A New Financial Threat Emerges in Foreign-Exchange Swaps

The global financial system is bloated with some $65 trillion in hidden dollar debts, a recent report from the Bank for International Settlements warns. This takes the form of foreign-exchange swaps that entail a currency trade made today with a commitment to reverse it in the future. Those future commitments constitute a form of debt, but they often aren’t recognized as such by accounting rules for banks or other companies. This level of off-balance-sheet forex-swap debt dwarfs the $28 trillion in on-balance-sheet swap liabilities that BIS tabulates.

The BIS notes that this form of credit has exploded in recent years, rising from $37 trillion in off-balance-sheet obligations on the eve of the 2008 panic. A variety of factors explain the increase, most tracing to the consequences of 15 years of unnaturally low interest rates around the world.

Asset managers such as pension funds and insurers in developing economies have expanded investments in dollar-denominated assets as part of a search for yield amid lower interest rates globally. The fund managers then must enter into foreign-exchange swaps to hedge currency mismatches between their assets and liabilities. These swaps are a form of liability that entail liquidity and counterparty risks but aren’t recorded as credit or debt on the balance sheet.

Abracadabra, a new financial risk is born. This off-balance-sheet debt poses several threats to financial stability. No one knows for sure where all of this debt is lurking. And many events could trigger a cascading crisis.

One vulnerability is exchange-rate volatility. Sudden swings up or down in the value of the dollar relative to other currencies can trigger short-term collateral calls and liquidity crunches. This appears to have been part of the panic that struck British pension funds in September, as a sharp decline in the pound led to margin calls on forex hedges on top of the collateral calls pension managers faced related to their interest-rate derivatives.

Interest-rate risk is another danger. One reason the forex-swap market grew so fast in recent years is that a steeper U.S. yield curve compared to other major economies—relatively lower short-term interest rates and relatively higher long-term rates—essentially allowed banks and other firms to borrow short and lend long in dollars. As the U.S. yield curve has inverted, investors must roll over their short-term swap arrangements at much higher rates.

Meanwhile, dollar-denominated foreign-exchange-swap debts are overwhelmingly held outside the U.S.—American banks and companies tend to be creditors in these arrangements—and this exacerbates the liquidity risk. The Federal Reserve isn’t able to act as a lender of last resort to foreign banks or other institutions that face dollar liquidity squeezes arising from their swap positions. This leaves foreigners dependent on their local central banks’ currency swap arrangements with the Fed to provide dollar liquidity.

Because the Fed can’t and shouldn’t put itself and American taxpayers on the hook to bail out a market of this size, the world can only hope that these swap positions unwind smoothly as central banks return to less abnormal monetary policy. But the BIS report on these hidden debts serves as a warning for the future.

The Fed has become so focused on managing inflation (which it does badly) and domestic employment (which it may not be able to do at all) that officials tend to ignore asset prices and other evidence of financial risks—which they wouldn’t even be able to measure in this case were it not for the BIS. Perhaps we’ll all get lucky and this forex-swap bomb won’t detonate. But it’s dangerous for the Fed to keep counting on luck when its easy money policies create new financial risks.