What’s Fed’s swap line? And how does it affect the balance sheet?

Trading Tips

One of the first symptoms of the Covid-19 turmoil in March was a global dollar shortage, but an aggressive Fed response helped to avert the credit crunch. One of the side effects of this move was rapid expansion of the balance sheet however, the latest data from the Fed indicated that this trend has started to reverse. Various financial media cited lowering demand for the Fed’s swap lines as the major source of decline. In this article, we will try to figure out what was the exact reason why the balance sheet started to deflate last week.

Let’s start from key definitions. What is the Fed’s swap line? It’s an agreement between the Fed and other central bank on a mutual exchange of currencies for some predetermined period of time. A swap contract involves two transactions (“swaps”) – direct and reverse. The direct swap occurs when the Fed lends USD to the foreign central bank taking foreign currency as “collateral”. Conversely, the Fed exchanges foreign currency back for USD. Since the Fed’s counterparty is usually a large foreign central bank and exchange rate for direct and reverse swap is fixed, the Fed bears no credit or currency risk. A swap line is not free though, the Fed charges some interest on it.

The Fed has been providing short-term and medium-term swap lines for 7 and 84 days.

Direct swap leads to an increase in the Fed balance sheet while reverse swap results in a decline. Ignoring interest income, a swap line transaction with the ECB in the amount of 100 USD will be reflected in the balance sheet as follows:

Moments of time t and t + 1 are the dates of the forward and reverse swaps.

“Waning” 100 USD in the Fed’s liabilities in reverse leg of the swap may look odd because it creates impression that the Fed “destroys” USD. But that’s just how it works! Recall that US Dollars is a liability only for the Fed (asset for all others), so basically destroying USD (selling something on the asset side) the Fed basically “redeems” its debt!

In the table above, we can see which swap line transactions inflate and deflate the balance sheet.

Last week, we saw the news that the Fed’s balance sheet declined for the first time in several months thanks to lowering demand from foreign central banks for the Fed’s currency swaps:

However, it was stated slightly incorrectly, as reduction in demand is not the only source of decline. Let’s discuss why.

Based on the data on operations (https://apps.newyorkfed.org/markets/autorates/fxswap – Operation Results), demand for swap lines peaked in early March. The size of the swap agreements was the highest but started to decline later. The “hungriest” was the Bank of Japan, which borrowed a lot of USD through this credit facility for the medium term (84 days).

Maturity dates for those large March USD borrowings (i.e. reverse swaps) fell precisely for the middle of June. As we have already seen from the analysis above, reverse swaps have a deflating effect on the balance sheet. In other words, the Fed’s balance declined not only because foreign Central Banks reduced demand for currency swaps but also because the turn has come for the largest reverse swaps.

Disclaimer: The material provided is for information purposes only and should not be considered as investment advice. The views, information, or opinions expressed in the text belong solely to the author, and not to the author’s employer, organization, committee or other group or individual or company.

High Risk Warning: CFDs are complex instruments and come with a high risk of losing money rapidly due to leverage. 73% and 70% of retail investor accounts lose money when trading CFDs with Tickmill UK Ltd and Tickmill Europe Ltd respectively. You should consider whether you understand how CFDs work and whether you can afford to take the high risk of losing your money.

Share this post:

Let’s block ads! (Why?)


Leave a Reply

Your email address will not be published. Required fields are marked *