Sixty-five trillion dollars is a not big number: It’s a huge, barely comprehensible number. It’s more than 2 1/2 times the size of the entire US Treasury market, the world’s biggest. It’s 14% of the value of all financial assets globally, according to a tally from the Bank for International Settlements.
It’s also the value of hidden dollar debt unrecorded on the balance sheets of non-US banks and shadow banks as of June this year, also according to the BIS, the central bankers’ central bank. It has been growing rapidly, having nearly doubled since 2008.
The fact that most of this hidden debt is owed to banks is another reminder of the ever-growing and opaque interconnections between the traditional financial system and the shadow banking sector. A whole set of recent mini-crises has shown that these links are part of why central banks keep being forced to step in and stabilize government bond markets and other assets when stress levels rise.
This $65 trillion of debt we’re talking about isn’t a set of straightforward loans or bonds: It’s the repayment obligations on foreign currency swaps and forwards. These are typically used by foreign banks and investors when they want to buy a dollar-based asset like a US Treasury bond.
Swaps and forwards are fully collateralized and so ought to be relatively safe for the counterparty. When someone uses a swap to borrow dollars, they in effect pay for them with their own currency and make a commitment to sell the dollars back at a certain date in the future, most often in less than a year.
The trouble comes when dollars become difficult to source — especially as borrowers often use short-term swaps to buy long-term assets. Examples of such moments are the start of the Covid-19 pandemic in March 2020, or the peak of the 2008-2009 financial crisis. A global squeeze on dollars left foreign owners of dollar assets scrambling to find the funds they needed; otherwise they’d be forced into selling good assets quickly, adding to downward price spirals.
Central bankers ideally would like to be able to see these strains coming before they hit. In 2020 and 2008, the Federal Reserve used massive currency swap lines with other major central banks to get dollars out into the world and calm the chaos. But because these flows are hidden off balance sheets, no one really knows where in the world to find all this FX swap and forward debt. Neither does anyone have a better way to stop waves of dollar shortages from becoming destabilizing in the first place.
The BIS first studied this problem in 2017 and, in an updated report on Dec. 5, warned about the difficulties for central banks of setting policies to deal with dollar squeezes while in the fog of crisis. “Off-balance sheet dollar debt may remain out of sight and out of mind, but only until the next time dollar funding liquidity is squeezed,” wrote the authors, led by Claudio Borio, head of the BIS’s monetary and economic department. Central banks have to wait for the chaos to erupt before they know where and when dollars are needed — and even then they might not be entirely sure if they are directing the flows where they are required.
This debt is not recorded on balance sheets due to accounting conventions for derivatives. These allow banks, pension funds, insurers and so on to book only their net exposure. With an FX swap, the initial net exposure is zero and it will only move up or down as exchange rates change.
This accounting treatment is fine for most kinds of derivatives that can be closed out with a cash settlement of only the net value of the contract. With FX swaps and forwards, however, the full amount of dollars owed has to be found and repaid to the counterparty to close out the trade — that is what makes them more like debt.
The BIS has improved the data available but it’s a long way from perfect. The study shows that shadow banks — or non-bank financial intermediaries, to give them their official name — have increased their dollar swap and forward liabilities to $26 trillion, which is twice the size of their on-balance-sheet dollar debts. Non-US banks have $39 trillion of similar liabilities, more than double their on-balance-sheet dollar debts.
These numbers are derived partly from the BIS’s triennial global derivatives survey, but the economists still don’t know exactly how these debts are spread among different kinds of shadow banks.
The global Financial Stability Board and others are becoming more focused on the issue of hidden leverage because of its ability to cause sudden waves of stress that cascade through markets to threaten the global system as a whole. The BIS is also concerned about the lack of transparency in the exposures of the banking system to the shadow banking world — a worry that we’ve written about here, too.
Years of ultra-low interest rates and investors’ aggressive hunt for returns have driven leverage higher — and the growth FX swap and forward liabilities is one mammoth example of that. Rising rates and volatile asset prices make high leverage a dangerous source of instability, ever more so because it is hidden.
More transparency would be wise. For FX swaps and forwards in particular, accounting changes could also be useful: Repurchase agreements, or repos, where bonds and cash are exchanged, are already reported on a gross basis rather than the net basis of derivatives. Maybe these currency debts should be, too.
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Paul J. Davies is a Bloomberg Opinion columnist covering banking and finance. Previously, he was a reporter for the Wall Street Journal and the Financial Times.
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