(Bloomberg) — The $65 trillion in debt held by non-U.S. entities through currency derivatives poses a hidden risk to the global financial system, according to the Bank for International Settlements.
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In an article titled “Big, missing and growing,” the BIS said a lack of data made it difficult for policymakers to predict the next financial crisis. In particular, they expressed concern about the fact that debt is not recorded on balance sheets due to accounting conventions to track derivative positions.
The findings, based on data from a survey of global currency markets earlier this year, offer a rare insight into the extent of hidden leverage. Currency swaps were a point during the 2008 global financial crisis and the 2020 pandemic, when the stress of dollar funding forced central banks to step in to help struggling borrowers.
To be sure, the loan is fully secured and secured in stable currency. To understand how the system works, consider a Dutch pension fund that bought assets in the United States. As part of the transaction, it will often use a foreign currency swap to exchange euros for dollars. Then, when it closes, the fund will return dollars and buy euros. The payment obligation for a trading period is recorded in an off-balance sheet account that the BIS calls a “blind spot” in the financial system.
It is this lack of transparency that puts policymakers at a disadvantage, according to BIS researchers Claudio Borio, Robert McCauley and Patrick McGuire.
“It is unclear how many analysts are even aware of the existence of large off-balance sheet liabilities,” they wrote. “In times of crisis, policies to restore the smooth flow of short-term dollars in the financial system — such as central bank swap lines — are built in a fog.”
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Central banks have found ways to manage demand for the dollar during times of stress. The Federal Reserve has tools such as swap lines and the FIMA Repo Facility to prevent market capture.
Of concern to researchers at the BIS is the scale of the exchanges. They estimate that banks headquartered outside the United States carry $39 trillion of that debt — more than double their balance sheet liabilities and ten times their equity. Accounting conventions require only derivatives to be accounted for on a net basis, so the full amount of cash involved is not reported on the balance sheet.
Borio, head of the BIS’s monetary and economic department, said, “There is a staggering amount of off-balance sheet dollar debt that is partially hidden, and currency risk adjustment remains stubbornly high.”
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In a separate report on Monday, the BIS also cited settlement risk as another potential source of volatility in the foreign exchange market. Researchers estimate that $2.2 trillion of daily foreign exchange turnover is exposed to settlement risk, the possibility that one of the trading parties will fail to deliver the asset.
Pay-to-pay arrangements, a settlement mechanism that coordinates transfers to ensure that no one is left with a claim, are unsuitable or too expensive for some trades, the BIS paper said.
In response, Jerome Kemp, president of post-trade processing firm Baton Systems, responded, “There is an urgent need for wholesale market participants to seek alternative ways to eliminate exposure to settlement risk in a wide range of currencies outside of traditional specialties.” to the paper.
–With help from Eva Szalay.
(Updates with context from additional BIS report)
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