Swap Lines Underscore the Dollar's Global Role: When Global Financial Markets Become Stressed, Central Banks Coordinate Currency Swaps to Ease the Strain. Given the Central Role the U.S. Dollar Plays in International Commerce, These Swaps Have Played an Important Role in Fostering the Functioning of Financial Markets

Article excerpt

Economic recovery for the U.S. economy is not without potential potholes. One of the biggest risks to continued expansion is the ongoing sovereign debt crisis in Europe, which has been roiling global financial markets for two years and has already slowed global economic growth and impeded parts of the U.S. economy, such as the export sector.

In reality, two related issues are at work in Europe: a sovereign debt crisis caused by high government debt burdens and pressure on European financial institutions related to large holdings of that debt by financial institutions there.

Regarding the latter, banks in Europe, like their counterparts elsewhere, often borrow to fund their activities. But when the health of European banks deteriorated because of their exposure to the fiscally weak countries in the euro area, borrowing money, including U.S. dollars, became increasingly difficult. Europe's troubled banks faced a dollar shortage as other financial institutions, such as U.S. money market funds, became reluctant to lend them greenbacks.

This situation is significant because one of the major business lines of European banks is providing financing in dollars on a global scale--for trade, purchasing dollar-denominated assets, or syndicating loans to corporations. Banks the world over, in fact, have a great need for dollars because much of the world's trade, investment, and lending is conducted in U.S. currency.

Swaps ease the strain

Given the dollar's importance throughout the world, it is vital to ensure that its global use as a medium of exchange is unimpeded. To prevent Europe's dollar funding troubles from spreading to other parts of the world and harming the U.S. financial system, in May 2010 the Federal Reserve opened temporary central bank liquidity swap lines (also referred to as reciprocal currency arrangements) with a number of foreign central banks. The swap lines were used extensively during the last financial crisis a few years earlier. The swap lines are consistent with the Federal Reserve's mandated responsibility to provide liquidity to the financial system in times of stress in order to shield the U.S. economy from the effects of financial instability, regardless of its source

The swaps involve two steps. The first is literally a swap--U.S. dollars for foreign currency--between the Federal Reserve and a foreign central bank. The exchange is based on the market exchange rate at the time of the transaction. The Fed holds the foreign currency in an account at the foreign central bank, while the other central bank deposits the dollars the Fed provides in an account at the Federal Reserve Bank of New York. The two central banks agree to swap back the money at the same exchange rate, thus creating no exchange rate risk for the Federal Reserve. The currencies can be swapped back as early as the next day or as far ahead as three months.

The second step involves the foreign central bank lending dollars to commercial banks in its jurisdiction. The foreign central bank determines which institutions can borrow dollars and whether to accept their collateral. The foreign central bank assumes the credit risk of lending to the commercial banks, and the foreign central bank remains obligated to return the dollars to the Fed. At the conclusion of the swap, the foreign central bank pays the Fed an amount of interest on the dollars borrowed that is equal to the amount the central bank earned on its dollar loans to the commercial banks. The interest rate on the swap lines is determined by the agreement between the Fed and foreign central banks.

Paula Tkac, a vice president and senior economist in the Atlanta Fed's research department, described swap lines in terms of access. "Think of currencies as differently colored--tickets you wouldn't want a crisis to occur because some institutions need green tickets, represented by dollars, but they only have access to blue tickets, represented by euros," she said. …