>> Hidden debt risks in the foreign exchange market
First of all, how big is the transaction scale of the foreign exchange market? By the end of 2019, the balance of the three core instruments of foreign exchange swaps, forwards and currency basis spreads in the foreign exchange market reached 86 trillion U.S. dollars, and U.S. dollar transactions accounted for 90% of it.
Foreign exchange swaps, foreign exchange forwards, and currency basis swaps are all derivatives, but they are different from other derivatives. Other derivatives have a nominal value and a delivery value (that is, how much money is nominally represented and really involves the funds to be mobilized).
For example, private funds are large, but the actual transaction amount involved is not large, just like interest rate swaps. This is a typical example. The principal does not change, because only interest cash flow is exchanged, so this number is small.
However, although the three core foreign exchange instruments, forward contracts, foreign exchange maturities, and currency basis swaps, are derivatives, they are different from all derivatives because they have to pay the full contract value when they mature.
For example, in foreign exchange swaps, it is agreed that after one month, 100 million US dollars will be exchanged for 680 million RMB. This is a rigid debt. So it's very large in scale.
As mentioned earlier, foreign exchange swap is essentially a kind of currency as collateral to obtain another currency. This is a mortgage loan, even the same as a repurchase.
However, accounting standards around the world require repurchases to be included in the balance sheet. As long as repurchases are made, the balance sheet will expand, and there will be costs.
But foreign exchange swaps are different. Although the nature of foreign exchange swaps is completely equivalent to repurchases, accounting standards allow them to be kept off-balance sheet, which leaves risks.
Why are there different accounting principles for financing of the same nature? Because financial accounting theory believes that currency is a special asset, which is different from national debt and other existing assets, and should be treated separately. Therefore, it is not recorded in the balance sheet, but it is kept outside the balance sheet, but it is real. The debts have a real binding force on banks and financial institutions.
BIS (Bank for International Settlements) published several papers in the first half of this year, devoted to the issue of hidden debt. Are foreign exchange swaps and foreign exchange forwards debts? How should they be calculated? How big is this amount?
After reading the papers, the scale is intimidating. According to BIS statistics, by the end of 2019, non-U.S. banks around the world (that is, banks in other countries other than Bank of America) have as much as 30 trillion US dollars of off-balance sheet hidden debt, which is the nature of foreign exchange swaps and foreign exchange forwards. , far exceeding the 14 trillion dollar liabilities on the bank's balance sheet.
Looking at non-bank financial institutions around the world, such as hedge funds, pension funds, etc., their off-balance sheet implicit debt (also foreign exchange swaps, etc.) is as high as 18 trillion US dollars, which is still far more than the close to 12 trillion on the table. trillions of dollars in debt.
Therefore, due to the principle of accounting and bookkeeping, a financial black hole of 48 trillion US dollars is hidden in the global foreign exchange market, which is a black hole of rigid debt. Therefore, the bankruptcy of a foreign exchange risk counterparty or a series of such bankruptcies will threaten the safety of the entire debt.
Because everyone is in the same payment chain. For example, I signed a foreign exchange transaction with you. After one month, I will get 100 million US dollars, and you will get 680 million yuan. I will exchange it with you. Ok, we signed the treaty on this swap.
Similarly, behind me and behind you, there are a series of people signing swap contracts with us, so others are expecting me to get a sum of money, and behind my counterparty, there are other counterparties waiting for him In exchange for this money with me, if one of these two people goes bankrupt, the entire chain will be broken. Once the chain is broken, how will these rigid liabilities be cashed out? This will lead to huge debt risks.
Therefore, these papers on BIS generally believe that if the next financial crisis breaks out in the foreign exchange market, it will be a mess, and they don’t know how to clean it up.
In the 2008 financial crisis, this problem has actually been exposed once. During the financial turmoil in March 2020, the issue of foreign exchange swaps (rigid liabilities) reappeared.
In fact, we now completely rely on the Fed's central bank currency swap. Without this currency swap, everyone is finished. Now the invisible debt problem in the foreign exchange market has not disappeared, and it is still expanding. Seriously threatening the security of global financial markets. This is a hidden worry in the foreign exchange market.
>> Invisible payment risks in the foreign exchange market
In addition to the hidden debt risk, there is another risk---hidden payment risk.
There is a classic case of invisible payment risk: at 3:30 pm on June 26, 1974, the Herstatt Bank in Germany suddenly closed down. Note its closing time, which is 3:30pm, 6 hours earlier than New York.
The bank just received a deutsche mark this morning for foreign exchange swaps. The U.S. dollars corresponding to this money should have been paid to New York, but before it could be sent out, and the door in New York had not yet opened, the bank closed down first, and as a result, the money that should be paid was not paid. What did it lead to? The chaos of global payments.
Countless people were waiting for the money, and there was a line behind that bank in New York, because the bank in New York also did swaps with other people, and other people did swaps with other people. Everyone was waiting for the other party to pay them the money, but no one expected the bank to fail, and it happened within 6 hours of time difference.
As a result, bank runs and closures occurred in various countries, and many small banks collapsed. This is a real case.
This problem has aroused the long-term concern of the global financial community. This time-lag risk of foreign exchange payment and settlement must be resolved. What should we do? Real-time liquidation! ! ! This is the Continuous Link Settlement Bank established in 2002, referred to as CLS Clearing Bank. Liquidation is carried out in the form of PVP.
The so-called PVP refers to a transaction that either does not happen or happens at all. It will not happen, if a bank in the middle loses the chain, the entire payment system will collapse, and this phenomenon will not happen. After the transaction is issued, it can only be settled after the other party confirms it. This method can effectively avoid payment risks. Many currencies in developed countries basically adopt the PVP method.
But looking at the graph below (left one), you can see that since 2013, the proportion of PVP (green) has been decreasing. Because the foreign exchange trading volume of emerging market countries has soared, most currencies are not included in the CLS.
BIS has calculated that there are up to 8.9 trillion US dollars in cross-border payment and settlement of funds in the global foreign exchange market every day. A few of them are settled by PVP, but most of them are settled by non-PVP. That is to say, the money is always facing the risk of payment interruption. If any company goes bankrupt, any payment is not smooth, and the liquidation of the payment system will induce a global financial disaster. Just like what happened in 1974.
From this we can see how fragile the financial system, including the foreign exchange market, is. The U.S. dollar dominates as the central currency, and its vulnerability is becoming more and more obvious. The more people rely on it, the more the system can't bear this burden, which will form a fragile bottleneck and eventually lead to financial turmoil and financial crisis.
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