BIS, CLS Data Throws Light on Bank’s FX Swaps Positioning

For dealers of a certain generation the words “five-eighths a half, might pay nine-sixteenths for a Japanese name” evoke the money markets of the 1980s, when Japanese banks’ demand for US dollars saw them willing to pay mid-market for funding. A new study published by the Bank for International Settlements (BIS), using its own and CLS data, seeks to throw light on the banks’ role in FX swaps markets, especially when it comes to funding.

The report, published in the latest BIS Quarterly Review, finds that not much has changed, with US and euro area banks being net providers of dollars to Japanese banks, although it also finds that, counter-intuitively, US banks are actually net borrowers in the interbank FX swaps markets, thanks to maturity transformation whereby they borrow dollars via short-dated FX swaps, to lend them to non-bank parties via longer-term FX swaps.

Two other key findings of the report are that, perhaps unsurprisingly as regulatory and capital pressure builds on cash markets, that the use of dollar lending via FX derivatives has more than trebled from 2013 to mid-2021 to over $1 trillion. This is partly because, the BIS says, such activity has become “lucrative” for banks.

The report also reaffirms another anecdotal view of the FX swaps market, that banks tend to accommodate customer demand for FX hedging services by turning to the interbank FX swap market. This is found by the first combination of CLS and BIS data shows, indicating that US banks’ estimated net off-balance sheet dollar lending to customers grew significantly between 2016 and 2020. They offset this mainly by borrowing dollars via interbank FX swaps rather than via an adjustment of their on-balance sheet positions. The report adds that estimates for euro area and Japanese banks also show that shifts in interbank FX swaps offset changes in positions with customers.

The report also observes that the increased use of FX swaps creates “huge payment obligations”. The BIS OTC derivatives (OTCD) statistics, which capture outstanding (notional) amounts of internationally active banks in more than 50 jurisdictions, put the global total at $97 trillion in mid- 2022 (of which $66 trillion were in FX swaps and forwards). Almost 90% involved the payment of US dollars and the total exceeded global GDP in 2021 ($96 trillion) as well as outstanding global external portfolio investment ($81 trillion) and international bank claims ($40 trillion) at end-2021.

As is happening more broadly in FX, the report also finds evidence of continued consolidation in FX markets, finding that a relatively small number of banks account for the lion’s share of outstanding OTC FX derivatives. Estimates derived from banks’ financial disclosures at end-2022 suggest that the top five banks reported roughly a third of global outstanding positions and the top 25 banks more than 80%, the BIS says. It adds that US banks’ sizeable share of the global market puts them well ahead of their euro area, UK and Japanese peers.

US banks, as noted, dominate the market, the combination of data shows these banks are the largest intermediaries in FX derivatives involving either the euro or the yen. Their gross outstanding FX derivatives involving the euro have stood near $12 trillion since 2016, the BIS states, putting them on one side of roughly 40% of global euro positions and, until recently, ahead of euro area banks. In addition, it says outstanding amounts involving the yen have stood close to $7 trillion since 2016, putting US banks on one side of an even larger share of global yen positions.

The report concludes by observing that payment obligations that arise from FX swaps are “huge, but opaque”. It adds that the short-term nature of these instruments makes the FX swap market susceptible to funding squeezes, such as those during the GFC and in March 2020 when the Covid-19 pandemic went global. “In both cases, only extraordinary policy actions in the form of central bank swap lines restored the smooth flow of dollars.” The report notes, adding, “Monitoring the FX swap market is thus an essential element in financial stability analysis.”

The report points out that the combination of BIS and CLS data adds to authorities’ monitoring tool kit in two ways. “First, it provides richer measures of banking systems’ dollar funding positions. CLS data aggregates contain important information about the size, tenor, currency and counterparty structure of banks’ (mostly interbank) FX swaps positions, information not found by examining on-balance sheet currency positions alone,” it states. “This enables better estimates of the size of banks’ gross and net outstanding dollar borrowing positions, and more accurate measurement of their rollover needs at particular tenors.

“Second, the data combination provides the first (indirect) estimates of banks’ net FX derivatives positions in a given currency with customers, something not possible using only BIS or CLS data in isolation. This can aid in global efforts to enhance monitoring of non-bank financial institutions, which account for an ever-larger share of global financial sector activity.”

The full report can be found here