Different Types of Swaps

When hedging bond issues in foreign currency, firms and governments typically match the bond maturity and that of the currency swap (McBrady et al (2010), Munro and Wooldridge (2010)). The first source is the BIS derivatives statistics, which draw on reports activ trades forex from 73 global dealer banks. FX swaps and forwards are treated together since, as noted above, after the spot exchange only the forward position survives. That said, BIS statistics on FX turnover show that FX swaps are the modal instrument (see below).

The forward rate is the exchange rate on a future transaction, determined between the parties, and is usually based on the expectations of the relative appreciation/depreciation of the currencies. Expectations stem from the interest rates offered by the currencies, as demonstrated in the interest rate parity. If currency A offers a higher interest rate, it is to compensate for expected depreciation against currency B and vice versa. The off-balance sheet US dollar debt of non-banks outside the United States substantially exceeds their on-balance sheet debt and has been growing faster. At end-June 2022, the missing debt amounted to as much as double the on-balance sheet component (Graph 2.B), which was estimated at “only” $13 trillion (Graph 2.A). 2 The estimate of outstanding FX swaps (separate from outright forwards) is derived from the Triennial survey, where turnover figures for these instruments are reported separately.

Why use currency swaps?

Excessive leverage and poor risk management in the CDS market were contributing causes of the 2008 financial crisis. This means that there is a risk that one of the parties may default on their obligations. Both parties can pay a fixed or floating rate, or one party may pay a floating rate while the other pays a fixed rate. 18 In the BIS locational banking bitbuy review statistics, the United States does not report resident banks’ local positions, which prevents measuring US banks’ global dollar asset and liability positions. The estimate in the right-hand panel of Graph 7 for “Offices inside the US” is inferred from these banks’ net non-dollar positions, and assumes that non-dollar local positions are small.

Today, many swaps in the U.S. are regulated by the Commodities Futures Trading Commission (CFTC) and sometimes the SEC, even though they usually trade over-the-counter (OTC). Due to the Wall Street reforms in the 2010 Dodd-Frank Act, swaps in the U.S. must use a Swap Execution Facility (SEF), which is an electronic platform that allows participants to buy and sell swaps pursuant to regulation. The specific regulations that apply to swaps internationally vary by jurisdiction.

The market turmoil during the GFC and in March 2020 highlighted the central role of the US dollar in the financial system. In each episode, disruptions in dollar funding markets led to an extraordinary policy response in the form of central bank swap lines, whereby the Federal Reserve channelled US dollars to key central banks. Foreign currency swaps are a way of getting capital where it needs to go so that economic activity can thrive. Theses swaps provide governments and businesses access to potentially lower cost borrowing. They also can help them protect their investments from the effects of exchange rate risk. The fixed-for-fixed rate currency swap involves exchanging fixed interest payments in one currency for fixed interest payments in another.

In this case, both the U.S. company (Party A) and the German firm (Party B) make floating rate payments based on a benchmark rate. Commodity swaps are common among individuals or companies that use raw materials to produce goods or finished products. Profit from a finished product may suffer if commodity prices vary, as output prices may not change in sync with commodity prices. A commodity swap allows receipt of payment linked to the commodity price against a fixed rate.

For example, imagine ABC Co. has just issued $1 million in five-year bonds with a variable annual interest rate defined as the London Interbank Offered Rate (LIBOR) plus 1.3% (or 130 basis points). Also, assume that LIBOR is at 2.5% and ABC management is anxious about an interest rate rise. Just as for the case of the $10.7 trillion worth of on-balance sheet debt, this additional dollar debt contracted through FX derivatives is to some extent supported by dollar revenues and/or assets, ie currency-matched. The previous analysis suggests that the whole amount of that debt could be rationalised by hedging activity, be it trade or asset holdings. Such hedging can support financial stability, especially if maturities are matched.

13 Graphs 5 and 6 plot two estimates for net interbank borrowing (solid and dashed blue lines) and net FX swaps (shaded area and dashed black line). In the locational banking statistics, banks report cross-border inter-office positions. These positions should sum to zero for each banking system but often do not. The maturity of the instruments is largely short-term (Graph 1, centre and right-hand panel).

Foreign Exchange Swap vs. Cross Currency Swap

If they suffered a loss due to fluctuating exchange rates affecting their business activity, the profit on the swap can offset that. During the financial crisis in 2008, the Federal Reserve allowed several developing countries that faced liquidity problems the option of a currency swap for borrowing purposes. A debt-equity swap involves the exchange of debt for equity—in the case of a publicly-traded company, this would mean bonds for stocks.

1. Despite their role, the geography of their utilisation remains opaque.
2. This matched global GDP in 2021 ($96 trillion) and was three times global trade ($29 trillion).
3. The amount of the security itself is not actually exchanged, only the interest rates.
4. Assume that an agent wishes to purchase a foreign currency asset, A, and hedge the corresponding FX risk.
5. Counterparty risk, market risk, liquidity risk, operational risk, regulatory and legal risks, limited availability, complexity, and potential costs are important considerations when using swaps.
6. Interest rate payments are usually calculated quarterly and exchanged semi-annually, although swaps can be structured as needed.

There’s a potential $80 trillion of capital that’s being held in shadow banks and non-US banks, essentially hidden from the ledgers of the BIS. This is a staggering amount of money, with some estimates putting the amount at roughly 14% of all financial assets globally. For example, say that European Company A borrows $120 million from U.S.

Size of market

At issue is the definition of derivatives and control, which gives rise to the asymmetric treatment of cash and other claims in repo-like transactions. These questions, together with their regulatory implications, would merit further consideration. Regardless of whether the off-balance ifc markets review sheet debt is currency-matched or not, it has to be repaid when due and this can raise risk. To be sure, such risk is mitigated by the other currency received at maturity. Most maturing dollar forwards are probably repaid by a new swap of the currency received for the needed dollars.

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(Here we abstract from the haircut so that the security is altogether self-financing.) Current accounting principles require that this be reported on a gross basis, so that the balance sheet doubles in size. Yet the position is functionally equivalent to that of an FX swap or forward. The only difference is that in case 3 the agent has the freedom to use the domestic currency cash to buy another domestic currency asset rather than having it tied up in a forward claim. This box explains how the accounting treatment of borrowing and lending through the FX swap and related forward market gives rise to missing debt.

The second takes a bird’s eye view of the aggregate market, including its instruments, currencies and counterparties. The third relates aggregate market data to the hedging of trade and the asset-liability management of non-banks. The fourth delves into banks’ role, tracing banking systems’ post-GFC reliance on the market for funding.