Over the past 50 years as international markets have increasingly become intertwined and the dollar became the worldwide reserve currency the Federal Reserve has worked with foreign central banks to bring about measures to provide global monetary stability. One of the tools that the Fed had put into place, though rarely used until recently, is known as a reciprocal currency arrangement. A brief history of this policy can be found in a Federal Reserve paper titled The Federal Reserve in the International Sphere. An excerpt from this document explains the reciprocal currency arrangements and their intended purpose.
These facilities, which are also known as reciprocal currency arrangements, provide short-term access to foreign currencies. A swap transaction involves both a spot (immediate delivery) transaction, in which the Federal Reserve transfers dollars to another central bank in exchange for foreign currency, and a simultaneous forward (future delivery) transaction, in which the two central banks agree to reverse the spot transaction, typically no later than three months in the future. The repurchase price incorporates a market rate of return in each currency of the transaction. The original purpose of swap arrangements was to facilitate a central bank’s support of its own currency in case of undesired downward pressure in foreign exchange markets. Drawings on swap arrangements were common in the 1960s but over time declined in frequency as policy authorities came to rely more on foreign exchange reserve balances to finance currency operations.
These swap agreements were rarely entered into up until 2007. This changed with the global market dislocations that began in 2007 and escalated after the Bear Stearns bailout in March 2008 and the failure of Lehman Brothers in September 2008. Around the world there was a rush to buy dollars leaving a shortage of dollars and an excess supply of many other currencies. As a result many central banks found that they were short dollars and were unable to defend their currency. Starting in 2007 the Federal Reserve felt that it was in the best interest to provide global stability by entering into reciprocal currency agreements with central banks around the world. A recent report by the Federal Reserve Bank of New York titled Central Bank Dollar Swap Lines and Overseas Dollar Funding Costs provides an overview of the evolution of the reciprocal currency arrangements or dollar swap facilities that the Federal Reserve established with a range of foreign central banks in 2007 and 2008, and exited by February 2010.
In brief, the performance of the CB swap facilities is tightly intertwined with the pricing and functioning of TAF auctions, which was been another means of providing dollar liquidity to banks. Both the TAF and dollar swap facilities have been effective at reducing dollar funding costs to domestic and foreign firms and have been viewed as successful backstop facilities for depository institutions. Empirical studies have pointed to the particular role played by the international facilities in influencing financial markets. The large expansion of the Federal Reserve’s balance sheet that was associated with the CB dollar swaps in 2008 Q4 occurred as global banks demanded term funding to cover potential year-end shortages. These positions unwound significantly in 2009 Q1 as outstanding balances matured and were not rolled over, and continued to decline over the course of 2009. Availability of dollars to foreign banks was associated with credit tiering across these financial institutions that persisted, even if at a lower degree of severity, well into 2009. Overall, we conclude that currency swap facilities have been an important part of the toolbox of central banks for dealing with crisis management and resolution, beyond their more traditional use in foreign exchange policy.
Chart 1. The cost to foreign banks increases dramaticaly upon the bankruptcy of Lehman.
Chart 2. Even strong currencies such as the Pound and the Euro are under significant stress in the second half of 2008 and central bankers around the world enter into swap agreements with the U.S. Federal Reserve.
Chart 3. The maturity of new swap lines extends past 30 days post the Lehman bankruptcy. As of the end of 2009 these contracts have mostly expired.