Central Bank Currency Swap Mechanism: A Lifeline in Times of Crisis

Central Bank Swap Lines (CBSL) or Central Bank Liquidity Lines (Central Bank Currency Swap Mechanism) is a tool proposed and established by the US Federal Reserve (Fed) together with other Central Banks, to prevent the risk of contagion of liquidity crises from a major economy spreading to the US or globally.

CBSL is not a new tool. Fed has used this tool (or similar) many times in financial crises impacting globally. For example, before the Bretton Woods system collapsed, the crisis after the 09/11 bombing, the 2008 Financial Crisis, and the sovereign debt crises in Latin America or Europe...

And recently, last year, CBSL was again used by Fed with 5 major Central Banks, during the crisis following the collapse of SVB.

In the current time when major banks face Crisis from commercial real estate debt, it is likely that Fed and major Central Banks will need to use this tool again (if necessary).

• FYI: just 3 days ago, Fed also just executed Liquidity Swap with ECB, (possibly due to escalating tensions in German banks from investment risks in US commercial real estate).

Therefore, Viet Hustler will provide readers with basic insights into the Central Bank Currency Swap mechanism through this week's Market Knowledge column.

What are Currency Swaps and the Central Bank Currency Swap Mechanism?

What is a Currency Swap?

Currency Swap is a transaction where the borrower can borrow in one currency, with collateral being another currency.

For the simple example below:

• Company A (in Australia) can only issue bond debt in USD, but this company needs AUD (Australian Dollar) to operate in Australia.

  

• A does not want to exchange USD for AUD directly: possibly because the current exchange rate is not favorable or fearing that the exchange rate will change unexpectedly later when exchanging back USD to repay bond debt at maturity.

• A will borrow from B (usually a bank - Banks) in AUD and give B a corresponding USD collateral amount (possibly using the current exchange rate).

• After an agreed period of time, A will return to repay B both principal + a swap fee in AUD to get back the collateralized USD amount.

• Thus, the bank B will face no exchange rate risk whatsoever.

• Meanwhile, A also avoids most exchange rate risk when using the very USD received back from B to repay the bond debt (of course they still need to exchange a bit of USD to pay the bond interest).

FYI: Furthermore, this mechanism can be implemented between multiple parties and currencies; and can include complex interest rate and currency swaps (cross-currency interest rate swap - figure below).

Therefore, at the individual or business level, currency swap is only used when exchange rate volatility is extremely high (different from the Central Bank perspective as analyzed below).

In addition, currency swaps are quite similar to a repos contract (repurchasing contract) with currency as the commodity.

• For example: a temporary contract to sell EUR for USD and promise to buy back EUR with USD (at an agreed price).

Currency Swap Mechanism between Central Banks

Currency swap lines between Central Banks (Central Bank Swap Lines or Central bank liquidity lines) are currency swap transactions (as per the principle above) between 2 Central Banks (CBs).

This is particularly important for Central Banks during crisis periods because:

• Because if they directly buy large amounts of foreign currency with their domestic currency, their currency will immediately depreciate!

Some other information:

• The largest current Central Bank Liquidity Lines system (Swap Line Network) is being implemented between 6 major Central Banks: Federal Reserve (US), ECB (Eurozone), Bank of England (UK), Bank of Canada, Bank of Japan and Swiss National Bank.

• However, during the COVID-19 pandemic, the Fed also conducted currency swap transactions with 9 other countries; those swap lines ended in December 2021.

  

• The majority of the loaned currency is USD. The reason is the paramount role of USD in trade payments, reserves, and global capital markets — to be analyzed below.

  • Therefore, the Fed is often the creditor lending USD - especially during global liquidity crises.

    

• However, there are other cases, such as ECB also lending EUR and USD to BOE last year, or lending EUR or Swiss Francs to Central Banks in Europe.

  

The important role of the currency/liquidity swap mechanism between Central Banks

Demand for currency swaps under normal conditions

The demand for foreign currency for the 5 major currencies mentioned above is very high. Because not every country can borrow in its own domestic currency (the issue of Original Sin).

• FYI: As of 2020, the 5 main currencies used for borrowing on the international market are still: USD, EUR, GBP, JPY and CHF (Eren and Malamud, 2022).

  • Up to 97% of debt on the international market is issued in these 5 currencies (Hausmann and Panizza, 2003).

  

Especially for USD, as this currency still plays the dominant role in: foreign exchange reserves, international trade settlement currency and denominated currency for loans / bonds.

• Related articles: "In God We Trust" - faith in the position of the USD

The role of the liquidity swap mechanism between Central Banks during crises

The analyses below will be from the perspective of the US and the Federal Reserve due to the significant position of the USD as analyzed above.

During liquidity crisis periods, the role of the USD, which is already very large, becomes even larger for most other countries:

(FYI: similarly, the role of the EUR in Europe - including outside the Eurozone - is also very large).

Why? Because when a crisis occurs, the first thing businesses do to avoid bankruptcy is to raise capital!

• But businesses can mostly only raise capital through bonds denominated in the major currencies above - especially USD.

For commercial banks:

• When a liquidity crisis occurs, commercial banks also need to repay a series of bonds and loans denominated in USD.

• The commercial banking system also has to carry out a series of investment transactions in stocks / bonds on the international financial market in USD…

• Businesses need to pay for goods in international trade also in USD - and they also have to borrow from commercial banks => demand for USD from commercial banks is even higher.

In this case, the Fed is forced to conduct Liquidity Swaps with Central Banks because:

When USD demand is so high, it will push the USD value too high, leading to a series of major problems:

• For the capital market and businesses: high USD borrowing costs cause businesses/banks to stop borrowing => cannot raise capital => bankruptcy!

• For the US and the USD: the USD-denominated debt market will rise sharply in the short term but could suddenly freeze if businesses stop borrowing USD (due to excessively high exchange rate costs).

  => causing a strong squeeze in the USD value (rising too high then dropping suddenly).

As for the Fed: if it does not implement Liquidity Swap, the problem will not only be the USD exchange rate but also the massive Treasury bond market

• Excessive USD demand will cause local commercial banks to sell US Treasury bonds

  → this massive bond market will have oversupply and lack of demand

  —> Treasury yields (US government borrowing costs) will rise sharply!

Example:

After the collapse of Lehman Brothers in September 2008, the capital market dried up due to extreme risk aversion, so US outbound investment activities (in USD) dropped sharply.

Eurozone banks at that time faced difficulties in raising USD to fund their USD-denominated activities.

To prevent these banks from suddenly selling large amounts of T-bond and causing extreme price volatility, ECB and Fed had to conduct large-scale Liquidity Swap so that ECB/Eurosystem could provide USD to banks in the Eurozone.

So why does the Fed have to swap currencies with foreign central banks instead of directly with foreign commercial banks?

There are 2 main reasons:

• Consolidation advantage

  • During periods of market stress, tens of thousands of banks worldwide will need to borrow USD.

  • The Fed cannot work with all these banks, so they only need to focus on working with central banks.

• Risk concerns:

  • If lending individually, the Fed would have to conduct market research and credit risk assessments for each bank it lends to.

  • FYI: Even in the US, the Fed only lends through the Discount Window to banks it knows well.

  • However, local central banks understand their own banks well because their role is to supervise and regulate their domestic banking systems.

  • The Fed does not need to worry about the credit risk of its counterparties (no counter-party risk).

How have the US dollar swap lines saved the world economy?

Stress in the debt market in March 2020 - when the world was almost fully locked down, if uncontrolled, could have led to a series of bankruptcies and economic chaos.

However, the Fed reactivated the currency swap lines established with other central banks during the 2007-2009 financial crisis.

• BoE swapped unlimited amounts of GBP for USD and EUR, allowing BoE to provide USD as demanded by the banking system

  • UK commercial banks could meet the growing USD demand from corporate clients

    → no defaults on USD payments

    → avoiding mass bankruptcies of creditors throughout the entire supply chain.

• Meanwhile, Turkey's request for a USD swap limit was rejected by the Fed on the grounds that its central bank is not sufficiently independent from the government.

  • As a result, commercial banks in Turkey dumped the Lira en masse to obtain USD… causing the Lira to depreciate uncontrollably to this day.

    

  • The Lira's depreciation made local currency consumption increasingly expensive for people => inflation spiraled out of control to 67% currently.

    

In March 2023, amid the regional banking crisis, the Fed and 5 major central banks worldwide announced a currency swap agreement.

• The unprecedented swift action by SNB to provide USD liquidity to UBS to acquire Credit Suisse was also thanks to this Liquidity Swap system.

  

CONCLUSION

Although only used on special occasions, the currency/liquidity swap mechanism between central banks is an important part of the cross-border monetary policy toolkit for decades. Its role is quite significant in stabilizing exchange rates in general and US Treasury yields in particular during crises.

Because central banks can ensure the supply of necessary foreign currency to their domestic financial systems without needing to:

• directly buy foreign currency or use foreign exchange reserves (avoiding unexpected impacts on exchange rates)

• or sell US Treasury bonds - in case of USD demand (avoiding increasing US government borrowing costs and affecting the world's largest bond market).

This mechanism also ensures that financial institutions worldwide can provide credit to households and businesses when needed - and protects the global economy in general and the US in particular from escalating financial stresses arising from liquidity issues.