The FX Swap Market: Growing in the Shadows

Introduction

The foreign exchange (FX) swap market generates almost $4 trillion in new contracts on any given day. To put that in perspective, imagine global equities had a daily trading volume of 12 billion.

Such an enormous market ought to be both transparent and well regulated. Yet the rapidly expanding FX swap market is neither; it is instead exceedingly opaque with many key statistics hard or impossible to find.

Global Foreign Exchange Market Turnover: Instruments

Source: “Triennial Central Bank Survey of 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 a currency and simultaneously lends another currency. The amount a party must later repay is fixed at the start of the contract, and the counterparty repayment obligation serves as the transaction’s collateral. FX swaps thus are an easy way for a party to quickly obtain dollar or FX funds.

FX Swaps: How They Work

On balance, the currency gap is fully hedged by the off-balance FX swap. One counterparty obtains more lending in a foreign currency without an increase on its balance sheet.

Though an FX swap in theory implies that the counterparties transact with each other, in fact, banks are the main intermediaries.

When they receive a request from a client to hedge an exposure, banks source the funds through matched-book or reserve draining intermediation. In the former, the banks finance expanded FX lending by increasing their repo borrowing and other liabilities. The main drawback of such an approach is that it grows the bank’s balance sheet, which impacts its leverage ratio or liquidity coverage ratio. Since the global financial crisis (GFC), these Basel III ratios are binding and costly.

Through reserve draining intermediation, banks can finance the dollar lending and thus reduce their excess reserve balance with the US Federal Reserve. This way the size of the balance sheet stays the same, and the bank avoids any potential Basel III regulatory implications.

But there is more to the FX swap market: Banks also conduct FX arbitrage and market making, so the real FX swap market resembles the following chart. Banks treat the three different positions — hedging, arbitrage, and market making — as fungible and just manage the overall currency exposure for all their activities.

FX Swaps: How They Work with Arbitrage and Market Making

A Growing Market

Why is the FX swap market expanding at such a rapid clip? Profitability is one key factor. Banks lend dollars through FX derivatives that pay a dollar basis premium. This is what the banks make on top of what they would accrue simply by lending on the money market. The dollar basis premium has been very lucrative, especially for banks with abundant dollar funding. At the same time, by turning to FX swaps, these banks are accommodating their clients’ hedging requirements without affecting their Basel III ratios.

Technology is another often-overlooked contributor to the growing market. FX swaps are short-term instruments, with more than 90% maturing in under three months. Rolling the spot positions to the nearest date can impose an administrative burden. Technology can automate many of these tasks and add other functionalities, such as automatic hedging and collateral management. Innovation is also disrupting how FX swaps are intermediated. Phone usage is declining, while electronic intermediation is expanding.

Such a large and lucrative market ought to be fiercely competitive. Yet US banks dominate, with the top 25 accounting for more than 80% of the positions. What explains this preeminence? Up to 90% of FX swaps involve the US dollar in one leg. For example, a Dutch pension fund conducting a euro-to-yen FX swap would first swap euros into dollars and then dollars into yen.

Opaque and Fragile

The main risk posed by the FX swap market is the dollar squeeze. In this scenario, those entities without access to Fed dollars acquire large, short-term payment obligations. When the market functions smoothly, these FX swaps can be rolled over. But amid increased market volatility, dollar funding may dry up, leaving non-US banks and entities to scramble to find dollars to make good on their commitments. Ultimately, during the GFC and the COVID-19 pandemic, the Fed countered a dollar squeeze by providing swap lines to other central banks, funneling the needed dollars directly to them. However, these lines came with incomplete information given the market’s opacity.

In fact, Dodd-Frank legislation exempted FX forwards and swaps from mandated clearing, so the market has no central clearinghouse. Even without a legal obligation, about half the FX turnover was settled by the largest global FX settlement system, CLS, in 2022. By using CLS, banks mitigate their settlement risk. This system has held up during periods of severe financial distress, and more counterparties are choosing to settle with CLS. Still, the other half of the market remains over the counter (OTC) and unaccounted for. Which begs the question: what happens during the next period of market turmoil? How many dollars should the Fed provide? To which countries?

The FX swap market also suffers from a lack of price efficiency. Despite the enormous volumes traded, there is clear evidence of window dressing: As each month and quarter ends, intermediation spreads spike. In “FX Spot and Swap Market Liquidity Spillovers,” Ingomar Krohn and Vladyslav Sushko find that prices are not only distorted, but liquidity is also impaired. When globally systemically important banks (G-SIBs) periodically pull out of the swap market to avoid increasing the so-called complexity component, it leads to higher capital requirements.

But reducing regulatory exposure does not reduce risk exposure. When banks intermediate in FX swaps, it affects their intraday liquidity and intra-bank credit and ultimately changes their asset composition changes. That’s why the FX swap market needs both regulatory management and effective risk management.

What’s Next?

Technology and increased settlement through CLS may help make the FX swap market more transparent and price efficient, but they are no substitute for what’s really needed: more intermediation competition.

Achieving that will require reform, and that is best accomplished by choice and with foresight. The other option is to wait for a dollar squeeze that the central banks can’t mitigate to force reform upon the market.

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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

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