Central Bank Swap Lines: A Primer
On March 19, as uncertainty continued in some financial markets, the Federal Reserve (Fed) and five other major central banks announced that they would enhance the availability of US dollars via their standing central bank swap lines. At the Yale Program on Financial Stability our mission is to create, disseminate, and preserve knowledge about financial crises. Consistent with the goal of that mission, we offer a brief overview of swap lines and their functions.
What are central bank swap lines?
A central bank swap line is the central banker’s version of a currency swap, which is itself a loan in one currency collateralized by another currency. So, for example, let’s say you have euros but need dollars. I lend you $100 for a month, and you secure that loan with $100 worth of euros as collateral. At the end of the month, you give me my dollars back (plus interest) and I give you your euros back. (For those in the finance field, if this arrangement sounds like a repo, that’s because it is—they are typically structured as repurchase agreements). That’s a currency swap. So, a central bank swap is just that, but between two central banks.
The Fed uses swap lines as a regular policy tool to help maintain the flow of credit to U.S. households and businesses by reducing risks to U.S. financial markets caused by financial stresses abroad. The Fed’s network of standing swap lines with major central banks has been in place since 2013. It permits any of the six central banks to borrow any of the currencies of the other central banks in exchange for its own currency as collateral (dollars/euros/yen/Swiss francs/pounds sterling/Canadian dollars). Typically, the borrowing central bank lends those dollars “downstream” to commercial banks in its country.
Why does the Fed use them?
This question is twofold: (1) why is there demand for such things, and (2) assuming there is demand, why doesn’t the Fed lend directly to whomever needs dollars instead of lending to another central bank?
First, there’s always a baseline level of global demand for dollars (and some other currencies to a lesser degree) because of the dollar-based financial system. In other words, banks abroad need dollars because lots of their activities are dollar-denominated, from settling import-export trades to making bond coupon payments on dollar-denominated corporate debt. Banks around the world are invested in dollar assets such as bonds, Treasuries, mortgage-backed securities, and equities. In times of heightened market stress, dollar funding markets in the US can seize up, raising the costs of funding abroad. Providing dollars can help ease those costs.
But there is also some self-interest for the Fed to provide dollars abroad. Let’s say there were British banks that really needed dollar liquidity, and the Fed did not provide dollar swap lines. Those banks would turn to the Bank of England. But the Bank of England also can’t get dollars on the market cheaply, so it quickly begins to sell its Treasuries holdings. That could push down Treasury prices and raise their yields—in other words, the resulting fire sale of US government debt could raise the borrowing costs of the US government.
Second, why does the Fed provide dollars through central banks, rather than directly to overseas banks? If, for example, a bank in Japan is particularly in need of dollars, why wouldn’t the Fed initiate a currency swap with that bank instead of arranging a central bank swap line with the Bank of Japan? There are two main reasons: the logistical hassle and risk management. Start with logistics―if the Fed lent to every bank that really needed dollars during times of market stress, it would be lending to thousands of banks around the world. That’s a huge pain. Lending through a central bank dramatically consolidates things.
Most importantly, there are risk management concerns. The Fed would have to do its market research and know the counterparty credit risk of each bank it lends to (even in the US, the Fed only lends through its Discount Window to banks it knows well). If its counterparty fails to pay back the loan, the Fed loses money. But the BoJ probably knows the Japanese banking sector better than the Fed does because it supervises and regulates those institutions. By lending to the Bank of Japan, the Fed’s counterparty credit risk is limited to the risk that the Bank of Japan defaults—a very low risk—instead of the credit risk it would face lending to individual banks. In other words, the Fed has shifted the credit risk to the overseas central bank. This allows the Fed to provide dollars quickly and at low cost.
Has the Fed done this before?
Yes, many times. Swap lines are not new. The Fed initially used swaps to a great extent during the Bretton Woods era in the 1960s and ’70s to defend the official gold peg. They deployed swaps to Mexico in the ’80s and ’90s to help it address its crises. More recently, the Fed deployed swaps after the September 11 attacks and extensively during the Global Financial Crisis and the Eurozone Sovereign Debt Crisis. At the outset of the COVID-19 pandemic, the Fed and the other central banks quickly reactivated the standing swap network and enhanced its terms.
To whom is the Fed lending?
Currently, the activation of swap lines is limited to the standing network of swaps among the Fed and five other major central banks. Those central banks are the Bank of Canada, the Bank of England, the Bank of Japan, the European Central Bank, and the Swiss National Bank. During the COVID-19 pandemic, the Fed entered into swaps with nine additional countries; those swap lines ended in December 2021.
What does this mean?
For now, it just means that global central banks are concerned about the potential for dollar funding stresses. It does not necessarily mean that there are severe stresses already. Central banks often activate swaps on a precautionary basis to calm markets. Activation doesn’t imply that a central bank is already borrowing under the swap line. Often, a foreign central bank will auction dollar funding to banks in its jurisdiction and will only draw on its swap line with the Fed if it receives bids. On March 20, Bloomberg reported that only two members of the network (the Swiss National Bank and the European Central Bank) held successful auctions, while two others (the Bank of England and the Bank of Japan) held auctions but received no bids.
Do other countries do this?
Yes. As evidenced by the standing swap network, many central banks have swap lines. Although the dollar is the world’s primary reserve currency, there is global demand for other currencies. Some currencies are used widely as reserve currencies within specific regions. For example, European countries that are not in the Eurozone (for example, Poland) may have relatively high demand for euros as a result of their financial and trade relationships. Japan has swaps with countries throughout Southeast Asia; India has swaps with some of its regional neighbors, like the Maldives. In response to the COVID-19 pandemic, many countries implemented swaps as temporary liquidity backstop measures.