Meet the Author

Owen F. Humpage |

Senior Economic Advisor

Owen F. Humpage

Owen Humpage is a senior economic advisor specializing in international economics in the Research Department of the Federal Reserve Bank of Cleveland. His current research focuses on the history and effectiveness of U.S. foreign-exchange-market interventions. In addition, he has investigated the Chinese renminbi peg, quantitative easing in Japan, and the sustainability of U.S. current-account deficits.

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Meet the Author

Michael Shenk |

Research Assistant

Michael Shenk

Michael Shenk was formerly a research assistant in the Research Department of the Federal Reserve Bank of Cleveland. His work focused on international topics and housing-market indicators.

10.09.08

Economic Trends

Swap Lines

Owen F. Humpage and Michael Shenk

The current financial crisis is global. Banks in many countries are scrambling for liquidity—not just in their own currencies, but in dollars too. The Federal Reserve has attempted to facilitate this process by setting up swap lines with the world’s key central banks.

The dollar is the world’s leading international currency. Many cross-border transactions—even between individuals who are not residents of the United States—are denominated in U.S. dollars. Commodities, most notably oil, are an excellent example; they typically are priced in U.S. dollars, and payments usually are made in U.S. dollars. Because of the dollar’s international role, large banks around the globe hold significant amounts of dollar-denominated assets and liabilities. Many of these banks have found themselves stuck with dollar-denominated assets that are tied to the U.S. real estate debacle or that are otherwise distressed. These banks, like many U.S. domestic banks, have been scrambling for needed dollar liquidity, but the interbank market has frozen up as banks with funds worry about potential counterparties’ balance sheets.

Indicative of the problem, rates on overnight inter-bank loans have recently shot skyward. Over the past year, spreads between the Libor (the index rate on overnight dollar funds in the London interbank market) and the federal funds rate, which typically are miniscule, became large and very volatile. In September, these rate spreads frequently exceeded a whopping 4 percentage points.

Special Temporary Swap Lines

  Billions of dollars
Bank of Australia Bank of Canada National Bank of Denmark Bank of England European Central Bank Bank of Japan Bank of Norway Bank of Sweden Swiss National Bank Total
12/12/2007 -- -- -- -- 20 -- -- -- 4 24
3/11/2008 -- -- -- -- 30 -- -- -- 6 36
5/2/2008 -- -- -- -- 50 -- -- -- 12 62
9/18/2008 -- 10 -- 40 110 60 -- -- 27 247
9/24/2008 10 10 5 40 110 60 5 10 27 277
9/26/2008 10 10 5 40 120 60 5 10 30 290
9/29/2008 30 30 15 80 240 120 15 30 60 620

Source: The Federal Reserve Board.

The Federal Reserve has been helping to provide dollar liquidity to foreign markets by agreeing to “swap” U.S. dollars temporarily for foreign currency. On September 29, the System offered swaps totaling $620 billion dollars to nine key central banks through April 2009, if necessary. In a swap transaction, the Federal Reserve and a foreign central bank immediately exchange U.S. dollars for the foreign currency at a specific exchange rate—typically the prevailing spot rate—and simultaneously agree to reverse the transaction at a set exchange rate—often the same exchange rates—on a specific date in the future. Conducting the spot and forward legs of this currency swap at set exchange rates protects both the Federal Reserve and its foreign counterpart from losses (or gains) associated with any unanticipated intervening exchange-rate movements. During the term of the swap, the United States holds its foreign exchange in a special account at the foreign central bank, and the participating foreign central bank uses its newly acquired funds to provide emergency dollar liquidity to commercial banks.

Over the past 50 years, the Federal Reserves has often used swaps to finance foreign exchange interventions and to provide temporary funding to foreign countries in times of financial chaos. During the 1960s, for example, the Fed established a serious of reciprocal swap lines with the major developed countries. At the time, the dollar was pegged to gold, and foreign currencies were fixed to the dollar. When foreign countries accumulated unwanted dollars reserves, they could exchange them with the U.S. Treasury for gold. Often, however, the U.S. monetary authorities believed that the foreign inflow of unwanted dollars would soon reverse, so they encouraged foreign central banks not to convert dollars into gold too hastily. A key way of doing so utilized swaps. The Federal Reserve would swap dollars for foreign currency with a central bank that held too many U.S. dollars and then use the newly acquired foreign currency to buy the excess dollars from that same foreign central bank. This sounds odd, because this set of transactions left the foreign central bank holding just as many dollars as initially was the case. It often worked because the central bank now held dollars under a swap with an established, single exchange rate for both the forward and spot legs of the transaction. The deal then protected the foreign central bank for the term of the swap against any dollar depreciation.

After March 1973, when exchange rates began to vary with market pressures, the Fed sometimes intervened to influence them. When the Fed wanted to prop up the dollar by selling foreign exchange, it often facilitated the operation by drawing foreign exchange on its swap lines. Use of the swap lines for foreign exchange intervention waned as the Fed eventually acquired a substantial portfolio of German marks and Japanese yen, which it could use for intervention purposes instead. The Fed also used swap lines to provide dollars temporarily to Mexico during the peso crises of 1982 and 1995. The United States terminated all of its on-going swap lines when Europe inaugurated the euro, except for two lines with our NAFTA partners, Canada and Mexico. Nevertheless, swaps are easy to step up and offer central banks a useful, very flexible mechanism for acquiring foreign currencies.