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What are currency swap lines and how do they work?

Currency Swap Line

Amid current pandemic crisis, one of the big news making rounds is the Fed's swap line arrangements. The Federal Reserve announced on 19th March at the FOMC meeting that it was broadening its swap lines to provide funding to countries.

However, this is not the first time. In the past, the Federal Reserve has made use of its swap lines, especially during times of crisis. The Fed's FX swap lines were especially useful during the 2008 Lehman Brother's crisis.

The Forex Swap line is basically a monetary policy tool that a central bank has. Also known as FX swap line, it is often used by central banks in order to provide additional liquidity to the markets.

The Federal Reserve Bank in the United States uses its FX swap line in order to provide other central banks access to the U.S. dollars. As a world's reserve currency, it is essential that the global markets have adequate access to the U.S. dollars.

Currency (FX) swap line explained

An FX swap line is an agreement between two central banks to exchange their respective currencies. It allows once central bank to obtain the foreign currency liquidity from the central bank which is issuing it.

A central bank can set up a currency swap line agreement between as many foreign central banks as needed. For example, the Federal Reserve has a currency swap line agreement with the ECB, the SNB and so on.

Elsewhere, the ECB has swap line agreements with the Danish Central Bank, The Swedish Riksbank and so on. These swap lines are established in order to provide access for Danish and Swedish central banks to gain access to the euro currency and so on.

How does a Forex Swap Line work?

A forex swap line is basically a contract between two central banks. One central bank, for example the Federal Reserve gives dollars to another central bank (ex: the ECB). This exchange of dollars for euros is based on the prevailing spot rate.

The forex swap line contract can be between one week to a month, or more. At the end of the tenure of the contract, the respective central bank once again exchange the currencies. This exchange is also based on the same spot rate that was used for the initial exchange.

Besides the exchange of currencies, the lending central bank charges an interest rate. This interest rate is set as the spread which is relative to the overnight index swaps rate which is paid at the end of the tenure and payable in U.S. dollars.

A forex swap line contract is like a pre-approved line of credit between central banks. Each request by a foreign central bank is individually approved.

The central bank receiving the U.S. dollars is then able to loan these out to other financial institutions in its jurisdiction and is typically for the same tenure and spread.

In return, this central requires the financial institutions to provide high quality liquid assets as collateral.

Why are currency swap lines needed?

Currency swap lines are usually required during times of market turmoil. This is when the general interbank lending market liquidity dries up. An FX swap line has, in recent years become an important tool for maintaining the financial stability.

More importantly, the currency swap lines are used to prevent the market turmoil from adversely impacting the real economy. The ECB for example has established swap line agreements since 2007. The basic idea behind the swap lines is that if a home central bank has a swap line agreement with the foreign central bank, then it can provide liquidity in the foreign currency.

Swap line agreements, especially where the U.S. dollar is involved is very effective. Given the dollar’s reserve currency status, the fact remains that global economies are depended on this currency. Therefore, many central banks, especially those which rely heavily on trade with the United States tend to have swap agreements in place to ensure that there is always USD liquidity in the markets.

One of the main things to point out is that through the FX swap line agreement, the Federal Reserve provides USD funding directly to another central bank. It does not directly lend to foreign financial institutions. It is up to the receiving central bank to decide on how to further distribute the liquidity.

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