The landscape of US dollar funding experienced significant turbulence starting in late February 2020, as supply and demand imbalances triggered a surge in funding premiums amidst highly volatile financial markets. This analysis delves into these pressures within the foreign exchange (FX) swap market, a crucial arena where participants engage in currency swaps (for instance, Euro and US dollar) with a commitment to reverse the exchange at a predetermined future date and exchange rate. We will explore the demonstrable positive impact of central bank swap lines on the EUR/USD FX swap market’s functionality. These swap lines are instrumental in enabling the Eurosystem to channel US dollars to banks within the Eurozone.[^1] The enhancement of these swap lines, coupled with a more frequent supply of US dollars through liquidity operations, not only addressed the immediate US dollar funding needs of banks but also invigorated market activity. Banks involved in these US dollar operations became more inclined to act as intermediaries, passing on funds sourced from the Eurosystem to a wider array of market participants. This was pivotal in alleviating tensions in US dollar funding conditions and restoring orderly market function in the EUR/USD FX swap market. This analysis is underpinned by market transaction data collected via the ECB Money Market and Statistical Reporting (MMSR).[^2]
Amidst the heightened market volatility and risk aversion precipitated by the coronavirus (COVID-19) pandemic, the EUR/USD FX swap basis spread—a key indicator of US dollar funding costs for European banks—experienced a notable increase. The FX swap basis spread represents the differential between the implied interest rate for borrowing US dollars in the EUR/USD FX swap market and the US dollar risk-free rate, typically benchmarked against the US dollar overnight index swap (OIS) rate. Under typical market conditions, the FX swap basis spread remains narrow[^3], primarily reflecting transient market frictions, such as those linked to balance sheet reporting periods. However, starting from late February, European banks began to demand a higher premium to secure US dollar funding in the EUR/USD FX swap market, causing the FX swap basis spread to widen. This reflected a sharp escalation in US dollar demand as market participants accumulated cash in anticipation of potential liquidity drains towards the real economy. European banks and corporations with substantial US dollar business exposure were particularly affected. By February 28th, the overnight FX swap basis spread had escalated to 25 basis points, doubling within just three days. Concurrently, the three-month maturity FX swap basis spread widened to 49 basis points by March 3rd, exceeding the average February 2020 level by 30 basis points (refer to Chart A).
Despite the announcement on March 15th of enhanced central bank swap lines designed to ease these pressures, the premium for borrowing US dollars in the EUR/USD FX swap market initially continued its upward trajectory, especially for shorter-term maturities. In response to deteriorating US dollar funding conditions globally, on March 15th, a coordinated action was announced by the Federal Reserve System, the ECB, the Bank of Japan, the Bank of England, the Swiss National Bank, and the Bank of Canada to bolster US dollar liquidity provision through standing swap line arrangements.[^4] The ECB communicated that the Eurosystem would introduce 84-day operations from March 18th onwards, in addition to the existing 7-day operations. Furthermore, the pricing for both operations was reduced by 25 basis points, aligning it with the US dollar OIS rate plus 25 basis points. However, the announcement itself initially provided minimal respite to US dollar funding premiums in the EUR/USD FX swap market, especially in shorter maturities. Consequently, short-term US dollar borrowing rates began to increase sharply, culminating in the overnight FX swap basis spread peaking at 644 basis points on March 17th, just before the first US dollar operations under the enhanced swap line terms.
The Eurosystem’s inaugural US dollar operations under these more favorable pricing conditions, commencing on March 18th, brought substantial relief to short-term US dollar funding conditions within the EUR/USD FX swap market, although longer maturities experienced a less pronounced impact. On March 18th, marking the first offering of the 84-day US dollar operation since spring 2014, the ECB allocated USD 76 billion to 44 bidders in the 84-day operation and USD 36 billion to 22 bidders in the 7-day operation. The total allocation of USD 112 billion on this single day was unprecedented since 2008. Both operations were significantly more cost-effective than prevailing market rates. Market feedback indicated that the substantial uptake and broad participation among banks helped mitigate any potential stigma associated with engaging in these operations. Following the announcement of the US dollar operation results, MMSR reporting agents indicated a notable decrease in US dollar funding premiums for short-term transactions, with the overnight FX swap basis spread plummeting by 476 basis points to 168 basis points. In contrast, the three-month FX swap basis spread saw a temporary tightening, but to a lesser degree, from 157 basis points to 107 basis points, before rebounding to 144 basis points on March 19th. Given the highly uncertain market outlook and potential for sudden US dollar outflows, banks initially prioritized hoarding the US dollar liquidity obtained through the Eurosystem’s facility. Only a fraction of this liquidity was channeled back into the market, predominantly in shorter tenors, thus limiting the relief on longer-term US dollar funding premiums.
The establishment of daily 7-day US dollar operations starting from March 23rd[^5] proved crucial in fostering a sustained improvement across all tenors, as uncertainties surrounding US dollar availability diminished. Market participants viewed the daily operations as highly beneficial, as this frequency reduced ambiguity regarding the availability of US dollars to meet daily funding needs. In addition to daily 7-day operations, the Eurosystem continued to offer weekly 84-day operations, ensuring access to US dollar funds for Eurozone banks over an extended period. This dual approach facilitated a gradual pass-through of liquidity from US dollar operations to the broader market and effectively lowered US dollar funding premiums.[^6]
However, US dollar funding costs in the EUR/USD FX swap market remained elevated as the March quarter-end approached. Banks typically exhibit reluctance to expand balance sheets for intermediation activities spanning quarter-ends due to regulatory ratio reporting requirements. The March quarter-end also coincides with the fiscal year-end for banks in jurisdictions like Japan, where tax liabilities are influenced by balance sheet size. Consequently, the relief provided by US dollar operations was somewhat diminished around this period. As a result, funding conditions in EUR/USD FX swap markets remained volatile leading up to the quarter-end across both short and long maturities. The overnight FX swap basis spread remained higher than pre-COVID-19 crisis levels and spiked at the March 2020 quarter-end, reaching 209 basis points on March 30th—88 basis points higher than the March 2019 quarter-end. Simultaneously, the three-month FX swap basis spread averaged 95 basis points in the last week of March, approximately five times the average basis spread recorded in February 2020.
Post-quarter-end, the premium for borrowing US dollars in the EUR/USD FX swap market decreased further, signaling a normalization of US dollar funding conditions. Consequently, the Eurosystem’s US dollar operations gradually became less attractive, leading to reduced participation. FX swap basis spreads progressively normalized throughout April, driven by improving market sentiment and reduced concerns about US dollar liquidity. Short-term US dollar funding premiums (one-day to one-week tenors) declined rapidly after the quarter-end, returning to near pre-pandemic levels by mid-April. Longer-term FX swap basis spreads took longer to normalize but also stabilized around pre-crisis levels by the end of April. Mirroring these market developments and observations in other jurisdictions, the Eurosystem’s US dollar operations started to lose economic appeal in April. The utilization of the Eurosystem’s US dollar facility subsequently decreased significantly. In the latter half of May, the ECB’s total allotment was less than USD 3 billion, a substantial decrease of USD 173 billion compared to the second half of March (see Chart B). On April 21st, the ECB recorded no bids for the first time since the enhanced US dollar operations commenced. Operations without allotment became increasingly frequent, reflecting the normalization of US dollar funding conditions in the EUR/USD FX swap market.
Market turnover in the EUR/USD FX swap market demonstrated resilience throughout the crisis. Initially, market participants increased activity in longer tenors anticipating a tightening of US dollar funding conditions. MMSR transaction data indicate a significant surge in turnover for maturities exceeding one month in the weeks preceding the crisis peak. This suggests that as US dollar funding conditions began to deteriorate, market participants sought to secure US dollar funding at prevailing rates in anticipation of further market tightening. Volumes for maturities longer than one month, including forward transactions, remained elevated until March 19th,[^7] the settlement date for the first enhanced US dollar operation. Driven by heightened longer-term trading volumes, total daily market turnover between February 25th and March 19th increased by over one-third on average compared to the rest of February 2020, reaching approximately USD 250 billion (see Chart C).
Central bank US dollar operations played a vital role in supporting the functionality of the EUR/USD FX swap market, with US dollar funding sourced from the Eurosystem effectively reaching the market. However, a general shift towards shorter maturities was observed. Overall activity in the EUR/USD FX swap market remained high following the launch of enhanced US dollar provision by central banks and further increased post-March quarter-end. This suggests that funds borrowed by banks through Eurosystem operations were indeed passed on to other market participants, helping to meet increased crisis-related US dollar demand. The increased activity in April was predominantly concentrated in short-term maturities, reflecting elevated risk aversion and market participants’ preference to lend surpluses primarily in shorter tenors. Notably, the volume of one-day transactions increased by over 50% after the March quarter-end, from a daily average of USD 118 billion in the first quarter of 2020 to USD 184 billion in the period between April 1st and 20th. Eventually, volumes and maturity composition returned to pre-crisis levels by the end of April.
Banks participating in the Eurosystem’s US dollar operations effectively channeled funds to other market participants, thereby alleviating US dollar funding pressures in the EUR/USD FX swap market, particularly in short maturities. MMSR transaction data reveal that a significant group of Eurozone banks involved in these operations substantially increased their daily US dollar short-term lending volumes. These lending volumes grew by an average of USD 34 billion between April 1st and 20th, coinciding with declining US dollar funding premiums. Given that MMSR reporting agents are among the largest banks in Europe and typically trade with a wide array of counterparties, it is likely that US dollar funds were broadly distributed throughout the market.[^8]
The provision of US dollars through Eurosystem operations enabled major European banks to restore their US dollar intermediation role, which had been disrupted by the crisis in March. MMSR reporting agents are key intermediaries in the US dollar market, supplying US dollar liquidity to various market counterparties. Collectively, MMSR reporting agents are typically net lenders of US dollars in the EUR/USD FX swap market, meaning they usually have a US dollar surplus that, under normal conditions, is invested in the EUR/USD FX swap market. However, as the crisis intensified, some reporting agents experienced a deterioration in their net lending position—measured by the difference between US dollars lent and borrowed in the EUR/USD FX swap market. The total net US dollar surplus declined from USD 153 billion to USD 82 billion (see Chart D). Furthermore, MMSR reporting agents participating in the Eurosystem’s US dollar operations accounted for approximately three-quarters of the total take-up in these operations.[^9] These reporting agents experienced a significant decline in their net lending position, even becoming net borrowers of US dollars in the EUR/USD FX swap market leading up to the enhanced US dollar provision, while the net lending position of other reporting agents decreased only marginally. Following the participation of these reporting agents in the Eurosystem’s US dollar operations, the total net lending position in the EUR/USD FX swap market began to normalize, reaching USD 161 billion by May 21st—USD 79 billion higher than during the crisis peak on March 17th. This indicates the effectiveness of US dollar operations in providing market relief and counteracting the shocks experienced in the first half of March, as market functionality gradually recovered and banks became more willing to intermediate. The swap lines between central banks thus played a crucial role in mitigating the strains within the US dollar funding market, supporting the continued flow of credit from banks to households and businesses, both domestically and internationally.
[^1]: Eurosystem refers to the European Central Bank (ECB) and the national central banks of the euro area countries.
[^2]: MMSR data are collected from a panel of euro area banks and cover transactions in different segments of the euro money market and the EUR/USD FX swap market.
[^3]: The FX swap basis spread can be negative or positive, reflecting relative funding pressures in the two currencies.
[^4]: For more information, see the press release issued by the Federal Reserve System on 15 March 2020.
[^5]: Daily operations were offered until 1 July 2020 and subsequently reduced to three times per week.
[^6]: For a detailed analysis of the effectiveness of central bank swap lines during the global financial crisis, see Goldberg, L.S., Kennedy, C., and Miu, J. (2011), “Central Bank Dollar Swap Lines and Overseas Dollar Funding Conditions”, Journal of International Money and Finance, 30(1), pp. 1-25.
[^7]: As 19 March 2020 was a Wednesday, the maturity date for transactions with a “spot” settlement (two working days after the transaction date) concluded on 19 March.
[^8]: The MMSR reporting panel comprises around 50 of the largest euro area banks, representing a significant share of the euro area banking sector.
[^9]: This figure is based on the reporting agents that participated in at least one of the US dollar operations between 18 March and 7 April 2020.
