Global financial system made vulnerable by the absence of a true lender of last resort
Hung Tran
A currency exchange office in Cairo. EM banks are increasingly reliant on volatile FX swaps markets for short-term dollar funding © EPA
Much attention has been focused on potential stresses in the US repo market. More attention should be paid to the FX swap market, which non-US banks and other entities have relied on for short-term US dollar funding.
Recent changes in supply/demand conditions for US dollar funds in that market could make it more susceptible to stresses. In particular, emerging market banks have become more exposed to risk.
Despite fears of another spike, US repo rates traded normally over the year end — in fact much more so than at year end 2018. The benign outcome owed much to the US Federal Reserve conducting repo operations and T-bill purchases to add about $400bn of reserves since September 17, increasing its balance sheet to $4.16tn.
Also helpful were reported changes in repo market strategy by at least two major US banks.
These changes include using total return swaps to mimic repo trading and asking clients to use “sponsored repo” deals through the Fixed Income Clearing Corporation (FICC) — both of which attract lower bank capital charges than regular repo trading. This allows those banks to participate in the repo market in a capital efficient way.
Also reflecting efforts to avoid higher capital charges, many US banks have tried to reduce trading with non-US clients. This, coupled with the use by foreign central banks of the Fed’s foreign reserve repo pool (to the tune of $250bn, down from a high of $306bn in September) has the potential to reduce the supply of US dollars to the FX swap market.
Meanwhile, non-US banks have relied ever more on the $3.2tn-a-day FX swap market.
According to the Bank for International Settlements (BIS), non-US banks have about $14tn of US dollar assets, not all of which are funded with liabilities such as deposits, loans and bond issuance. The FX funding gap — estimated by the IMF to be about $1.5tn — needs to be covered by borrowing in domestic currencies, swapped into US dollars.
The heavy reliance of non-US banks on the short-term FX swap market has kept cross currency swap rates persistently deviating from covered interest rate parities since the 2008 financial crisis.
Basis spreads are currently fluctuating between minus 20 and minus 40 basis points for major currency pairs.
The FX swap market has been tightly linked to the US repo market, whose turmoil in September was quickly transmitted to the FX swap market, pushing the three-month euro-dollar swap basis from minus 22 basis points to minus 42 basis points. Non-US banks needing US dollar funding are thus at the mercy of developments in the US repo market, and of potential declines in the supply of US dollar funds.
Particularly vulnerable are non-US banks headquartered in emerging market and developing economies (EMDEs). According to the recent World Bank report “Global Waves of Debt”, EMDE banks have increasingly replaced global banks headquartered in Europe, the US and other advanced economies in supplying FX loans to EMDE borrowers — which have increased their FX debt to about $4.6tn, 80 per cent of which is in US dollars and, increasingly, in bond issuance (see the IIF's Global Debt Monitor, November 2019).
The BIS found that in mid-2018, EMDE banks posted an outstanding amount of $1.4tn of cross-border loans to EMDE borrowers, out of their total cross-border loans of $3.7tn — compared with $2.2tn out of $29tn, respectively, for banks in advanced economies.
Consequently, EMDE banks have become as reliant on the FX swap market as non-US banks in general to cover their FX funding gap. Moreover, using exotic currency pairs, EMDE banks have to deal with illiquid segments of the FX swap market, involving much larger basis spreads — fluctuating between minus 200 and minus 400 basis points for Taiwan dollar-US dollar swap rates, for example — as well as wider bid-ask spreads and much greater volatility.
As such, EMDE banks are highly vulnerable to stresses in the FX swap market, transmitted from the US repo market, that threaten to shut them off from a vital but fragile short-term FX funding source.
The policy response appears obvious if not sustainable. Central banks in EMDEs where residents have incurred much FX debt need to be ready to intervene in the FX swap market, playing the role of “swapper of last resort” to moderate spillover effects from US repo market turmoil.
In fact, as reported by the BIS studying the case of Brazil, central banks supplying FX derivatives against FX risks of local borrowers could reduce by half the negative effects. Of course, those central banks can only be “swapper of last resort” for as long as their finite FX reserves last.
The fundamental vulnerability of the current financial system remains the absence of a true lender of last resort for non-US banks carrying huge US dollar liabilities.
Hung Tran is a non-resident senior fellow at the Atlantic Council and former executive managing director at the Institute of International Finance.
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