ICARUS EXCLUSIVE: COVID-19 & The Feds Additional Central Bank Currency Swaps Agreement

4th July 2020 – Keyser Söze

What Are They

A basic definition is exactly as the name implies. A swap is an agreement between two parties to temporarily exchange a security/asset/instrument for a given period. There are two main types of Fed Swaps. 1) US Dollar Liquidity Lines 2) Foreign Currency Liquidity Lines. As Australians, item 1 is where are focusing as item 2 is for the benefit of US financial institutions in need of foreign currency. These swaps lines allow the RBA to convert AUD to the FED in exchange for USD for a given set of time. In turn, the RBA can provide local banks and financial institutions access to USD as required.

Graph 1: Providing USD funding offshore trough swaps

Source: Central bank swaps then and now: Robert N McCauley and Catherine R Schenk

The FED describes the swaps as follows. In general, these swaps involve two transactions. When a foreign central bank draws on its swap line with the Federal Reserve, the foreign central bank sells a specified amount of its currency to the Federal Reserve in exchange for dollars at the prevailing market exchange rate. The Federal Reserve holds the foreign currency in an account at the foreign central bank. The dollars that the Federal Reserve provides are deposited in an account that the foreign central bank maintains at the Federal Reserve Bank of New York. At the same time, the Federal Reserve and the foreign central bank enter into a binding agreement for a second transaction that obligates the foreign central bank to buy back its currency on a specified future date at the same exchange rate. The second transaction unwinds the first. According to the FED, at the conclusion of the second transaction, the foreign central bank pays interest, at a “market-based rate”.

Who Has Them

To ensure USD liquidity for a select few, the Fed has had long standing agreements enabling USD swaps with the BoE, BoJ, ECB, and the SNB. On the 20th March, the Fed announced it would allow the central banks of an additional nine countries to draw on USD swaps up to US$30-60B each for at least six months. These countries are Brazil, Denmark, South Korea, Mexico, Norway, New Zealand, Singapore, Sweden, and Australia.

The need for this USD is illustrated in the Bloomberg chart below showing the spike in the cross-currency basis point rises in early 2020.

While there is no exposure to forex fluctuations for our RBA, which is a shame as the AUD has rocketed up since the agreement was offered, there is of course the interest rate payment to the FED for this generous availability of USD to ensure their system remains viable. US trade negotiations 101. A “win-win” deal for the FED is when they win twice. This interest rate was not found (it might be there in small print, but I couldn’t find it) from the RBAs/FEDs website, during my research.

So, the question is what is the market-based interest rate we are paying the FED? As Australia is AAA rated, one would assume it is as low as it could possibly be, but it can’t be lower than what local institutions are paying their US denominated loans in or there would be a clear arbitrage opportunity. If the FED can publish updates about the amount being swapped in an excel file, why can’t they list this “market rate” next to the swap amount? This lack of transparency that should make us concerned about these swaps. All one can be sure of though, is the FED will make money from it, and we, being the Australian tax payer will have to foot the bill for local Aussie institutions that have not held enough USD reserves to accommodate their short term repayment requirements, even though it was only 12 years ago in 2008 that they needed the same help as they do now. History repeats but banks never seem to learn from it.

What Local Institutions Gets Access And How

The current RBA/FED agreement is swaps of AUD up to a total of US$60B. The RBA has made these US dollars available through repo auctions with the minimum bid size being US$20M. Eligible counterparties need to be ‘Australian Members of the Reserve Bank Information and Transfer System’ (RITS) and Austraclear. Interestingly, among the standard names of Australian financial institutions, the Bank of China is listed as a member of the RITS. Highly unlikely they need USD, I think China has more USD than the US has 😊😊!!!

Where Are They On The RBA Balance Sheet

The RBA refers to these swaps as ‘Special Drawing Rights’ (SDRs) and are found on the RBA balance sheet under the ‘Gold and Foreign Exchange” line item. The amounts outstanding with all central banks is updated regularly by the Fed. The RBA is currently sitting at US$520m, down from US$1.17B only a few weeks ago. The hungriest USD swap consumer is the BoJ, even vastly exceeding the ECB during recent COVID-19 times. The only countries who seem to have had plenty of USD reserves pre-crisis have been Canada, Brazil, New Zealand and Sweden. All have not required to enter into any swap agreements during this period with the FED.

Why Do We Need Them

Well as you and I can’t travel to the US at the moment we don’t need USD do we… But our banks and other big financials do.

If the big four banks, and other RITS/Austraclear members don’t get access to USD that they need to service USD debt, or to facilitate international transactions for their clients required in USD, they would do what ever you and I need to do when we need US denominated capital, they would sell USD assets. If the world over can’t get access to USD, and in turn sell their USD assets in large volumes, the resulting sell side pressure that would occur on US treasuries, shares, corporate bonds might make the March 23rd drop look like a small pullback.

But why do Australian banks need access to so much USD ? Because a large share of their wholesale funding is sourced from overseas, as depicted in the following chart. Thanks to the RBA, Kellie Bellrose and David Norman for the below charts found in their December 2019 article which states this large share of funding sourced from overseas markets has long been cited as a vulnerability by a range of commentators. Well Kellie Bellrose and David Norman, you can add Keyser Söze to that list please. I also wonder, why are the banks getting overseas funding when they can get it from the RBA or Australian government? The answer is probably because when the government lowers the cash rate and in turn asks the banks to lower mortgages rates, they can turn around and say, “Oh jeez, I’d really love to, but we have all this overseas funding that costs us more then local funding so we can’t pass on the full rate cut”. Now they are on the record as saying this overseas funding costs more, so remember that when you think of the “market rate” the Fed is charging the RBA (you and me).

Although local deposits are well above 50% of their funding sources, what happens when economies stop, people get laid off, wages reduced, people withdraw $20k from super, and business stop earning revenue? Deposits dramatically lower!!! So while access to current data and revenue guidance during this crisis has been conveniently stopped by the ASX for all listed companies, one can safely assume that the left hand bar on the above chart is a lot lower currently than it was in June 2019. Which in turn proportionally raises the ST/LT debt funding percentages.

When we are talking about Australian banks needing access to USD. We are talking about the big 4, as the other banks have a “very small” exposure to international funding according to Kellie and David. Even though the big 4 seem to have learnt their lesson from the GFC, well maybe not learnt but made to learn by the 2015 introduction of the ‘liquidity coverage ratio’ and the 2018 ‘net stable funding ratio’ regulations, wholesale debt still funds around 1/3rd of Australian banking activity, of which nearly 2/3rds is sourced from overseas. That is IF, with a big IF, deposits remain stable. So how much of that is in USD? Oh, only 50%…….

According to Kellie and David this wholesale funding from overseas is often in USD and “as a last resort” the RBA can provide liquidity to Australian banks. How is 50% USD funding “often” ??, its half the time.. not some of the time, not a bit of the time, not often, its half the time. So how do the banks service this USD debt when they run out of USD… Enter the FED/RBA swaps…. Which no doubt you and I are paying for. Because if it’s not clear who is paying what, it’s clear the public is probably paying.

ICARUS EXCLUSIVE: COVID-19 & The Feds Additional Central Bank Currency Swaps Agreement