Tuesday, May 11, 2010

Fed Swap Facilities

On May 9, the Fed reopened its swap facilities with the Bank of Canada, the Bank of England, the European Central Bank, and took similar action with respect to the Bank of Japan on May 10.

This New York Fed piece explains how the swap facilities work. The swap facility is a line of credit extended to a foreign central bank. Here's what happens when the foreign central bank uses its line of credit. The foreign central bank receives a loan as a credit to its account with the Fed (essentially a non-interest-bearing reserve account), in US dollars, and a loan appears on the asset side of the Fed's balance sheet. As collateral on the loan, the Fed receives a credit to its account at the foreign central bank of an equivalent amount in foreign currency, at the current exchange rate. The foreign central bank then, in turn, makes loans in US dollars to foreign financial institutions. When these loans are repaid to the foreign central bank, the balances in the Fed's account at the foreign central bank and in the foreign central bank's account at the Fed go to zero. It is as if the foreign central bank repurchased the foreign exchange (the collateral) from the Fed at the original exchange rate, so there is no exchange rate risk for the Fed. Further, any interest (earned in US dollars) that the foreign central bank earned on its lending to financial institutions goes to the Fed.

What's going on here? Essentially this is a roundabout way for the Fed to extend discount window loans, as US dollar lender-of-last-resort, to financial institutions in foreign countries which are holding US dollar-denominated assets. This is a perhaps under-emphasized feature of the Fed's interventions during the financial crisis. Lending through the swap facility began in earnest in fall 2008, and peaked at a whopping $583 billion in December 2008. The majority of this lending was to the ECB.

Reading between the lines here, the reopening of the swap facilities was likely done at the request of the ECB as part of the bailout package for Greece. The extension of the credit lines to central banks in England, Canada, and Japan, is likely just for show. Most of the actual lending - and even more so than in the financial crisis - will go the ECB.

Are the swap facilities a good idea at this time? There is some reporting on this here. Clearly the Greek crisis has increased the demand for US dollar denominated assets substantially in Europe, and this is reflected in recent drops in Treasury yields at all maturities. It makes sense to inject US dollar liquidity where it is scarce, and we could argue that this is in the interest of US residents. Two things puzzle me though:

1. The line of credit to the ECB appears to be open-ended. I don't see any limits. I assume the Fed would not write a blank check and would want to exercise some discretion here, but I don't see it.

2. Why doesn't the Fed charge the discount rate on these loans? This is the correct price to put on the lending. The Fed should not accept whatever rate the ECB chooses to lend the funds at.


  1. On question 2, see paragraph 3.b on the ECB Swap Agreement that can be found at http://www.newyorkfed.org/markets/FRBNY_ECB_Swap_Agreement.pdf

  2. Yes, this is much more specific than the New York Fed primer I linked to above (in fact the primer may be misleading - or else I am somewhat dense). If I understand this correctly, the interest rate on the loan is essentially the effective fed funds rate plus 100 basis points. Is that right?

  3. The OIS is actually an interesting contract. As I understand it, it gives you an expectation of the expected "average" overnight rate (the effective fed funds rate) during the period of the contract. Since loans may have maturities longer that overnight, you have to use something like this to compute the (expected) policy rate.

  4. Yes, it looks like a lot of the contracts were for 3 months during the financial crisis.

  5. Yes, OI = overnight index, a rolled-up daily interest money market account. It is the closest thing found in nature to a risk-free rate. OIS is a swap of this against a term loan reference e.g. 3M LIBOR. If there were no such thing as credit risk, the expectation of the OI leg would indeed match the LIBOR leg. But there is always more credit risk on the term side so the OI side pays a positive spread. Usually, this spread is pretty small, much less than 100bp. But during the credit crisis, it blew out amazingly. This is why the agreement doesn't just tie the interest to LIBOR: the rate would go up exactly when the ECB needs to draw on the facility, and that would defeat the purpose.

    Of course, the transaction as a whole is not a swap, because it is funded. The ECB is posting EUR as collateral, but the value of this collateral is strongly correlated to the creditworthiness of the ECB. So the 100bp could be viewed as an all-in risk charge.

    Overall, the structure seems intended to tie the interest charges to the market but fix the risk charges to a known quantity.