NY Fed economists Michael Fleming and Nicholas Klagge have a nice short note on the topic. The paer is highly timely as swap lines have been reintroduced. They wrote the paper in April 2010 and would not have expected reopening of these swap lines.How these swap lines work?
The swaps involved two transactions. At initiation, when a foreign central bank drew on its swap line, it sold a specified quantity of its currency to the Fed in exchange for dollars at the prevailing market exchange rate. At the same time, the Fed and the foreign central bank entered into an agreement that obligated the foreign central bank to buy back its currency at a future date at the same exchange rate. Because the exchange rate for the second transaction was set at the time of the fi rst, there was no exchange rate risk associated with the swaps.
The foreign central bank lent the borrowed dollars to institutions in its jurisdiction through a variety of methods, including variable rate and fi xed-rate auctions. In every case, the arrangement was between the foreign central bank and the institution receiving funds. The foreign central bank determined the eligibility of institutions and the acceptability of their collateral. And the foreign central bank remained obligated to return the dollars to the Fed and bore the credit risk for the loans it made.
At the conclusion of the swap, the foreign central bank paid the Fed an amount of interest on the dollars borrowed that was equal to the amount the central bank earned on its dollar lending operations. In contrast, the Fed did not pay interest on the foreign currency it acquired in the swap transaction, but committed to holding the currency at the foreign central bank instead of lending it or investing it. This arrangement avoided the reserve-management diffi culties that might arise at foreign central banks if the Fed were to invest its foreign currency holdings in the market
The authors also analyse whether swap lines worked in their first version. They look at three methods. Broad summary is:
Early evidence suggests that the swap lines were successful in smoothing disruptions in overseas dollar funding markets. Swap line announcements and operations were associated with improved conditions in these markets: Although measures of dollar funding pressures remained high throughout the crisis period, they tended to moderate following large increases in dollars lent under the swap line program. Moreover, the sharp decline in swap line usage as the crisis ebbed suggests that the pricing of funds offered through swap lines gave institutions an incentive to return to private sources of funding as market conditions improved.
Obviously there will be more papers in future on swap lines – version 1 and version 2. It also opens up questions over International Monetary System which relies on USD as the reserve currency.
