over the ability of banks to roll over their funding requirements and manage their liquidity risk. The turmoil also raised questions about banks' ability to continue their supply of credit to the local economy, as well as the external financing gap it could create. In this paper, we examine the channels through which FX swap transactions could affect a country's financial and economic stability, and highlight the strategies central banks can employ to mitigate market pressures. While not offering any judgment on the instrument itself, we show that the use of FX swaps for funding and hedging purposes is not infallible, especially during periods of market stress.

Abstract

The proliferation of foreign exchange (FX) swaps as a source of funding and as a hedging tool has focused attention on the role of the FX swap market in the recent crisis. The turbulence in international money markets spilled over into the FX swap market in the second-half of 2007 and into 2008, giving rise to concerns over the ability of banks to roll over their funding requirements and manage their liquidity risk. The turmoil also raised questions about banks' ability to continue their supply of credit to the local economy, as well as the external financing gap it could create. In this paper, we examine the channels through which FX swap transactions could affect a country's financial and economic stability, and highlight the strategies central banks can employ to mitigate market pressures. While not offering any judgment on the instrument itself, we show that the use of FX swaps for funding and hedging purposes is not infallible, especially during periods of market stress.

I. Introduction

The rising popularity of foreign exchange (“FX”) swaps to obtain FX funding and as a hedging instrument has raised questions about their role in macro-financial stability, in light of developments during the recent global financial crisis. The proliferation of cross-border transactions in FX swaps over time had left this market exposed to the fallout from the international liquidity crunch, despite being among the most liquid in the world. As the turmoil in international money markets spilled over into FX and currency swaps markets in the second-half of 2007, and intensified in the latter-part of 2008 following the collapse of Lehman Brothers, the impact on activity in FX swap instruments became very stark.

During this period, the turbulence in the FX swap markets was initially caused by a shortage of U.S. dollar funding among non-U.S. financial institutions.2 While these institutions were desperately trying to secure U.S. dollars to fund their operations, participants in the interbank market who had erstwhile supplied the currency were hoarding liquidity to support their own funding needs, as well as withholding lending over concerns of rising counterparty risk. The result was that many non-U.S. financial institutions had to obtain U.S. dollar liquidity through FX swap markets, causing the market to become increasingly one-sided.3 As the crisis evolved, some financial institutions with other FX liabilities, notably, the euro and Swiss franc, also faced similar funding difficulties.4 During this period, hedging activity and speculative plays via the FX swap market also increased the volatility in the FX spot market for numerous currencies.

Given the importance of banks as key dealers and users of FX instruments, and as anchors for financial stability and economic activity, disruptions in the FX market in general could have potentially far-reaching consequences.5 As evidenced during the recent crisis, stress in the FX swap market segment, in particular, gave rise to concerns in some countries over the ability of their banks to roll over their funding needs, and consequently, the supply of credit to the local economy and the financing of the balance of payments. The crisis also highlighted the role of central banks in FX swap markets.

The objectives of this paper are twofold. We examine the channels through which FX swap transactions could (i) affect a country’s financial stability; and (ii) their impact on economic stability:

  • From a financial stability perspective, we show how regulatory requirements under the Basel Accords affect the charge of banks holding FX swaps for funding and/or hedging purposes. We separately demonstrate how the use of FX swaps by banks could have important implications for their liquidity positions, especially during periods of significant market volatility. We also discuss how recent accounting rules have improved the disclosure of FX swaps on banks’ balance sheets.

  • In economic stability terms, we consider how dislocations in the FX swap market could increase the costs of funding and hedging for banks, with consequences for their lending activity and a country’s balance of payments. FX swap transactions could also cause significant exchange rate volatility during periods of market turmoil, with potential implications for economic activity. We also present the strategies that central banks could employ in mitigating pressures in the FX swap market.

It should be emphasized here that the paper is not intended as a critique of FX swaps. Rather, the aim is to discuss the various ways in which the use of the instrument could have stability implications, in light of the financial crisis. While FX swaps were not an independent source of shock during this crisis, their widespread use in international financial markets may have amplified existing stresses.

The paper is organized as follows. The background on and key features of FX swaps are presented in Section II. Section III demonstrates the ways in which FX swaps could impact financial stability, followed by an examination of how such transactions could affect macroeconomic stability in Section IV. Section V discusses the strategies that central banks could employ to mitigate stress in the FX swap market, and Section VI concludes. The more technical information on the applications and implications of FX swaps is presented in the appendices.

II. Stylized Facts

An FX swap is an agreement between counterparties to exchange one currency for another, at predetermined times, without incurring foreign exchange risk. Put another way, FX swap transactions represent the actual borrowing and lending of currencies on a collateralized basis. It enables the use of the FX market to obtain foreign currency funding, as an alternative to borrowing and lending in the eurodollar and other offshore markets (Box 1). FX swaps are widely used by banks and other financial institutions for managing liquidity and shifting delivery dates. Participants in the FX swap market often find it useful to be able to move temporarily into or out of a particular currency in exchange for another without incurring the exchange rate risk of holding an open position in the currency that they are temporarily holding. FX swaps are also commonly used for hedging FX positions, speculation, and for taking positions on interest rates, among other purposes (see below).

Activity in FX swaps had grown strongly in recent years, up until the financial crisis.6 The turnover in traditional global FX markets grew at unprecedented rates over the April 2004 to April 2007 period, with the average daily turnover expanding by 69 percent to $3.2 trillion. More than half the increase was attributable to FX swaps with the average daily turnover rising by 80 percent compared to 45 percent the preceding three-year period (Figure 1). The increasing importance of these instruments was partly attributable to changes in hedging activity.

Figure 1.
Figure 1.

Global Foreign Exchange Market Turnover, by Instrument 1/

(In billions of U.S. dollars)

Citation: IMF Working Papers 2010, 055; 10.5089/9781451963533.001.A001

Source: Bank for International Settlements.1/ Amounts are the daily average in April of each year.

Overall, the increase in FX swaps transactions between reporting dealers and other financial institutions accounted for about half the growth in the global turnover in this market.7 Separately, turnover with non-financial customers recorded a strong increase of 10 percent, to account for 45 percent of all FX swap turnovers over the 2004–07 period. During this time, the share of FX swap transactions with a maturity of less than seven days increased to 78 percent from 73 percent (Figure 2).

Figure 2.
Figure 2.

Global FX Swaps Turnover, by Maturity 1/

(In billions of U.S. dollars)

Citation: IMF Working Papers 2010, 055; 10.5089/9781451963533.001.A001

Source: Bank for International Settlements.1/ Amounts are the daily average in April of each year.

The FX swap market has also become an increasingly important linkage across countries. Cross-border transactions represented more than 60 percent of the total FX swaps turnover in April 2007. The cross-border turnover in FX swaps had expanded rapidly between April 2004 and April 2007, with the average daily turnover increasing by 78 percent, to $1.1 trillion (Figure 3). About 35 percent of the increase was attributable to interbank transactions, and almost 50 percent to transactions between reporting banks and non-bank financial institutions (Figures 4).

Figure 3.
Figure 3.

Global FX Swaps Turnover, by Location 1/

(In billions of U.S. dollars)

Citation: IMF Working Papers 2010, 055; 10.5089/9781451963533.001.A001

Source: Bank for International Settlements.1/ Amounts are the daily average in April of each year.
Figure 4.
Figure 4.

Cross-Border FX Swaps Turnover, by Counterparty 1/

(In billions of U.S. dollars)

Citation: IMF Working Papers 2010, 055; 10.5089/9781451963533.001.A001

Source: Bank for International Settlements.1/ Amounts are the daily average in April of each year.

The financial crisis clearly took a toll on activity in the FX swap market. Positions taken in FX derivatives declined sharply in 2008 H2. Among the countries comprising the G-10 and Switzerland, notional amounts outstanding in forwards and FX swaps fell by 33 percent from the first-half of that year, followed by a slight uptick of 9 percent in 2009 H1 (Figure 5).8

Figure 5.
Figure 5.

G-10 and Switzerland: Notional Amounts Outstanding of OTC Foreign Exchange Derivatives, by Instrument

(In billions of U.S. dollars)

Citation: IMF Working Papers 2010, 055; 10.5089/9781451963533.001.A001

Source: Bank for International Settlements.

However, significant price movements resulted in sharp variations in gross market values, with forwards and FX swaps doubling to $1.6 trillion in the second-half of 2008 trillion, then almost halving again to $870 billion in 2009 H1 (Figure 6).9

Figure 6.
Figure 6.

G-10 and Switzerland: Gross Market Values of OTC Foreign Exchange Derivatives, by Instrument

(In billions of U.S. dollars)

Citation: IMF Working Papers 2010, 055; 10.5089/9781451963533.001.A001

Source: Bank for International Settlements.

III. Financial Stability

Policymakers have long recognized the riskiness of banks’ FX activities, which tends to heighten during periods of increased volatility in exchange rates. Indeed, the Basel Committee on Banking Supervision (BCBS) had noted some time ago that, “…there are few [activities] in which a bank may so quickly incur large losses as in foreign exchange transactions” (BCBS, 1980). The BCBS further stated that supervisors needed to be vigilant so that the risks from banks’ FX operations never became so large as to threaten their solvency and liquidity, and potentially, the health and stability of the entire banking system.

The promulgation of international standards and regulations attempts to capture the risks posed by the use of FX instruments, and to ensure greater transparency in their disclosure. They include the application of the Basel Accords (Basel I and Basel II), as well as the International Financial Reporting Standards (IFRS). Participants in the market for OTC FX derivatives, among other derivatives instruments, also enter into standardized International Swaps and Derivatives Association (ISDA) contracts with their counterparties, which include provisions for mitigating credit risk.10 In this section, we focus on the risks associated with the use of FX swaps in particular.

Some Key Features of FX Swaps1

The FX swap is a standard instrument that is traded in the over-the-counter (OTC) market. An FX swap has two separate legs settling on two different dates; it provides for one exchange and one re-exchange only (and is not a stream of payments), i.e., one currency is swapped for another for a period of time, and then swapped back. The deal date is the date on which the two counterparties enter into the FX swap contract. The deal date is also referred to as the contract date. The value dates are the dates on which the currencies are exchanged and re-exchanged.

Counterparties agree to exchange two currencies at a particular rate on one value date (the “near date” or the “spot value date”) and to reverse payments, almost always at a different rate, on a specified subsequent value date (the “far date”). If both value dates are less than one month from the deal date, it is known as a “short-dated swap”; if one or both value dates are one month or more from the deal date, it is a “forward swap.” The two legs of an FX swap can, in principle, be attached to any pair of value dates.

In practice, a limited number of standard maturities account for most FX swap transactions. The first leg usually occurs on the spot value date, and for about three-quarters of all FX swaps the second leg occurs within a week; however, there are also FX swaps with longer maturities of up to several years. Among dealers, most of these are arranged for even or straight dates—e.g., one week, one month, three months—but odd or broken dates are also traded for customers.

The cost of an FX swap is determined by the interest rate differential between the two swapped currencies. As with outright forwards, arbitrage and the principle of covered interest rate parity operate to make the cost of an FX swap equal to the FX value of the interest rate differential between the two currencies for the period of the swap (instances of deviations from covered interest parity are discussed later in this paper). The cost of the FX swap transaction is measured in swap points, such that:

fDC/FXsDC/FX=sDC/FX[(1+rDC)1+rFX1],

where f is the forward rate, s is the spot rate, r is the interest rate and DC/FX represents quotes in domestic currency per unit of foreign currency. Thus when rDC rises, the swap points for borrowing domestic currency increases. The counterparty that holds the currency that pays the higher interest rate for the period of the swap will pay the points, neutralizing the interest rate differential and equalizing the return on the two currencies, while the counterparty that holds the currency that pays the lower interest will earn or receive the points. At the outset of the transaction, the present value of the FX swap contract is always zero (excluding the transaction cost).

The objective for utilizing an FX swap may be different from that for an outright forward. The latter is typically used to manage the risk inherent in currency markets by enabling the rate and date on which a given amount of FX will be purchased or sold. Although FX swaps are also used to hedge FX exposures—and the FX swap market tends to be much more liquid than the forward market—the most common use of FX swaps is for institutions to fund their foreign exchange balances. The FX swap differs from the interest rate swap, which provides for an exchange of a stream of interest payments in the same currency but with no exchange of principal; it also differs from the currency swap, in which counterparties exchange and re-exchange principal and streams of fixed or floating interest payments in two different currencies.

1 See, for example, http://www.forexhound.com for a more detailed exposition on the mechanics of FX swaps.

A. Capital Charges under the Basel Accords

A bank’s capital adequacy ratio is derived from regulatory capital and risk-weighted assets. Under the Basel Accords, risk weights are applied to the assets on a bank’s balance sheet (risk-weighted assets) in order to calculate the appropriate capital charges, and thus, determine if a bank is adequately capitalized.11 The use of FX swaps by banks would incur a capital charge for credit risk, but reduce the capital requirements for market risk.

Credit risk

FX swaps carry a capital charge for credit risk. Under the Basel Accord, a “credit exposure” for derivatives such as swaps, forwards and options on currency, interest rate, equity and commodity products would be calculated as the sum of the current net replacement value (NRV) plus an add-on component that is supposed to capture future exposure, depending on the tenor and type of contract (Jorion, 2009).12 Counterparty risk weights are then applied to the credit exposure to derive the credit risk charge.13

Market risk

FX swaps could be applied to reduce banks’ market risk from existing FX positions. In general, FX positions taken by banks could require capital charges for market risk under Basel II. Specifically, there is a capital charge for FX risk, under Pillar I on Minimum Capital Requirements, so that banks which hold overall net open FX positions on their balance sheets will be subject to a capital charge of 8 percent of the overall net open positions.14 15 Thus, banks have significant incentive to close such exposures through hedge transactions, commonly using FX swaps.16 In other words, banks’ use of FX swaps for hedging purposes, despite incurring credit risk, could help to reduce capital charges for market risk.

B. Liquidity Risk

The use of FX swaps could increase the liquidity risk for banks. A bank that is perfectly hedged in terms of its FX exposure would still be exposed to liquidity movements arising from that hedge. Specifically, marking-to-market under ISDA agreements between counterparties—while decreasing credit risk—may instead create liquidity risk (Jorion, 2007). The practice requires more frequent collateral payments as contracts need to be valued on a regular basis and cash exchanged with the counterparty through the margin call process (Box 2).17 Thus, variations in the fair value of an FX swap could potentially drain the bank’s liquidity in volatile market conditions.

Margin calls by a swap counterparty may be triggered in the event of a sharp depreciation of the domestic currency resulting in a large fair value adjustment (FVA). In a situation where the spot domestic currency exchange rate experiences a persistent weakening trend, which places pressure on the corresponding forward rate, margin calls by the counterparty would continue. Any sustained outflow of liquidity from the bank could get to a point where the bank may no longer be able to meet its short-term cash flow obligations and is ultimately faced with a solvency problem.

C. Transparency under International Financial Reporting Standards

In the International Financial Reporting Standards (IFRS), the International Accounting Standard IAS 39 is the main standard for derivatives, and therefore applies to the accounting of FX swaps. The standard prescribes principles for recognizing and measuring financial assets, financial liabilities and contracts for non-financial items, including financial derivatives.18 Traditionally, financial derivatives were accounted for using historical cost accounting. Given that there is usually no initial cost attached to financial derivatives, their presentation in financial statements would usually be in the form of a note to the accounts, which would not fully reveal a company’s real exposures. However, IAS 39 brings derivatives onto financial statements, thus increasing the transparency of exposures.

Margin Calls on an FX Swap Contract

FX swaps are bilateral, or OTC, in nature in that they are contractual arrangements between two counterparties. As such, it creates potentially significant counterparty risks in that if one party defaults under the swap agreement, the other could suffer huge losses. These risks typically have very low probability of realization for instruments that trade in a centrally cleared market, where an adequately capitalized clearinghouse assumes the counterparty risk which is mitigated by the posting of initial collateral by participants with the clearinghouse, and the meeting of maintenance margin requirements. In OTC derivatives markets, counterparties may initially trade up to an agreed threshold of exposure (“margin threshold“), and then one counterparty may make a margin call when the amount of its exposure to the other counterparty exceeds the threshold.

In order to avoid constant margin calls back and forth, FX swap counterparties in most cases establish a mutually agreed upon margin threshold. The margin threshold is determined on a counterparty by counterparty basis, and is typically based on the credit ratings of the individual parties. FX swaps are typically conducted under some form of negotiated master swap agreement, such as that published by ISDA, which contains an exposure threshold mechanism that allows for the collateralization of counterparty exposures beyond a certain level. However, the potential exists for significant future counterparty exposure in the event of a sharp deterioration in the creditworthiness of one or both counterparties from the time the threshold is negotiated.

A margin call is made by a counterparty when its FX swap position is “in the money,” i.e., when the position of the other party is “out of the money.” The margin is collateral that the holder of the out-of-the-money position in the swap contract has to deposit to cover its credit risk. In other words, the swap counterparty who is out-of-the-money must provide a certain level of margin or collateral in case of default. For the counterparty who is in-the-money, the receipt of the margin or collateral would reduce credit risk. The collateral can be in the form of cash or securities, and it is deposited in a margin account. The amount of the collateral is calculated as the difference between the contracted forward exchange rate which must be paid out upon the maturity of the swap contract and the forward exchange rate on the agreed-upon day at which the contract is marked-to-market (e.g., on a fortnightly basis, or on the last day of every month for the duration of the contract), discounted using the market-determined interest rate over that time period to arrive at the net present value, and less the margin threshold.

Swap exposures cannot be netted across counterparties (although it may be netted within the same counterparty), which prevents margin calls from being offset across counterparties. For example, say a bank has a negative swap exposure to one counterparty and a positive swap exposure to another counterparty. If the first counterparty is entitled to make a margin call on the bank, it could not instead choose to make a margin call on the other counterparty to the bank. The outcome may be that the bank’s working capital is tied up (if it cannot make a margin call of equivalent amount on the other counterparty) even if its net market exposure turns out to be zero across both counterparties, thus creating a drain on its liquidity.

IAS 39 abolishes the common accounting practice for synthetic instruments which nets hedges in the balance sheet and presents the hedged item and hedge instrument as a single item. Further, all derivatives instruments must be carried at fair value on the balance sheet, for example, through marking-to-market.19 Any change in the fair value should be recognized in the profit and loss statement (and ultimately, the retained earnings item in the balance sheet), that is, by making an FVA. Gains and losses from a hedging instrument cannot be offset against gains and losses in the value of the hedged item.

FX swaps are carried on the balance sheet at fair value. On the day the FX swap is transacted, its fair value is likely to be zero.20 On balance sheet date, the value at which the FX swap reported in the balance sheet may be positive (if the swap is in-the-money and an asset), negative (if the swap is out-of-the-money and a liability) or, possibly zero. The main factor that would cause the fair value of the swap to vary from its assumed initial zero value is the movement in the forward rate relative to the contracted forward exchange rate of the transaction. Upon settlement of the swap contract, the item becomes realized―it is closed out at transaction value and, by definition, drops out of mark-to-market.

IV. Economic Stability

A well-functioning FX swap market tends to support macroeconomic and external stability by allocating FX liquidity in an efficient manner, and reducing the volatility of the spot exchange rate. However, during periods of stress in financial markets, spillovers to the FX swap market could result in illiquidity and significantly increase transaction costs. Consequently, an external financing gap may arise, creating pressure on a country’s currency. In order to mitigate the effects of financial stress and to limit the impact on the real economy, central banks may provide FX swap facilities to market participants.

A. Increased Costs of FX Funding and Hedging

A high reliance on funding through FX swaps could result in severe liquidity shortages during turbulent periods, and consequently, a rise in funding costs (Box 3). During the recent crisis, for example, U.S. dollar funding became scarce, making it increasingly costly to obtain U.S. dollars through FX swaps with the euro, the pound sterling and the Japanese yen (Figures 79).21 Prior to August 2007, the U.S. dollar “basis” was close to zero. However, in late-2007, the spread between the two widened, implying a market-based U.S. dollar funding rate that is higher than U.S. dollar LIBOR, i.e., investors had to pay a premium to obtain U.S. dollars in the FX swap market. Furthermore, counterparties who were concerned about liquidity constraints became increasingly reluctant to lend FX over longer periods, leading to a sharp shortening of FX swap maturities and increasingly costly rollover activity.

Figure 7.
Figure 7.

U. S. Dollar Basis Spread on the EUR, Implied from 3-Month USD/EUR FX Swap Contracts (In basis points)

Citation: IMF Working Papers 2010, 055; 10.5089/9781451963533.001.A001

Sources: Bloomberg; and authors’ calculations.
Figure 8.
Figure 8.

U. S. Dollar Basis Spread on the GBP, Implied from 3-Month USD/GBP FX Swap Contracts (In basis points)

Citation: IMF Working Papers 2010, 055; 10.5089/9781451963533.001.A001

Sources: Bloomberg; and authors’ calculations.
Figure 9.
Figure 9.

U. S. Dollar Basis Spread on the JPY, Implied from 3-Month USD/JPY FX Swap Contracts (In basis points)

Citation: IMF Working Papers 2010, 055; 10.5089/9781451963533.001.A001

Sources: Bloomberg; and authors’ calculations.

More costly FX swaps can lead to further FX funding strains for banks, which could then impair macroeconomic stability through several channels. First, hedging an existing balance sheet position becomes more expensive for the bank. If the bank cannot hedge an open position, it would incur a regulatory charge on capital (see above). The bank could alternatively decide to shrink its balance sheet position, which could translate into a liquidity squeeze on the domestic economy. Second, obtaining FX funding becomes more expensive, potentially increasing the cost of credit to the economy. Third, an increase in perceived counterparty risk may require lower margin thresholds, and any subsequent margin calls would directly reduce the liquid assets available to the bank that is out-of-the-money, further reducing its ability to provide credit to the economy.

The Pricing of an FX Swap

Coffey, Hrung, Nguyen, and Sarkar (2009) provide a concise exposition on the pricing of an FX swap under normal market conditions. The authors use the example of a European investor who is interested in investing euro for three months. The investor has two options:

  1. Invest the money in the unsecured euro cash market for three months at the prevailing eurodenominated interest rate; or

  2. Convert the euro into U.S. dollars through a three-month FX swap and invest the dollars for three months at the prevailing dollar-denominated interest rate, for example, by purchasing and holding a three-month U.S. Treasury bill. After three months, the investor collects the final payout from the Treasury bill and concludes the FX swap by trading the dollars back for euro.

In an efficient market, these two strategies must provide equal returns at the end of three months. Otherwise, arbitrage would ensure that the less costly option/higher return option is exploited until the two returns are equalized once again. Put another way, the U.S. dollar “basis spread” on another currency is the premium paid by international institutions to obtain dollars in the FX swap market. It is defined as the dollar-denominated interest rate implied from an FX swap with another currency minus a benchmark unsecured U.S. dollar-denominated lending rate such as U.S. dollar LIBOR. Assuming a no-arbitrage condition and using data on the euro-dollar spot and forward rates, as well as the euro LIBOR as a proxy for the European interest rate—the U.S. dollar interest rate implied by euro-dollar FX swaps could be derived. The U.S. dollar basis vis-à-vis the euro would then be calculated as follows:

U.S. dollar basis spread on the euro = Implied FX swap U.S. dollar interest rate – benchmark U.S. dollar interest rate.1

During normal times, the U.S. dollar basis spread on another currency should hover around zero for the major, very liquid currencies. However, during the recent global financial crisis, FX swap-implied U.S. dollar funding rates significantly exceeded the dollar-denominated interest rate on several occasions, when demand for the U.S. dollar far outstripped its supply, even against the major currencies.

1Depending on the tenor of the FX swap rate and U.S. dollar interest rate used in the calculation, the derived U.S. dollar basis rate would apply to the same tenor term loan.

B. External Financing Gap

A dysfunctional FX swap market could impair the external stability of a country by creating a financing gap in the Balance of Payments (“BoP”).22 Such a gap could manifest if domestic financial institutions’ demand for external financing through FX swaps is higher than the external supply, a situation that could arise during periods of market stress. The increasing degree of cross-border integration of FX swap markets in recent years (see above) suggests that the potential impact on a country’s external financing needs from disruptions to this market could be significant.

A financing gap in the BoP could materialize in several ways:

  • In a situation where domestic financial institutions transact with foreign counterparties in FX swaps, any shortening of maturities as a result of concerns about rising counterparty risk essentially front-loads rollover requirements. This, combined with higher costs of using FX swaps would increase the institutions’ external financing needs. Consequently, those financial institutions may find it difficult to meet their rollover requirements and may be forced to close out their FX swap positions and repay their FX obligations. Financial institutions may need to purchase FX in the spot market, placing pressure on the domestic currency. The outcome would be similar where domestic financial institutions transact with foreign counterparties, who rely on FX swaps themselves to fund carry trade plays.

  • Alternatively, if foreign counterparties are constrained for liquidity or are concerned about counterparty risk, they may decide to cut their exposures to FX swaps and in doing so, reduce the overall external financing available to the country, and thus increase its external financing gap.

  • Margin calls could also create an external financing gap. If domestic financial institutions or corporates have to honor the margin calls on their FX swap contracts with foreign counterparties, such payments would result in outflows in the country’s financial account. From a macroeconomic perspective, the aggregate outflow could be substantial since margin calls are typically linked to factors such as exchange rate depreciation, which could affect many domestic institutions simultaneously.

The adjustment required to close the external financing gap could have wide-ranging macroeconomic implications. It could create pressure on the exchange rate or the central bank’s international reserves, depending on the country’s exchange rate regime. It could also squeeze FX liquidity in the domestic economy, affecting trade and other economic activity.

C. Exchange Rate Volatility

A competitive and liquid FX swap market typically helps to smooth any volatility in the exchange rate, as it enables market participants to manage their FX risks and access short-term FX funding. However, FX swap transactions could potentially act to magnify volatility in illiquid markets or during stressful periods. This can occur as a result of either hedging or speculative transactions (Box 4). Market participants who enter into FX swap transactions for hedging purposes typically have open FX positions which they may want to close as part of their risk management strategy; speculators may represent one of the possible counterparties on the other side of these transactions. Such activity in increasingly illiquid markets has the potential to cause volatility in the exchange rate, if they are sufficiently large.

Volatile exchange rates could potentially affect various aspects of economic activity. They generally make economic decisions more difficult because of the increase in exchange rate risk. While the evidence to date has not been conclusive, some empirical findings suggest links to growth, investment, and trade. For instance, Aghion, Bacchetta, Ranciere and Rogoff (2008) find a negative impact from exchange rate volatility on growth in countries with less developed financial sectors, while Furceri and Borelli (2008) show that exchange rate volatility has a negative effect on foreign direct investment in economies with a high level of openness. Clark et. al (2004) note that some of the empirical evidence points to a negative relationship between exchange rate volatility and trade, but that the effect appears fairly small and is by no means robust and universal.

Exchange rate volatility could also complicate monetary policy decisions. Recent empirical evidence points to a positive pass-through of exchange rates to inflation, both in emerging-market and advanced economies (Ca’ Zorzi, Hahn and Sánchez, 2007). Devereux and Yetman (forthcoming) and Choudhri and Hakura (2006) also find evidence of a positive pass-through effect, but suggest that a lower inflationary environment leads to lesser exchange rate pass-through.

Greater exchange rate volatility could also increase the indirect credit risk for the banking system through unhedged borrowers. For example, in several Central and Eastern European countries, firms and households had taken out foreign currency loans prior to the financial crisis to benefit from lower foreign interest rates, relative to those for domestic currency loans.23 If shocks to the economy are accompanied by exchange rate depreciation, the borrowers may have to service rising debts in domestic currency terms. This could lead to a worsening in banks’ asset quality arising from a deterioration in borrowers’ ability to repay their debt.

How Would Hedging and Speculation Using FX Swaps Affect the Spot Exchange Rate?

There are several scenarios under which transactions in FX swaps could affect the level and/or the volatility of the exchange rate of a country’s currency. In times of market stress, when markets are illiquid or increasingly one-sided, such transactions could exacerbate the volatility in the exchange rate, with potential consequences for risks in the banking system, economic activity and policy.

Scenario 1. Bank closing a net open FX position1

Assume that a local bank has more domestic currency liabilities on its balance sheet than domestic currency assets. The bank would thus have exactly the opposite position with the FX-denominated items—it would have more FX-denominated assets than liabilities, i.e., have a long FX position on its balance sheet.

  1. In order to close the net open FX position, the bank converts excess domestic currency liquidity to FX via an FX swap transaction.

  2. The bank then sells the FX in the spot market in exchange for domestic currency to close the open FX exposure, potentially strengthening the domestic currency.

  3. Upon the maturity of the FX swap contract, the bank would sell domestic currency in the spot market in exchange for FX—potentially weakening the domestic currency—to repay the FX to, and receive domestic currency from, the counterparty.

Scenario 2. Foreign investor holding local securities

Assume that a foreign investor holds a portfolio of local securities. The investor thus has an open domestic currency position and wants to hedge the existing exposure against a potential depreciation in the domestic currency:

  1. The investor enters into an FX swap to borrow domestic currency and lend FX. In other words, the investor has now taken on a domestic currency-denominated liability (domestic currency is payable in the future) and an FX-denominated asset (FX is receivable in the future).

  2. The investor then sells the domestic currency on the spot market for FX, potentially weakening the domestic currency.

  3. When the investor decides to sell the local securities, the domestic currency from the receipt of the sale is then swapped back for FX.

Scenario 3. Speculator in the FX market

Assume that a speculator is on the other side of an FX swap transaction with a domestic bank. The speculator has FX but wishes to speculate in domestic currency in anticipation of a sharp depreciation in the latter; the bank has domestic currency but requires FX to fund its operations.

  1. The speculator swaps FX for domestic currency (borrows domestic currency and lends FX) with the bank.

  2. The speculator then sells down the domestic currency on the spot market for FX, which could contribute to the weakening of the domestic currency.

  3. When the speculator closes out the position at the maturity of the swap contract, s/he would purchase domestic currency on the spot market at that time—with the anticipation of doing so at a significantly depreciated level—and swap the domestic currency back for FX with the bank.

It should be noted that speculators play an essential role in the market by improving liquidity. While such activity may cause greater volatility at times, it also plays an important part in the necessary process of risk repricing, especially in liquid markets.

1See Appendix IV for assumptions on FX spot and swap rates, and Appendix V for an illustration of how FX swaps could be applied to close net open FX positions.

V. Central Bank Measures to Mitigate Risks From and Shocks to FX Swap Markets

FX swap facilities are standard liquidity management instruments that could be utilized by a central bank for various purposes. Their use represents an open market operation—where the central bank acts as a counterparty to domestic financial institutions (or corporations)—to control liquidity in the system, manage the international reserves of the central bank, or to smooth disorderly fluctuations in the exchange rate. In the event of a shock to FX swap markets, a central bank has several tools at its disposal to address FX funding shortages and any resulting pressure on the exchange rate. It may raise interest rates, to try to attract investors; it may intervene by conducting outright sales of foreign reserves to help meet the funding need and alleviate the pressure on the exchange rate; it may also use existing foreign exchange reserves for FX swap operations with market counterparties.24

From a balance sheet perspective, the provision of FX liquidity through FX swaps could result in either a temporary or permanent drawdown of the liquid FX assets of a central bank. The reduction in FX assets would typically be offset by an increase in FX assets receivable in the future, through a claim on the counterparty arising at the settlement of the FX swap (Box 5). Given the covered nature of FX swap transactions, the central bank would normally not assume any of the underlying FX risk. However, the drawdown of liquid reserve assets associated with the transaction could be permanent if the swap counterparty defaults. Conversely, FX spot sales would permanently draw down a central bank’s reserves.

FX swaps were used as a crisis management tool during the recent crisis. Central banks used FX swap facilities extensively to increase FX liquidity in the system when domestic institutions were faced with FX funding shortages. In situations where domestic financial institutions were unable to roll over their existing FX swaps, central banks’ facilities substituted as counterparties to the private sector. Where reserves in the required foreign currencies were insufficient or (liquid) reserves were limited in those currencies, swap lines with the central banks issuing the foreign currencies in shortage were established to backstop losses of liquid reserves.

The major central banks coordinated their actions to mitigate the transmission of shocks through the global FX swap market and ensure FX liquidity.25 The U.S. Federal Reserve and the European Central Bank opened swap lines with each other and with various other countries amid substantial dollar and euro shortages in December 2007, and at various points in 2008. These swap lines augmented the liquid euro and U.S. dollar assets of the receiving central banks, enabling them to credibly commit to providing large amounts of much-needed FX to domestic market participants through their own domestic FX swap facilities.

Impact of Central Bank FX Swap Operations on Its Balance Sheet

FX swaps which are executed for monetary policy purposes affect central banks’ balance sheets. Such operations consist of simultaneous spot and forward transactions in the domestic currency (“DC”) against foreign currency. If the central bank wants to absorb domestic currency liquidity from the market and provide FX liquidity at the same time, it will borrow domestic currency and lend FX. Conversely, if it wants to provide domestic currency liquidity and absorb foreign currency, it would lend domestic currency and borrow FX. After receiving bids from counterparties (banks), the central bank would decide on the swap points and allotment to each bank. The details of the transactions depend on the type of auction chosen by the central bank e.g. a single rate (Dutch) or multiple rate (American) auction.

Example. Providing FX Liquidity through FX swaps

Assume that the central bank decides, in a single rate auction, to provide FX liquidity to the market (and absorb domestic currency liquidity) by executing an FX swap on the domestic currency with FX; it allocates FX100 million, equivalent to DC105 million at the current spot rate, priced at 5 forward basis points (or 500 pips) premium (i.e, the forward rate is 1.05 + 0.05 = DC1.10 per unit of FX). At the start of the operation, the central bank provides FX100 million to the market, and absorbs DC105 million. On the maturity date of the operation, the central bank removes the FX100 million and injects DC110 million back into the market.

The balance sheet effects of the central bank’s FX swaps with the banking system are, in principle, the same as those for outright operations. For the spot leg of the transaction, lending FX has a contractionary effect in that it reduces the central bank’s claim on non-residents and banks’ reserves. The monetary base falls, but net domestic assets remain unchanged. The forward leg creates, in this case, a forward domestic liability that is matched by a forward foreign asset. These contingent claims and obligations are, in most cases, recorded initially in off-balance sheet accounts and, subsequently, in on-balance sheet accounts for each receipt or payment.

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Since FX swaps create assets and liabilities that are contingent, they are, by definition treated as off-balance sheet items. Therefore, central bank’s FX swap operations would usually have no permanent impact on their balance sheets. The structure of an FX swap, where the terms of the forward leg are set in advance, ensures that these operations do not carry exchange rate or other market risks, although keeping large notional amounts of short positions of FX swaps vis-à-vis the domestic currency could create FX vulnerabilities for the central bank.1 Also, default by a counterparty would affect the composition of foreign and domestic currency in the balance sheet.

1 The data template on International Reserves and Foreign Currency Liquidity provides a tool for assessing the impact of FX swaps on the vulnerability of central banks. The template supplements traditional data on international reserves, that cover largely cross-border and balance-sheet activities, with those on foreign currency positions and off-balance sheet activities. It is a prescribed category of the IMF’s Special Data Dissemination Standard.

VI. Concluding Remarks

The spillover of the liquidity crunch in international money markets into the FX swap market during the recent financial crisis has placed a spotlight on the latter’s potential impact on macro-financial stability. The increasing reliance on FX swaps for FX funding by some market participants and the sharp increase in cross-border transactions in this instrument gave rise to significant concerns when the market faltered during this tumultuous period. Specifically, the role of banks as key dealers and users of FX instruments—and their central importance for financial stability and economic activity—raised worrying questions in some countries about the possible impact of FX swaps on the health of the banking system and real economy.

First, we examine the ways in which FX swaps transactions could affect a country’s financial stability. Capital adequacy requirements under the Basel Accords hold implications for the application of capital charges when these instruments are held by banks, either for speculation purposes, to finance their FX needs and/or to hedge their open FX positions. FX swaps held by banks could also impact their liquidity positions, through margin calls by counterparties, even though they may be fully hedged for FX movements. Encouragingly, the accounting requirements under IFRS are aimed at improving the transparency of reporting by users of these instruments, by bringing them onto the balance sheets of the reporting entities.

Next, we contemplate the stability implications from an economic perspective. We consider how dislocations in the FX swap market could increase the costs of funding and hedging for banks, with attendant consequences for their lending activity to the local economy, and a country’s Balance of Payments. We also discuss how FX swap transactions could potentially exacerbate the volatility in exchange rates when markets are illiquid or under stress, with possible negative implications for the real sector. During the recent crisis, central banks used FX swap facilities extensively to facilitate the rollover of FX swaps by the private sector during the crisis, in some cases, supported by swap lines with other central banks.

We conclude that the application of FX swaps is not infallible, despite their usefulness. That said, this paper is not intended as a critique of FX swaps, but rather, to examine the channels through which FX swaps could affect financial and economic stability, given their increasing popularity leading up to the crisis. As recent events have shown, the use of this instrument could actually exacerbate risks to financial and economic stability during periods of turmoil. Thus, central banks, which typically use FX swaps as a monetary policy tool, and banks, which transact in this instrument for funding, hedging or speculative purposes, need to ensure that they have the necessary measures in place to address the stability problems that could arise from its use.

FX Swaps: Implications for Financial and Economic Stability
Author: Ms. Li L Ong and Ms. Bergljot B Barkbu
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    Global Foreign Exchange Market Turnover, by Instrument 1/

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    Global FX Swaps Turnover, by Maturity 1/

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    Global FX Swaps Turnover, by Location 1/

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    Cross-Border FX Swaps Turnover, by Counterparty 1/

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    G-10 and Switzerland: Notional Amounts Outstanding of OTC Foreign Exchange Derivatives, by Instrument

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    G-10 and Switzerland: Gross Market Values of OTC Foreign Exchange Derivatives, by Instrument

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    U. S. Dollar Basis Spread on the EUR, Implied from 3-Month USD/EUR FX Swap Contracts (In basis points)

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    U. S. Dollar Basis Spread on the GBP, Implied from 3-Month USD/GBP FX Swap Contracts (In basis points)

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    U. S. Dollar Basis Spread on the JPY, Implied from 3-Month USD/JPY FX Swap Contracts (In basis points)