ft swap lines

Richtmann’s overriding point is that the swap line system was created by bricolage, aka hobbled together in the style of a do-it-yourself handyman, out of necessity rather than considered thought. 

His conclusion from the thesis was this:

... the permanent C6 swap-lines may have rectified the structural shortfall of a missing International Lender of Last Resort for participating jurisdictions. The cooperative arrangement amongst major central banks is a backstop at the very top or core of the hierarchical international monetary system (Mehrling 2013). However, with rising fragility in Emerging Markets (Shin 2013), i.e. the periphery of this system, that specifically relies on the top for stability (McCauley, McGuire, and Sushko 2015) the C6 standing liquidity swap-lines are far from the end of the story of financial stability.

His latest thoughts on the current revitalisation of the facilities, plus some very useful historical context about them, follow below the broken line (with our emphasis). 

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Liquidity swap lines were the major central bank policy novelty of the last financial crisis. They’ve been around ever since. But central banks have just added more fire power. Markets will now test whether cutting the penalty rate on swap-lines addresses stigma concerns significantly. Also, will weekly auctions be enough?

Here is what they are and how it’s happened. 

Central banks generally take care of money markets within their own jurisdictions. They provide liquidity to the banks and financial actors to alleviate funding stress. In a crisis this is called lending of last resort and goes back to financial journalist Walter Bagehot’s rule to “lend freely, at a penalty rate against good collateral”. In the financial crisis of 2007/08 the US Federal Reserve did just that on a massive scale through their discount window facilities.

However, the largest chunk of US dollars trades outsides of the United States. The so-called off-shore dollar market comprises of all financial actors who trade in greenbacks but are not directly linked to the Fed’s balance sheet. The market first arose in London in the 1960s as a way to circumvent US trading regulations and to do petro-financing. 

In 2007/08, this market was at the core of the financial crisis. European banks acted as intermediaries between Chinese and Middle Eastern funding and US borrowing. In the process this system leveraged up and when BNP Paribas closed access to three of their hedge fund in August 2007, funding stress in the off-shore dollar market became apparent.

Not all dollars are equal

Off-shore banks borrow and lend in US dollars and in a perfect world all US dollars are equal. And up until the last financial crisis dollars on-shore and off-shore did trade at par. But as the crisis unfolded, dollar funding off-shore became more expensive than on-shore, as indicated by the Libor-OIS spread where the Overnight Index Spread indicates an implied one week Fed Funds rate.

With hikes in funding costs, banks would generally turn to their respective central bank and acquire liquidity. Just as economist Walter Bagehot told everyone to do. However, the European Central Bank has no dollars to hand out. Yes, there are foreign currency reserves. But they are scattered throughout the National Central Banks and wouldn’t have been enough to stem the crisis.

So, in December 2007 the Fed extended their first liquidity swap lines to the ECB and the Swiss National Bank. The off-shore central banks then handed out the greenbanks in their jurisdictions. While this first line was limited to $20bn and $4bn, respectively, October 2008 brought an entirely new round: To the ECB, SNB, Bank of England and Bank of Japan dollar swap lines were made in unlimited volume and ten other central banks – among them developing economy jurisdictions – received limited amount lines. 

All swap line facilities were discontinued in February 2010. But just two months later, and after a personal plea from then-ECB president Trichet, they were back. And here the cartel of six central banks comprised of Fed, ECB, SNB, BoJ, BoE and Bank of Canada took hold. In 2013, liquidity swap lines were announced to be permanent and reciprocal. Only the ECB and the BoJ have drawn on them after the GFC. European banks have used this facility regularly. Since, they have capped the cross currency basis, i.e. the surcharge on off-shore borrowing. In March 2019 amid Brexit uncertainty, the Bank of England activated its Euro swap-line with the ECB.

Enter the present stage. On Sunday the six central banks renewed the swap line package. Two aspects are new: The penalty rate dropped and funding can be accessed not only for 7 days but also for 84 days.

During the GFC banks borrowed through swap line facilities at a rate of OIS plus 100 basis points. After hefty discussion within the FOMC on stigma concerns, this was dropped to OIS plus 50 bps in November 2011. 

The new facilities will be offered at OIS plus 25 bps. Off-shore banks thus pay the same price for dollar funding as on-shore banks. The duration extension to medium-term funding of 84 days will come in handy in the present crisis and reflects the difference between this crisis and the last: The real-side effects now ripple into the financial system, while the money market dislocations during the GFC rippled into the real economy. 

Returning to Bagehot, with the unlimited volumes of swap lines, central banks are definitely lending freely. However, their high rate went out of the window which means the facility will have the effect of pulling off-shore money markets onto central bank balance sheets. 

The stigma, meanwhile, won’t be too much of a concern to European banks because bids at the ECB will just disappear within the huge pool of eligible banks. The broad brush push by the Fed to use them will have normalised their utilisation.

That said, there is a risk. British banks may remain unwilling to knock on Threadneedle Street’s door because word might get around on who is short of greenbacks.

Functionally, dollar auctions are currently held weekly on Tuesdays with allocations published on Thursdays. That means if and when the Fed decides to increase their frequency to a daily rate, it could be another dollar funding stress indicator.