The Dollar Shortage, Again! in International Wholesale Money Markets
During the 2008-2009 global financial crisis, There were many European Banks which got into trouble due to shortage of US Dollar funding in the whole sale international interbank market. US Federal Reserve eventually extended currency swaps to ECB and other central banks to ease the pressure.
Is it happening now? There is no banking crisis but there seems to be Dollar Shortage.
Foreign Exposure of European Banks
Liquidity Constraints in Global Money Markets (International Interbank Market)
Non US Borrowers got funding from FX Market
and Non Bank Sources (Shadow Banking)
Funding and liquidity management
Funding can be defined as the sourcing of liabilities. Funding decisions are usually, but not exclusively, taken in view of actual or planned changes in a financial institution’s assets. The funding strategy sets out how a bank intends to remain fully funded at the minimum cost consistent with its risk appetite. Such a strategy must balance cost efficiency and stability. A strategy which targets a broader funding base may entail higher operating and funding costs, but through diversity provides more stable, reliable funding. One which focuses efforts on generating home currency funding may prove more reliable in adverse times but entail higher costs in normal markets. The balance of cost and benefit will reflect a range of factors (see Section 3). Accordingly, funding risk essentially refers to a bank’s (in-)ability to raise funds in the desired currencies on an ongoing basis. Liquidity management is the management of cash flows across an institution’s balance sheet (and possibly across counterparties and locations). It involves the control of maturity/currency mismatches and the management of liquid asset holdings. A bank’s liquidity management strategy sets out limits on such mismatches and the level of liquid assets to be retained to ensure that the bank remains able to meet funding obligations with immediacy across currencies and locations, while still reflecting the bank’s preferred balance of costs (eg of acquiring term liabilities or holding low-yielding liquid assets) and risks (associated with running large maturity or currency mismatches). Accordingly, liquidity risk refers to a bank’s (in-)ability to raise sufficient funds in the right currency and location to finance cash outflows at any given point in time. Funding and liquidity management are interrelated. Virtually every transaction has implications for a bank’s funding needs and, more immediately, for its liquidity management. The maturity transformation role of banks renders them intrinsically vulnerable to both institution-specific and market-related cash flow risks. The likelihood of an unexpected cash-flow shock occurring, and a bank’s ability to cope with it, will reflect not only the adequacy of its funding and liquidity management strategies, but also their coherence under stressed conditions. A bank’s funding strategy will condition liquidity management needs. Hence, the risks embedded in the chosen funding strategy will translate into risks that liquidity management will have to address. Failure to properly manage funding risk may suddenly manifest itself as a liquidity problem, should those sources withdraw funding at short notice. Conversely, inadequate liquidity risk management may place unmanageable strains on a bank’s funding strategy by requiring very large amounts of funding to be raised at short notice.
From The Global Financial Crisis and Offshore Dollar Markets
The Global Shortage of U.S. Dollars
International firms need U.S. dollars to fund their investments in U.S.-dollar-denominated assets, such as retail and corporate loans as well as securities holdings. The funding for these investments is typically obtained from a variety of sources: the unsecured cash markets, the FX swap market, and other shortterm wholesale funding markets.
During the financial crisis, a global shortage of dollars occurred, primarily reflecting the funding needs of European banks. Baba, McCauley, and Ramaswamy (2009) show that European banks had substantially increased their U.S. dollar asset positions from about $2 trillion in 1999 to more than $8 trillion by mid-2007. Until the onset of the crisis, these banks had met their funding requirements mainly by borrowing from the unsecured cash and commercial paper markets and by using FX swaps. Unfortunately, most unsecured funding sources eroded during the crisis. For example, U.S. money market funds abruptly stopped purchasing bank-issued commercial paper after they faced large redemptions associated with the bankruptcy of Lehman Brothers (Baba, McCauley, and Ramaswamy 2009). The reduced availability of dollars resulted in higher dollar funding costs.
The remainder of this article describes the increase in dollar funding costs as reflected in the FX swap market, the primary market enabling global financial institutions to manage multi- currency funding exposures without assuming the credit risk inherent in unsecured funding markets. As liquidity in major unsecured lending markets eroded, the demand for dollar funding through FX swap markets intensified sharply and pushed up the cost of raising dollars through FX swaps. Moreover, heightened demand for dollar funding in conjunction with a reduced willingness to lend dollars noticeably impaired the functioning of the FX swap market, particularly as term liquidity dried up.
Measures of Liquidity Tightening
FX Swap implied basis spread
Two measures are used to show the increased cost of dollar funds in private markets during the crisis.
The first is the spread between the London interbank offered rate (Libor) and the overnight index swap (OIS) rate.
The second measure is the foreign exchange (FX) swap implied basis spread, which reflects the cost of funding dollar positions by borrowing foreign currency and converting it into dollars through an FX swap.
What are the Money Markets
Wholesale money markets
Unsecured cash term deposits and loans
Money market calculations and conventions
Benchmark rates and their determination
Overnight indexed rates such as Eonia and Sonia
Treasury bills (a first look at risk-free)
Commercial Paper – CP credit ratings
Secured money market loans – sale and repurchase agreements (Repos)
Money market derivatives
Short term interest rate futures (STIRs): Eurodollar, Short Sterling and Euribor futures
Forward rate agreements
Interest rate swaps
Overnight index swaps (OIS): Sonia and Eonia swaps
Monetary policy and the money markets
How a central bank uses money markets to transmit its interest rate intentions.
OTC US Dollar Money Markets: Sources of short term Funding
A. Fed Funds Market (Domestic)
B. Interbank Money Market
Market for Short Term Securities
Market for Derivatives
Unsecured – Eurodollar
Secured – REPO
Secured (Collateralized markets) – FX Swap Market
Short Term Securities Market
Certificate of Deposits
Interest Rates Swaps
Money Markets in EU
In the unsecured market, activity is concentrated on the overnight maturity segment. The reference rate in this segment is the Eonia (Euro Overnight Index Average). It is a market index computed as the weighted average of overnight unsecured lending transactions undertaken by a representative panel of banks. The same panel banks contributing to the Eonia also quote for the Euribor (Euro Interbank Offered Rate). The Euribor is the rate at which euro interbank term deposits are offered by one prime bank to another prime bank. This is the reference rate for maturities of one, two and three weeks and for twelve maturities from one to twelve months.11
The market for short term securities includes government securities (Treasury bills) and private securities (mainly commercial paper and bank certificates of deposits).
In the market for derivatives, typically interest rate swaps and futures are traded.
Is it happening again?
Policy Decisions such as
Rising Interest Rates
Repatriation of Corporate profits from Europe
Unwillingness to extend of CB Swap Lines
can cause liquidity crisis which show up in
Breakdown of CIP – Then and Now
A brief history of the three key periods of global USD-funding shortfalls:
The first episode immediately after the Lehman bankruptcy coincided with a US banking crisis that quickly became a global banking crisis via cross border linkages. Financial globalization meant that Japanese banks had accumulated a large amount of dollar assets during the 1980s and 1990s. Similarly European banks accumulating a large amount of dollar assets during 2000s created structural US dollar funding needs. The Lehman crisis made both European and Japanese banks less creditworthy in dollar funding markets and they had to pay a premium to convert euro or yen funding into dollar funding as they were unable to access dollar funding markets directly.
The second episode of very negative dollar basis took place during the Euro debt crisis. The sovereign crisis created a banking crisis making Euro area banks less worthy from a counterparty/credit risk point of view in dollar funding markets. As dollar funding markets including fx swap markets dried up, these funding needs took the form of an acute dollar shortage. European banks and companies that had dollar assets to fund had to pay a hefty premium in fx swap markets to convert their euro funding into dollar funding. Those European banks and companies that were unable to do so, were forced to liquidate dollar assets such as dollar denominated bonds and loans to reduce their need for dollar funding
The third phase of very negative dollar basis started at the end of last year. Monetary policy divergence has for sure played a role during the end of 2014 and the beginning of this year. The ECB’s and BoJ’s QE has created an imbalance between supply and demand across funding markets. Funding conditions have become a lot easier outside the US with QE-driven liquidity injections raising the supply of euro and yen funding vs. dollar funding. This divergence manifested itself as one-sided order flow in cross currency swap markets causing a decline in the basis. And we did see these funding imbalances in cross border corporate issuance.
Emergent and Related Issues:
Offshore Dollar Money Markets
International Lender of Last Resort
FX Swaps and Currency Swaps Market
Cross border funding
International Interbank Market
Shadow Banking – MMMF, ABCP,
LIBOR EURIBOR TIBOR
Covered Interest Parity (CIP) Breakdown
Wholesale Funding Market
Impact of Global Liquidity on Global Trade
Credit Networks of Global Banks
International Investment Positions of Banks
Derisking by global banks
Decline in Correspondent Banking
Shortage of Trade Finance
Why has Global Trade dropped so precipitously since 2014?
Is it because of shortage of US Dollars?
Key Sources of Research:
“This Is An Extremely Serious Problem” – Dollar Funding Shortage Hits Record In Japan