When central banks around the world initiated unlimited and multiple swap lines at the peak of the financial crisis last year, the mainstream press gave the event little, if any, coverage.
The jargon, of course, may have disguised the real issue to industry outsiders. The fact of the matter was that non-US banks — mainly European — had run out of short-term dollars on account of the huge impairments they had to take on dollar-denominated assets. This was heightened by the hoarding of dollars by US institutions worried about counterparty risk. By the time of Lehman’s bankruptcy, the problem had extended globally.
An FX swap, of course, is a short-term contract in which one party borrows a currency from, and lends another simultaneously to the same party.
A BIS working paper by Naohiko Baba and Frank Packer entitled “From turmoil to crisis: dislocations in the FX swap market before and after the failure of Lehman Brothers” now attempts to explain the level of that crisis. Some interesting findings are noted (our emphasis):
Facing unfavourable demand and supply conditions and the associated impairment of liquidity in interbank markets, many European financial institutions moved to actively convert euros into dollars through FX swaps, creating a one-sided market as US counterparts became more cautious about lending dollars.
As documented in Baba and Packer (2009), FX swap prices began to reflect relative counterparty risks after the onset of financial turmoil, indicating that concern over the counterparty risk for European financial institutions relative to that for US financial institutions was an important factor underlying deviations from short-term CIP. However, the study covers a period that ended prior to the bankruptcy of Lehman Brothers, when the turmoil in many markets became much more pronounced, concerns over the counterparty risk of financial institutions expanded well beyond those headquartered in Europe, and the dollar liquidity problem for European institutions deepened into a phenomenon of global dollar shortage.
The Fed’s extension of its swap lines to unlimited levels post Lehman could therefore be seen as an effective global banking rescue. As Baba and Packer further note:
In the immediate aftermath of the Lehman failure in mid-September, not only was the size of the swap lines to support dollar operations increased by a factor of 3-5 times, but new swap lines with other central banks were introduced, including the Bank of England (BoE) and Bank of Japan (BoJ).
On October 13, the maximum limits on the swap lines for the ECB, SNB, BoE and BoJ were lifted altogether, permitting these central banks and eligible counterparties unlimited access to US dollar funding in response to market conditions.
The paper goes on to note that one of the reasons the problem emerged in the first place was the pace in growth of US dollar assets at European banks in the past decade for which there was no equal retail dollar deposit holdings. Instead, European banks came to rely on the FX swap market to cover any related funding shortages.
This, of course, is hugely comparable to the CEE FX exposure crisis. In fact, if you were to present a layman’s analogy, you could say that — from the perspective of the European banks — it was like buying US property with dollar-denominated debt, but only having euros in your bank account to cover the loan payments with.
When the subprime crisis began to emerge in 2007, European banks went on a massive spree to secure dollar funding to support their troubled US conduits. It was under these circumstances that an increasing number of European institutions moved to convert European currencies into dollars via FX swaps. This, Baba and Packer note, is what resulted in the one-sided order flow, and the severe impairment of liquidity in the FX swap markets, which directly influenced Libor rates. As they note, by Lehman’s bankruptcy the problem had crescendo-ed into turmoil:
Global funding market pressures were evident in the virtual shut-down of the FX swap market. Dealers reported that bid-ask spreads on FX swaps increased to as much as 10 times the levels that had prevailed before August 2007. They also reported a widespread decline in interbank market making and exceptionally limited trading activity in term maturity tenors. The price action was reportedly driven by demand for dollar funding from global financial institutions, particularly European financial institutions. As many of these institutions increasingly struggled to obtain funding in the unsecured cash markets, they turned to the effectively collateralized FX swap market as a primary channel for raising dollar funding. This extreme demand for dollar funding led a sizable shift in FX forward prices, with the implied dollar funding rate observed in FX swaps on many major currencies rising sharply above that suggested by the other relative interest measures such as the dollar OIS (overnight index swap) rate and the dollar Libor. During the quarter, the spread of the three month FX swap-implied dollar rate from euro and sterling—US dollar FX forward points—over the dollar Libor fixing rate widened to around 330 and 260 basis points, respectively, in early October after the Lehman failure (Figure 1).
In fact, dollars were so highly sought after it appears banks were prepared to pay counterparties to take their gold as collateral for dollars. Which sort of explains the dollar “safe haven” rush we saw over the peak of the crisis:
As for why it took until the Lehman crisis to drive the dollar higher, Baba and Packer conclude the unlimited nature of the Fed’s October swap lines may have had a lot to do with it:
While the establishment of dollar swap lines had not had a significant impact on the level of the FX swap deviation before the failure of Lehman Brothers, if anything, indicating that central banks had fallen behind the curve, our empirical evidence suggests that they became effective in diminishing the level of FX swap market deviation in the later period.
The unlimited swap lines are active until at least October.
Related links:
Forex swaps forever! (or at least until October) - FT Alphaville
Stocks, commodities and the dollar: Where to next? – FT Alphaville
From turmoil to crisis: dislocations in the FX swap market before and after the failure of Lehman Brothers - BIS