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Capital Markets

Monetary Mystery: The Case of the Missing Debt

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September 19, 2017

Corporate balance sheets would be more than twice their size if borrowing through FX swaps and forwards were included: BIS

Fri Currency in Gears SmallCall it the case of the missing debt. The Bank for International Settlements has released a new report pointing out that foreign exchange, in the form of derivatives like FX swaps, currency swaps and their cousins, forwards, are worth “tens of trillions of dollars” and are debt-like in their makeup. However, they are, for the most part, invisible.

“[O]ne cannot find these amounts on balance sheets,” the BIS says in its report, “FX swaps and forwards: missing global debt?” That’s because this debt “is, in effect, missing.” And as a result, global regulators know little about it: “How much is owed, by whom and for what purpose: trade hedging, asset-liability management, market-making? What does it imply for measures of international credit like the BIS global liquidity indicators (GLIs)?”

The BIS’s GLIs are an attempt to capture what it can in terms of outstanding debt, but is mainly focused on credit, which is recorded. The BIS says there is no single indicator that captures global liquidity, according to the BIS, so all that is known is what is officially recorded by central banks and others.

As for the missing debt, the BIS has combined data on the total amount of derivatives contracts outstanding with international banking statistics along with ad hoc surveys “to form a view of the size, geography and use of the missing foreign currency debt. The more detailed analysis focuses on the dollar segment, given the currency’s outsize role in the foreign exchange and other financial markets.”

This means that the known amount of dollar debt of non-banks outside the US, including bank loans and bonds, totaled $10.7 trillion at the end of March 2017. The BIS estimates the corresponding additional debt borrowed through the FX derivatives markets, or the unaccounted-for debt, is much higher than that: likely $13–14 trillion.

With so much outstanding, and with the BIS’s own thoughts on shadow banking, this amount might be a threat to global financial stability. But the international banking monitor says the implications are unknown. What it means for that stability is “quite subtle and require[s] an assessment of both currency and maturity mismatches,” the BIS says.

That’s because there is a mixed bag of evidence that the missing debt is either offset to some extent or not at all. For example, the BIS says, there is data to support the notion that this missing FX derivative “debt” is supported by “dollar revenues and/or assets, i.e., currency-matched.” There is also analysis that suggests that “the whole amount of that debt could be rationalised by hedging activity, be it trade or asset holdings. It also indicates that a portion of dollar off-balance sheet lending, estimated at as much as $3 trillion, may hedge the on-balance sheet dollar bond debt included in the existing GLI estimate.”

However, “regardless of whether the off-balance sheet debt is currency-matched or not, it has to be repaid when due and this can raise risk,” the BIS notes. Still, the BIS says this also can be mitigated by the other currency received at maturity and most maturing dollar forwards are likely repaid by a new swap of the currency received for the needed dollars. “This new swap rolls the forward over, borrowing dollars to repay dollars,” the BIS says.

Despite this, strains can occur especially in a financial crisis, the BIS says. “In particular, the short maturity of most FX swaps and forwards can create big maturity mismatches and hence generate large liquidity demands.” This was most evident during the funding squeeze suffered by many European banks during the 2008 financial crisis.

The BIS says it needs to do further research to get to a better sense of the size of the missing debt and its impact. But that would require “better data to help evaluate the size and distribution of both currency and maturity mismatches,” the BIS says. It adds that its analysis also points to “deeper and more complex questions about the accounting conventions themselves.”

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