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The foreign exchange swap market generates nearly $4 trillion in recent contracts day by day. To put this into perspective, imagine if global stocks had a every day trading volume of 12 billion.
Such an enormous market must be each transparent and well regulated. But the rapidly growing FX swap market is neither. Instead, it is incredibly opaque and plenty of essential statistics are difficult or unattainable to search out.
Global foreign exchange market turnover: instruments
Source: “Triennial Central Bank Survey on Foreign Exchange and Over-the-Counter (OTC) Derivatives Markets in 2022” Bank for International Settlements (BIS)
How do FX swaps work?
FX swaps are derivatives through which counterparties exchange two currencies. One party borrows one currency and lends one other currency at the identical time. The amount that a celebration must subsequently repay is set at the start of the contract and the counterparty’s repayment obligation serves as security for the transaction. FX swaps are subsequently a straightforward way for a celebration to quickly obtain dollar or FX funds.
FX Swaps: How They Work
On balance, the currency gap is totally hedged by the off-balance currency swap. A counterparty receives more loans in a foreign currency without increasing its balance sheet.
Although a foreign exchange swap theoretically signifies that the counterparties transact between one another, in point of fact banks are the important intermediaries.
When banks receive a request from a customer to hedge an exposure, they raise the funds through matched book or reserve draining intermediaries. In the previous case, banks finance the expansion of foreign exchange lending by increasing their repo loans and other liabilities. The important drawback of such an approach is that it increases the bank’s balance sheet, which affects its leverage ratio or liquidity coverage ratio. Since the worldwide financial crisis (GFC), these Basel III metrics have develop into mandatory and dear.
By brokering reserves, banks can finance dollar lending, thereby reducing their excess reserves on the Federal Reserve. In this manner, the scale of the balance sheet stays the identical and the bank avoids possible regulatory implications of Basel III.
But there may be more to the foreign exchange swap market: banks also engage in foreign exchange arbitrage and market making, so the actual foreign exchange swap market resembles the next graphic. Banks view the three different positions – hedging, arbitrage and market making – as fungible and easily manage the general currency risk for all their activities.
FX Swaps: How They Work with Arbitrage and Market Making
A growing market
Why is the FX swap market growing so quickly? Profitability is a key factor. Banks lend dollars through foreign exchange derivatives, which pay a dollar-based premium. This is what banks earn along with the income they’d earn from lending on the cash market alone. The dollar base premium was very lucrative, especially for banks with ample dollar funding. At the identical time, by utilizing foreign exchange swaps, these banks meet their customers’ hedging requirements without affecting their Basel III metrics.
Technology is one other often ignored consider the growing market. FX swaps are short-term instruments, greater than 90% of which have a maturity of lower than three months. Postponing spot positions to the closest date may involve an administrative burden. Technology can automate lots of these tasks and add additional features, comparable to automatic hedging and collateral management. Innovations are also disrupting the way in which FX swaps are brokered. Telephone usage is declining while electronic mediation is increasing.
Such a big and lucrative market must be highly competitive. Still, US banks dominate, with the highest 25 accounting for over 80% of positions. What explains this preeminence? Up to 90% of FX swaps include the US dollar on one side. For example, a Dutch pension fund conducting a euro-to-yen foreign exchange swap would first exchange euros for dollars after which dollars for yen.
Opaque and fragile
The important risk of the FX swap market is dollar pain. In this scenario, corporations without access to Fed dollars tackle large, short-term payment obligations. If the market is functioning easily, these FX swaps may be rolled over. But with market volatility increasing, dollar funding could dry up, leaving non-U.S. banks and corporations struggling to search out dollars to satisfy their obligations. Ultimately, the Fed addressed dollar pain in the course of the global financial crisis and the COVID-19 pandemic by providing swap lines to other central banks and funneling needed dollars on to them. However, because of the opacity of the market, these lines contained incomplete information.
In fact, the Dodd-Frank laws exempted foreign exchange futures and swaps from mandatory settlement, leaving no central clearinghouse out there. Even with no legal obligation, around half of foreign exchange turnover in 2022 was processed through the biggest global foreign exchange settlement system, CLS. By using CLS, banks reduce their settlement risk. This system has proven itself in times of great financial distress and increasingly more counterparties are selecting to settle with CLS. Nevertheless, the opposite half of the market stays over-the-counter (OTC) and is just not taken into consideration. This begs the query: What happens in the following phase of market turbulence? How many dollars should the Fed provide? To which countries?
The FX swap market also suffers from a scarcity of pricing efficiency. Despite the large trading volumes, there are clear signs of window dressing: at the tip of every month and quarter, intermediation spreads increase. In “Liquidity spillovers in FX spot and swap markets“Ingomar Krohn and Vladyslav Sushko find that not only are prices distorted, but liquidity can also be affected. If global systemically essential banks (G-SIBs) repeatedly withdraw from the swap market to avoid a rise within the so-called complexity component, this results in higher capital requirements.
However, a discount within the regulatory burden doesn’t result in a discount in the danger burden. When banks broker foreign exchange swaps, it affects their intraday liquidity and intrabank loans, ultimately changing the composition of their assets. For this reason, the FX swap market requires each regulatory management and effective risk management.
What’s next?
Technology and increased settlement through CLS may also help make the FX swap market more transparent and price efficient, but they are not any substitute for what is basically needed: more intermediation competition.
To achieve this, reforms are required and one of the best strategy to achieve this is thru decision and foresight. The other option is to attend for pressure on the dollar that central banks cannot alleviate to force reforms available on the market.
Photo credit: ©Getty Images / matejmo
