An agreement wherein two currencies are simultaneously borrowed and lent at a start date, with the amounts exchanged at maturity, is known as a foreign exchange swap, or FX swap. Since the swapped cash is used as security for repayment, they are helpful for risk-free financing. Every day, the foreign exchange (FX) swap market creates over $4 trillion worth of new contracts. To put that into context, think about the daily trading volume in global equities of twelve billion dollars.
A market of any size should be transparent and adequately regulated. However, the quickly growing FX swap marketplace is not incredibly opaque, making it difficult or impossible to uncover many facts.
How Do FX Swaps Function?
FX swaps are derivatives in which two currencies are exchanged between counterparties. In tandem with lending another currency, one party borrows another. The counterparty payback obligation acts as the transaction’s collateral, with the amount that a party must subsequently repay established at the beginning of the contract. Thus, FX swaps provide a simple means for a party to get dollars or FX funds quickly.
Overall, the off-balance foreign exchange transaction completely hedges the currency gap. More loans in foreign currency are obtained by one counterparty without causing an increase in its balance sheet.
In practice, banks serve as the primary intermediaries even if an FX swap theoretically suggests that the counterparties deal with one another.
Banks use reserve draining or matched-book intermediation to source cash when they get a request from a customer to hedge exposure. In the first instance, the banks increased their borrowing from repo repos and other liabilities to finance the expansion of FX lending.
This strategy’s primary disadvantage is that it expands the bank’s balance sheet, which affects the leverage ratio and liquidity coverage ratio. These Basel III ratios are expensive and legally enforceable after the global financial crisis (GFC).
Benefits of DBS’ FX Swap
Select from a range of foreign exchange products and solutions to manage your currency exposures and risks efficiently.
- Active Market Maker: Use numerous FX distribution methods and digital platforms to exchange and trade foreign currencies.
- Competitive pricing: Take advantage of our vast network and solid market position in the foreign exchange markets.
- Access an array of currencies and foreign exchange products, including swaps, forwards, spots, and NDF.
- Advanced Currency Solutions: Our experts will tailor their solutions to your unique requirements, whether you’re looking for basic FX conversions or more intricate solutions.
- Keep up-to-date: Receive the most recent market analysis from knowledgeable analysts and strategists.
- Make use of expertise: Determine potential FX risks and offer suggestions for effective hedging strategies.
An Expanding Industry
Why is the foreign exchange swap market growing so fast? Profitability is a crucial component. Through FX derivatives that charge a dollar basis premium, banks lend dollars. In addition to the profits they would otherwise receive from financing on the money market, this is what the banks make.
Particularly for banks with large amounts of dollar funding, the dollar basis bonus has proven quite profitable. Additionally, these banks are meeting their clients’ hedging needs while maintaining their Basel III ratios by using FX swaps.
Banks can finance dollar lending through reserve-draining intermediaries, which lowers their excessive reserve balance with the United States Federal Reserve. In this way, the bank avoids any future Basel III regulatory ramifications while maintaining the balance sheet.
