If you are like us, the Bank for International Settlements (BIS) was not on the tip of your tongue last week. But the BIS is raising some valid concerns about the size of the Foreign Exchange Swap Market (FOREX) and Foreign Exchange Derivatives. As we understand it, the derivatives part of this comes with three forms of risk: interest rates, currency exchange rates, and timing. While this is probably not on your priority list of things to consider, it is worth understanding since it looks to be a real concern.
Approximately 80% of all FOREX transactions happen quickly with the swaps being matched off and cleared. From multiple sources it has been reported that daily there are about $5 trillion in transactions, so all but $1 trillion clears. The remaining $1 trillion takes the form of a derivative where the two parties agree to a future settlement based on some combination of time, interest rates, and exchange rates.
All was well until this market started to swell to its current size and real-world events interrupted the normal flow of dollars from lenders. For a market to function smoothly there must be lenders willing to lend to borrowers. When the lenders dry up the system locks up. This makes sense, but if the availability of lenders is interrupted, then things can get ugly in a hurry. And guess what, with Covid, FED quantitative tightening, rising interest rates, and supply chain issues this is exactly what has happened. We would contend that there are added critical factors that are already an obstacle to transparent and smooth operation.
Some writers seem to believe that there is a perfect storm brewing, and the FOREX market may not function exactly as designed. It would seem that for this market to function as intended several things must work or be present.
- A ready supply of US dollars in a quantity to meet demand
- An unimpeded flow of goods
- Stable and low interest rates
- Stable exchange rates
- Rapid settlement of transactions as intended
In other words, this was a market made for where we came from, not where we are, nor where we are going.
What caused the U. S. Savings and Loan crisis in the 1980’s was mismatched maturities and rising rates. S&Ls were borrowing money short term with variable rates and loaning it out as long-term mortgages with fixed rates. All was fine until the rates rose and the cost of the borrowing exceeded the loan interest income. The result was bankruptcy for most S&L’s, and there are some parallels between those times and the FOREX market derivatives today.
Some commentators give a similar example of a Japanese insurance company that goes into the FOREX market and borrows money to buy a long-term bond. When interest rates were flat for extended periods this was an effortless way to make money because you could just calculate the difference in the rates and always know you had a profit. They state that the Japanese economy had benefited by as much as 1% on such transactions. But now we have the opposite where rates are rising, with short term rates higher than long term rates, and the dollar is getting stronger. Any country/company that was using this funding mechanism suddenly found itself on the wrong side of the transaction in every way. Perhaps this type of mismatched transaction was more widely used and that is one signal from the BIS? For sure it requires more knowledge of the borrower to know what level of losses they can withstand. Extending this example, we know that the Bank of Japan has recently placed some of its Treasuries in a FED repo facility to generate cash. This would lend credence to the concerns.
Then there is the on-balance-sheet versus off-balance-sheet issue. Having these transactions off-balance-sheet is the right thing to do because they would distort all numbers when evaluating a company’s performance. But off-balance-sheet gains and losses eventually must come on-balance-sheet once settled. It is only the size of the asset and matched liability that can logically be “hidden.” The BIS is raising the warning that if the underlying companies or countries may not be strong enough to stand big losses. The gains and losses can be hidden until final settlement takes place, but not after. This encourages the “kick the can down the road” scenario that has so often led to financial market disruptions.
Often the off-balance-sheet items are being used to mitigate risk with on-balance-sheet items, and there is an undisclosed risk mitigation going on with the FOREX. But you have no way of knowing the quality of the offset asset or liability, nor the quality of the decision making. Data to evaluate such risks can be dated because of the complexity of data gathering on world markets. But this poses even further risks to world markets. Even though most transactions are dollar denominated, the debt side of the transaction is usually outside the U. S. This might give some short-term comfort, but world markets are now so intertwined that contagion would seem likely.
Any time we hear either Hedge Funds or Derivatives are involved in a discussion, our antenna at once goes up. Hedge Funds are notorious for pushing the limits in pursuit of profits and risk taking. They also have an exclusion where they must only reveal a portion of their investments in detail. The stated purpose for the exemption is that the investors are too sophisticated to require such scrutiny. Derivatives based on foreign exchange can be an issue with any traders who think they can game the system. They are guessing that they are smart enough to know the direction of all markets that would affect global exchange rates. If this were true, then there would never be any financial emergencies.
Apparently, this facility offers the ability to roll losses forward when you discover you guessed wrong. This is the “waiting on a sunny day” theory where you know you are right, just your timing is off a little. In this way losses can be hidden for years by just rolling things over waiting for the sun to shine. It rarely does.
We watched the BIS December 9 quarterly call and think they overplayed the concerns a bit, but some level of concern is real. If $5 trillion rolls over every day and the total size of the pot is approaching $100 trillion that logically means that $95 trillion has some immediate exposure to interest rates, time, and exchange rates. These often move slowly, but they do move. So, let’s do some quick math.
A bucket of $95 trillion has a daily interest rate exposure of $2.6 billion for every 1% swing in interest rates and the FED has moved ours up by multipoles of that. It is true that this is a risk shared by all the countries in the world, but for the developed countries the risk is greatest. Even for the U. S. this exposure is enough to swing the value of a lot of financial things, and we have few companies that could take such big losses without repercussions across world markets. For sure we do not want the FED to be in a position where they need to step in. It is not fair to the American taxpayer, and it would only serve to bail out the bad actors.
Eventually these gains and losses must be exposed because they make their way back to the real balance sheets of the central banks and companies involved. Not all FOREX transactions are losses, nor are they inappropriate. According to the BIS the issue is we just do not know what we do not know. It could be that the BIS is using the size of the market to call attention to the need for more scrutiny and for real-time knowledge of the status of the borrowers and lenders. The BIS has an audit committee, and we would assume a deep audit facility. But these markets are so large, move so quickly, and involve so many countries that extra caution is called for.
A Wall Street Journal Editorial Board article on December 9, 2022, raised similar concerns and echoes the BIS statements. Years of QE, low rates, and stable exchange rates have once again encouraged excessive risk taking. This risk taking would overwhelm most nations outside the U. S., and even the U. S. could not take such a hit without causing a financial panic. We are now in a vastly different world with QT, rising rates, and somewhat volatile exchange rates.
The sum of this is that the BIS saying it is charged with monitoring an exchange and borrowing facility with little to no tools to exercise proper oversight in this environment. Over the past few years this has swelled to $100 trillion. The lack of transparency makes the risk unknowable, but real. Clearly if this does not come under control, then there will be a worldwide recession or worse.
One confusing discussion within the BIS quarterly call was that they seem to be saying: “This is a problem of some unknown risk, and someone needs to address it.” Well, addressing it is their problem but apparently, they do not see it as their problem. They seem to believe it is their job to identify the problem, not fix it, and that might be the real risk.
By design we do not allow direct comments on articles on our web site. But this is one where we would like to see either opposing or supporting discussions. For something this inconspicuous to have the potential for such an impact on all our lives seems unreal.