According to the Bank for International Settlements, there is a hidden risk to the global financial system, which is tied to $65 trillion of dollar debt held by non-US institutions via currency derivatives.
The BIS said that a lack of information is making it harder for policy makers to anticipate the next financial crisis because of a paper with the title huge, missing and growing. They raised concern about the fact that debt is going unrecorded on balance sheets because of accounting conventions on how to track derivative positions.
The findings, based on data from a survey of global currency markets earlier this year, offer a rare insight into the scale of hidden leverage. Foreign-exchange swaps were a flash point during the 2008 global financial crisis and the 2020 epidemic, when dollar funding pressure forced central banks to step in to help struggling borrowers.
The debt is fully collateralized and backed by hard currency. To understand how the system works, consider buying assets in the US from a Dutch pension fund. As part of the transaction, it will often use a foreign currency swap to exchange euros for dollars. The fund will repay dollars and receives euros when it is closed. The payment obligation is recorded off-balance sheet, which is a blind spot in the financial system, according to the BIS.
It is that opacity that puts policymakers at a disadvantage, according to BIS researchers Patrick McGuire, Robert McCauley and Claudio Borio.
They wrote that it is not even clear how many analysts are aware of the existence of large off- balance sheet obligations. In times of crises, policies to restore the smooth flow of short-term dollars in the financial system - for instance, central bank swap lines are set in a fog. Central banks have found ways to manage the demand for dollars during times of stress. The FIMA Repo Facility and swap lines are tools that are used by the Federal Reserve to prevent markets from seizing up.
It is the sheer scale of the swaps that is worrying for researchers at the BIS. They estimate that banks headquartered outside the US carry $39 trillion of debt -- more than double their on- balance sheet obligations and ten times their capital. The full extent of the cash involved isn't recorded on a balance sheet, because accounting conventions only require derivatives to be booked on a net basis.
Borio, head of the monetary and economic department at the BIS, said there is a staggering volume of off-balance sheet dollar debt that is partly hidden. FX risk settlement remains stubbornly high.
In a separate report on Monday, the BIS noted the settlement risk as another source of instability in the foreign-exchange market. The possibility that one party to trade doesn't deliver the asset is something that researchers estimate is the cause of $2.2 trillion of daily currency turnover being subject to settlement risk.
Payment-versus-Pay arrangements, a settlement mechanism that coordinates transfers to ensure no one is left holding a claim, tend to be unsuitable or too expensive for certain trades, according to the BIS paper.
According to Jerome Kemp, president of Baton Systems, said there was an urgent need for wholesale market participants to look for alternative ways to eliminate settlement risk exposure in a broad range of currencies outside traditional majors.