Why FX swap lines are the most important Fed action thus far

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Few things are as likely to imbue us with that sense of global financial crisis déjà-vu than a dollar swap line.

Last night the Federal Reserve announced it was easing the terms on which it provides foreign banks access to greenbacks.

The swap lines in four of the five locations listed in last night’s statement – the UK, the eurozone, Japan and Switzerland – never actually went away. What’s changed is that the terms are now better in two ways. They are cheaper in that they are just 25 basis points above the risk-free overnight rate, or OIS rate. (For reference, last week’s ECB dollar auction charged a fixed rate of 1.24 per cent.) The funding also lasts for three-months (or 84 days, to be precise). So, they stand a good chance of actually being used by banks. 

Why has the Fed done this? For the same reason as it has announced a whopping $700bn-worth of bond purchases at an emergency Sunday night meeting. It is spooked by the flight to that most liquid of assets.

Last week we saw something that you expect in times of panic: people ditching equities. Along with something you wouldn’t expect: a fall in the value of Treasuries, usually the financial world’s safe haven of choice. What does this correlation tell us? That there’s a global cash crunch.

A crunch happens when people liquidate assets sharply and unexpectedly draw upon the system’s available cash. Even though most of that cash heads straight back to the banks, there is often a price mismatch, as well as a switch in the institutions involved – some of whom may be more liquid in dollar funds than others.

If the assets are held abroad the pressure is further heightened because foreign banks simply don’t have the same volume of spare dollar liquidity to hand that US banks have. Their own central banks, meanwhile, are not equipped to flood them with cheap foreign-denominated liquidity. Hence swap lines.

Why is dollar funding so exposed in the case of a global pandemic? Well, we know from the great financial crisis, that it’s the only true global reserve currency. It’s still the means of exchange for about half of foreign trade. So what happens when, as we have begun to see – and are likely to continue seeing in the months ahead — businesses all over the world experience cash flow difficulties and stop paying their suppliers? Companies’ stocks of dollars will drop, at which point they will begin drawing on any financing they have. Which in turn will heighten funding shortages.

This, via Gillian Tett, is a tidy summary of Bank for International Settlements research (from 2014!) on just how big a problem this is: (our emphasis)

First, the bank-intermediated trade finance sector is large, between $6.5tn and $8tn. Second, more than a third of it, around $2.8tn, occurs via letters of credit from banks. These borrowing lines are typically not recorded on the banks’ books unless or until the client activates them. That, unnervingly, means “for the most part, L/Cs represent off-balance sheet commitments”, the BIS wrote. Third, since most global trade is invoiced in dollars, more than 80 per cent of L/Cs are settled in them as well. The BIS says, “a key condition for the ability of many banks to provide trade finance is their access to US dollar funding”. Fourth, dollar access is uneven. US banks can tap the Fed’s financing tools and big players can cut deals in the repo markets. But only a quarter of trade finance comes from major international banks, so much of the funding goes through intermediaries.

It’s a great big black hole then. A bit like all those CDOs, squared and cubed, that caused so much consternation just over a decade ago.

We think the Fed deserves praise for rolling out these new auctions so quickly. It has been cunning politically in linking a policy that Congress has in the past occasionally (and wrongly) interpreted as a bailout of the world at the expense of the US to the sort of massive rate cut that Donald Trump has long called for.

Still we’d argue that they’re only a partial solution.

If you’re sitting in Frankfurt, on the face of it this ought to ease fears that major European banks are about to see an unsustainable spike in their dollar funding costs. Nonetheless, during the global financial crisis – as it became increasingly obvious that use of these facilities was a major banking stress indicator – a great deal of stigma became attached to borrowing from the swap lines. The pricing and duration of the loans might help here, but for now we’re going to reserve our judgement as to whether that’ll be enough to coax banks into using them. 

A second shortcoming is that the major international banks are, according to the BIS, only providing a quarter of total trade finance. One doesn’t have to do much unravelling of the hideously complex web of dollar-denominated trade to see that a significant chunk of the responsibility lies with non-banks. None of which can access central bank funding. A dollar funding crunch remains a very live threat for them, then.

Last but not least, the Fed also ignores the most important country on the planet when it comes to trade: China. Notably, there is no dollar swap line set up with the PBoC. And we doubt that, in an era characterised by US isolationist policies, we are likely to see one soon. Especially as the Fed, having seemingly ruled out negative rates, now has little left to deploy to get the President off its back.

What’s the consequence of this? We’d refer you to a remarkably prescient note by Credit Suisse’s Zoltan Pozsar from March 3:

Once the PBoC exhausts its dollar liquidity in cash markets like the FX swap market, it will next tap its Treasury portfolio and will either repo or sell those Treasuries through dealers in New York to raise more dollars to lend to local banks.

Somewhat mitigating the impact of all that new QE. All very 2008 on repeat.

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