In its latest quarterly review, the Bank for International Settlements (BIS) suggested that the amount owed on foreign exchange swaps, forwards and currency swaps could precipitate a financial crisis.
The BIS said that non-bank financial institutions and funds had some $80 trillion of what it described as “hidden” off-balance sheet debt via FX swaps, a level that was more than all dollar Treasury bills, repo and commercial paper.
US Federal Reserve interest rate policy over the last decade or so meant that rates of return for cash became relatively and steadily more attractive through USD assets than in local currency for banks and non-banking institutions such as pension funds.
Since availability of USD-denominated credit lines for foreign institutions is limited, an effective method of increasing exposure to dollar assets was to simply convert local currency into USD, invest in the underlying asset, and take out a concurrent forward contract to convert the USD back into local currency at a specified point in the future.
In its report, the BIS said that payment obligations from FX swaps were recorded off-balance sheets, unlike with repo agreements.
There are ways to do derivative trades that are not reflected on financial statements… but this cannot account for the $80 trillion the BIS is talking about
Ivan Asensio, Silicon Valley Bank
But Ivan Asensio, head of FX risk advisory at Silicon Valley Bank, questions the use of the word ‘hidden’, explaining that global accounting regulation states that all derivatives must be placed on the balance sheet at fair market value, with fair value changes reflected in either the income statement or equity.
“There is no way around this for large public companies, banks and non-bank financial institutions globally, so I am not sure how these swap/forward trades are hidden,” he says. “There are ways to do derivative trades that are not reflected on financial statements – for instance, entering and exiting them within the reporting period – but this cannot account for the $80 trillion the BIS is talking about.”
It is also important to differentiate between the credit extended and the size of the swap or forward, since the credit extended to support $1 trillion in swaps/forwards is much less than $1 trillion.
“Based on my understanding of the BIS paper, roughly 75% of the swaps/forwards referenced have a tenor of less than seven days and most are just one day,” says Asensio. “The actual credit piece (debt) on a seven-day swap/forward is just a small fraction of the notional amount.”
Debt fuel
It should be noted that the Fed’s approach to global liquidity provision via swaps and repos has fuelled this debt, says Thomas Friesleben, managing director at StoneX Pro.
“The prominent call-out is the magnitude of dollar borrowing via FX swaps by offshore entities and the potential for funding squeezes, but this isn’t a new risk or something anyone would be surprised by.”
If offshore dollar borrowing continues to grow while banks and dollar lenders become more constrained by regulations on leverage and liquidity, this would increase the chance of funding squeezes at peak times.
“However, if corporates have to pay more to borrow USD, the risk of contagion is pretty small,” says Friesleben. “It would take a large funding blow-up for offshore entities such as life insurers, who tend to roll FX hedges via one-month or three-month swaps, to fail.”
Scott Bilter, principal at Atlas FX, states that the dollar debt the BIS refers to has grown broadly in line with global GDP since 2016 and suggests it has earned headlines now because of the relative infrequency with which the BIS issues such reports.
“Outstanding obligations to pay US dollars in FX swaps/forwards and currency swaps totalled $55 trillion a decade ago, so less than a 50% increase over 10 years,” he says. “If this is a threat now, it seems like it has been a threat for a long time.”
Asensio accepts that on a number of occasions demand for USD funding has caused material spikes to funding costs, which would be considered destabilizing by some market participants.
“However, I am not sure this is because of ‘hidden’ debt,” he says. “Market dynamics have changed. Banks and other financial institutions have been hoarding USD since the global financial crisis, and bank balance sheets are more capital constrained, which dampens liquidity. Also, volatility of fixed income assets has risen following inflation-fighting monetary policy activity.
“All these factors will contribute to potential funding squeezes.”
Others take a different view, with Dave Sissens, chief executive at RTGS.global noting that if there were a tightening of liquidity across the board, prices would come down and the margin on dollar trades would go up, creating instability and fluctuation far and beyond what can be considered standard.
In terms of the ability of FX markets to continue functioning – in other words, having the capacity to buy and sell currencies through central banks and beyond – the outstanding obligations do not in their own right cause any concern because the Fed has the ability to effectively print more money for support and to stave off any risks that it sees as systemic.
But these obligations have the potential to cause colossal price swings, suggests Michael Quinn, group trading manager at Monex Europe.
“The financial crisis in 2008 featured an 11th hour agreement between the Fed and European Central Bank to stave off a USD funding squeeze,” he says. “When demand significantly exceeds supply, or vice versa, there is always the potential for sharp moves in the underlying market.”
Currency buffers
The FX market is better prepared for a rise in the dollar and interest rates coupled with global recession than it was in the mid 1980s and late 1990s, with central banks – particularly in developing countries – creating a currency buffer in good times to use in bad times.
India used this tool to put the brakes on the rupee’s fall earlier this year, Turkey has used capital controls to curb the fall of the lira, and central banks in Japan and Switzerland have repeatedly stopped their currencies from weakening through interventions so as not to worsen domestic inflation.
Without a turnaround in the global economy to growth before the second half of 2023, we could face volatility on a scale our generation has not seen before
Alexander Kuptsikevich, FxPro
However, Alexander Kuptsikevich, senior market analyst at FXPro, cautions that global economic forecasts are continuously being revised down.
“The large buffers of central banks are buying time but are hardly a panacea – it all depends on the longevity of the problems,” he says. “Without a turnaround in the global economy to growth before the second half of 2023, we could face volatility on a scale our generation has not seen before.”
