FX Swaps: Implications for Financial and Economic Stability

IMF Working Papers, March 1, 2010

Source details

The proliferation of foreign exchange (FX) swaps as a source of funding and as a hedging tool has focused attention on the role of the FX swap market in the recent crisis.
Turbulence in international money markets spilled over into the FX swap market in the second-half of 2007 and into 2008, raising concerns about:
- the ability of banks to roll over their funding requirements;
- banks' ability to manage their liquidity risk;
- banks' continued supply of credit to the local economy; and
- the external financing gap that could result.
The paper examines channels through which FX swap transactions could affect a country's financial and economic stability and highlights strategies central banks can employ to mitigate market pressures.
The paper does not offer a judgment on the instrument itself but shows that the use of FX swaps for funding and hedging purposes is not infallible, especially during periods of market stress.

FX swaps played a central role during the international money market turbulence in the second-half of 2007 and into 2008.
Market stress in international money markets can spill over to FX swap markets, causing:
- rollover risk for banks using FX swaps for funding;
- amplified liquidity risk;
- potential reductions in banks' credit supply to domestic economies; and
- possible widening of external financing gaps for countries.
The use of FX swaps for funding and hedging is vulnerable during periods of market stress and cannot be assumed to provide uninterrupted funding or risk mitigation.

The paper highlights strategies central banks can employ to mitigate market pressures stemming from FX swap market dysfunction. (The paper examines and highlights these strategies; it does not pass judgment on the instrument itself.)