FX swaps, forwards and currency swaps generate future payment obligations that do not appear on balance sheets or in official debt statistics. According to the Bank for International Settlements, this hidden debt amounts to $39 trillion for non-US banks and $26 trillion for non-banks outside the United States.

Currency forwards are binding contracts that fix the exchange rate for the purchase or sale of a currency at a future date, while FX and currency swaps are agreements between two parties to exchange interest payments on loans in two different currencies.

The former serve as a hedge against volatility in the foreign exchange market. The latter are often used to obtain foreign currency funding at more favourable interest rates than loans available in a foreign market. None of them is reflected on company balance sheets or in official debt statistics.

Exponential growth

The problem is that, as the Bank for International Settlements (BIS) warns, by mid-2022 non-US banks with direct access to Federal Reserve credit owed some “$39 trillion” when their FX swaps, forwards and currency swaps are added together. This is more than twice the dollar debt on their balance sheets and more than ten times their capital.

For non-banks outside the United States, the amount is “$26 trillion”, twice the dollar debt on their balance sheets and $9 trillion more than they owed in 2016.

The total volume of this debt has almost doubled since 2008. In recent years, investors have taken advantage of monetary easing and ultra-low interest rates to increase their leverage in search of higher yields. 

Off-balance sheet

Implicit in this foreign exchange market is a huge dollar debt that is hidden because, unlike other derivatives such as repurchase agreements or repos, the payment obligations of FX swaps, forwards and currency swaps are recorded off-balance sheet.

The payment obligations of these derivatives amount to astronomical amounts. Adding all currencies, the amounts outstanding at the end of June 2022 reached $97 trillion, $30 trillion more than in 2016 and almost the same as global GDP.

In April 2022 alone, derivatives trading volume approached $5 trillion per day, according to the BIS, two-thirds of the world’s daily FX turnover. 

Overwhelming role of the dollar

As a vehicle currency, the dollar is on one side of 88% of outstanding positions, according to BIS data, and even a bank wishing to swap between two non-dollar currencies would use the dollar as an intermediate step.

As the BIS points out, “the very short maturity of the typical FX swap/forward creates potential for liquidity squeezes”. In fact, almost four-fifths of the amounts outstanding at end-June 2022 were due in less than a year.

The lack of direct information on these derivatives makes it difficult for monetary authorities to anticipate the magnitude and geography of dollar refinancing needs. As a result, it is more difficult to restore the smooth flow of short-term dollars into the financial system when needed, especially in times of crisis and when the dollar has experienced a significant appreciation.

Systemic risk?

As the BIS warns, hidden leverage and maturity mismatches in the portfolios of pension funds and insurance companies “could pose a policy challenge” to ensure the smooth flow of dollars in the next major crisis. It should not be forgotten that demand for dollars increases in times of market uncertainty.

Moreover, given the sheer scale of this debt, a significant volume of defaults could have serious systemic effects.

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