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September 18, 2008

What’s a swap line?

This morning the Federal Open Market Committee (FOMC) authorized a $180 billion expansion of its temporary reciprocal currency arrangements (swap lines). According to the Fed’s press release, the changes allow for “increases in the existing swap lines with the ECB and the Swiss National Bank” and for “new swap facilities…with the Bank of Japan, the Bank of England, and the Bank of Canada.”

“These measures…are designed to improve the liquidity conditions in global financial markets,” the release continued.

What did the Fed do and how will this action address some of the strain in liquidity conditions that recently have emerged?

A good place to start is by looking at what, exactly, a currency swap line is. A currency swap is a transaction where two parties exchange an agreed amount of two currencies while at the same time agreeing to unwind the currency exchange at a future date.

Consider this example. Today the Fed initiated a $40 billion swap line with the Bank of England (BOE), meaning that the BOE will receive $40 billion U.S. dollars and the Fed will receive an implied £22 billion (using yesterday’s USD/GBP exchange rate of 1.8173).

Currency Swap:

Figure 1

An underlying aspect of a currency swap is that banks (and businesses) around the world have assets and liabilities not only in their home currency, but also in dollars. Thus, banks in England need funding in U.S. dollars as well as in pounds.

However, banks recently have been reluctant to lend to one another. Some observers believe this reluctance relates to uncertainty about the assets that other banks have on their balance sheets or because a bank might be uncertain about its own short-term cash needs. Whatever the cause, this reluctance in the interbank market has pushed up the premium for short-term U.S. dollar funding and has been evident in a sharp escalation in LIBOR rates.

The currency swap lines were designed to inject liquidity, which can help bring rates down. To take the British pound swap line example a step further, the BOE this morning planned to auction off $40 billion in overnight funds (cash banks can use on a very short-term basis) to private banks in England.

Figure 2

In effect, this morning’s BOE dollar auction will increase the supply of U.S. dollars in England, which would work to put downward pressure on rates banks charge each other.

Consistent with this move, the overnight LIBOR rate fell from about 5.03 percent yesterday to 3.84 percent today.

Figure 3

The bottom line is that the Fed, by exchanging dollars for foreign currency, has helped to provide liquidity to banks around the world. This effort can help to bring interbank rates back down at a time when restrictively high rates can choke off access to financing that banks and other businesses need to operate.

By Mike Hammill in the Atlanta Fed’s research department

September 18, 2008 in Capital Markets | Permalink


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What does the Fed do with 22 billion pounds?

Also, is this a good gauge of the magnitude of bad (illiquid) debt held by European banks?

Posted by: tinbox | September 18, 2008 at 08:59 PM

My question - is this swap between CBs and the notional amounts are certian or have the foreign banks pledged assets to secure the swap?

In short is the USG on the hook for items that any other central bank has exchanged cash (or Ts)?


Posted by: Barley | September 18, 2008 at 11:45 PM

Won't opening swap lines with worldwide central banks create an artificial supply of dollars and as a result cause a short term devaluation of the dollar w.r.t the pound. Also would the reduction of the LIBOR cause a subsequent reduction in the risk premium charged to financial institutions?

Posted by: Akhil | September 24, 2008 at 05:06 AM

Interesting. While not harming your story, it might be of interest that the LIBOR systematically understates the borrowing costs, since banks have chosen to report too low interest rates (the LIBOR is survey-driven). Apparently, banks want to hide the true amount of stress in the system, even though it costs them, since they collect LIBOR + premium from their debtors.

Posted by: Dirk | September 27, 2008 at 06:49 AM

When I saw this morning that the Fed was more than doubling it's foreign swap lines to a total of $620, I figured I really need to understand these. A few questions:

1) Have they agreed to unswap at some future date at a set price, such that other central banks are taking on the currency risk of holding dollars?

2) Does this directly increase the money supply, and is it inflationary and/or a debasing of the dollar?

3) How is this functionally different from the Fed running the printing press, using that "new money" to buy pounds in the open currency market, and letting the British banks borrow in pounds from the BOE?


Posted by: lilnev | September 29, 2008 at 04:11 PM

Is the currency swap a "derivative"...I think the answer is yes.

Does this "Derivative" show up on the Fed's Balance Sheet ?

Wouldn't the risk to the USA be a precipitous drop in the value of the USD. If under the SWAP agreements, we need to return EUROs and the dollar continues to drop versus the other currencies, then wouldn't the number of Euros that we need to return increase as well ? I would assume that this would be inflationary...but would be interested in your comments....

Posted by: Dave Spurr | September 29, 2008 at 07:01 PM

Hello Mike,

Like Lilnev, I would be grateful to hear more detail about how these swaps work. In particular:

How is the unwind of the swap priced?

What is the Fed doing with the foreign currency it is receiving?

I presume that any lending by the foreign central banks is offset against the FRBNY lending, right?

I would be happy to be referred to a public document if one is available with such information. Thanks.

Posted by: RebelEconomist | September 30, 2008 at 01:11 PM

yesterday I spoke by telephone with one of the central banks undertaking swaps with the Fed. I was referred to the media dept where no one understood the mechanism of the swaps but I did have my call later returned by someone in the dealingroom who explained a little.

The USD side appears as a credit on the foreign CBs account with the Fed in NY while a corresponding foreign currency credit appears on the Fed's ledger. As the end of the agreed term the two credits are simultaneously extinguished. There is no foreign exchange rate movement risk nor interest paid by either party.

Therefore this doesn't sound like a derivative as none of the values derive from the price of anything else.

With the USD received by the foreign CB, these are used to repo local currency securities to provide the foreign market with USD liquidity largely for trade, letters of credit etc. The dealer advised there was a shortage of USD in his local marketplace because of the credit freeze.

It was only after the call I realized I'd forgotten the obvious question - that which appears at the very top of the comments - what does the Fed do with the foreign currency credit?

anyone know????

Posted by: blindedbytheslosh | September 30, 2008 at 07:22 PM

I have a professor that works for the Fed. I will ask him what the Fed does with the foreign currency tomorrow. This assumes he will answer me because he tends to avoid some questions because it is not in the interest of the Fed.

Posted by: bryan dennie | September 30, 2008 at 11:53 PM

My question is very similar to lilnev - is the Fed now running a printing press and if so - how is this sustainable within a serious dollar depreciation?

Thanks, Carmen

Posted by: macro carmen | October 01, 2008 at 07:39 PM

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