The Lowdown on Dollar Swaps

On Thursday, the ECB, Fed, Bank of England, Bank of Japan and Swiss National Bank released a statement announcing plans to conduct three unlimited US dollar liquidity operations through the end of the year (essentially, swaps of dollars for other eligible collateral) with terms of approximately three months. Their aim (and a credible one in our view) is to boost US dollar liquidity for eurozone financial institutions. The last time they introduced similar measures was in May 2010, when credit markets were showing signs of strain tied to (again) European woes.

It’s been well documented recently that European banks have experienced tighter conditions when borrowing US dollars tied to ongoing PIIGS debt and deficit issues. In fact, according to several sources, European banks lost access to more than $700 billion in US-dollar funding from US money-market funds and other lenders over the past year. Reflecting the scarcity of US-dollar borrowing, rates between banks in the swaps market have risen to their highest level in almost three years. However, that’s not to say any of the rates are near the peak panic levels of 2008—some are higher than others—but none are nearly to that point. Those rates declined further after Thursday’s news.

Obviously, this is far from a cure-all for Europe’s peripheral debt problems, deficits or competitiveness issues—and there likely isn’t a quick fix either. But the move, albeit novel, is symbolic of officials’ resolve to prevent a systemic credit logjam similar to 2008 and keep global capital markets functioning as smoothly as possible. The 90-day operation announced Thursday is simply an extension of the existing (and little-used) seven-day facility the ECB already has in place. And although the ECB reported two unnamed banks tapped the seven-day facility for $575 million on Wednesday, the total amount outstanding through the facility is still well below its long-term average, let alone 2008 levels. So it remains to be seen how much (or even if) the new 90-day facility will be utilized.

Similarly, it’s important to remember these same foreign banks have nearly $849 billion in excess reserves parked at the Fed. Although these reserves tie directly into banks’ Tier 1 capital ratio, in the event of an extreme liquidity crunch, they could tap into these funds to add liquidity to their operations.

Ultimately, while the coordinated central bank action Thursday isn’t an all-clear sign for the European debt saga, it is another step showing resolve to learn lessons from 2008. It’s normal and natural to be frustrated by the nearly two-year-old PIIGS issues, but in our opinion, the slow pace in resolving these issues is highly preferable to more sudden shifts—which that could easily be misguided and carry more severe consequences. And remember, the more gradual the process, the more effectively banks can hedge potential losses, earn profits (and most are profitable) to offset future potential sovereign debt haircuts and navigate the choppy waters. All this while global economic growth carries on, improving things for nearly everybody.