Swap Line: Definition, Purpose, Examples

how does credit default swap work

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Definition:  A swap line is another term for a temporary reciprocal currency arrangement between central banks. That means they agree to keep a supply of their country's currency available to trade to another central bank at the going exchange rate. It's used for overnight  and short-term lending only. Most swap lines are bilateral. which means they are only between two countries' banks.

Swap Line Purpose

The purpose of a swap line is to keep liquidity in the currency available for central banks to lend to their private banks to maintain their reserve requirements .

This liquidity is necessary to keep financial markets  functioning smoothly during crises. This reassures banks and investors that it is safe to trade in that currency. It also confirms that the central banks won't let the supply of that currency dry up. It's another monetary policy tool .

The Federal Reserve operates these swap lines under the authority of section 14 of the Federal Reserve Act and in compliance with authorizations, policies, and procedures established by the Federal Open Market Committee (FOMC).

Dollar Swap Line

On December 12, 2007, the Federal Reserve  opened a dollar swap line with the European Central Bank (ECB) and the Swiss National Bank.

On September 18, 2008, the Federal Open Market Committee  authorized a $180 billion expansion of its swap lines, extending them to the central banks of Japan, England and Canad. The Fed worked in conjunction with other central banks around the world to stop the banking panic that temporarily shut down money market accounts.

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This followed the bankruptcy of Lehman Brothers and the unprecedented $85 billion bailout of AIG. For more, see "Worst Global Financial Crisis Since the Great Depression ."

From September 24 - October 29, the Fed extended its dollar swap to Australia, Norway, Denmark, New Zealand, Brazil, Mexico, Korea, and Singapore. This indicates how the

banking panic, which started in New York, had spread throughout the world in just six weeks. It also shows the steps the Fed needed to take to support the U.S. dollar 's position as the world's global currency. If the dollar were ever going to collapse. it would have done so at that time. (Source: Michael J. Fleming and Nicholas, J. Klagge, "The Federal Reserve's Foreign Exchange Swap Lines ," Federal Reserve Bank of New York, April 2010)

Currency Swap Line

In October 2013, the ECB agreed to a three-year currency swap line with the Central Bank of China. The ECB now has instant access to 350 billion in yuan. and China has instant access to €45 billion. The swap arrangement creates liquidity in case of emergency, making it safer for Eurozone banks to do business in yuan instead of insisting on dollars or euros. (Source:Q&A: What's a Currency Swap Line?  WSJ. October 10, 2013)

China also created swap lines with Hungary, Albania and Iceland. Its Central Bank's goal is to gradually untie the yuan from its peg to the dollar and make it one of the world's top-traded currencies. For more, see Is the Yuan Replacing the Dollar As the World's Reserve Currency?

How It Affects You

Central bank swap lines keep the global financial system functioning by providing the credit it needs for day-to-day operations. Without this credit, grocery stores couldn't pay truckers to deliver food. Gas station owners wouldn't be able to order new tanks to refill the ones that go dry. Your employer would ask you to work without being paid this week.

You might think this could never happen, but it almost did on September 17 2008. That's when credit started to dry up, and businesses panicked. They started withdrawing their overnight cash deposits held in money market accounts. The Fed created several tools to support liquidity in the money market accounts, restoring confidence at that time. The U.S. Treasury Secretary Hank Paulson worked with the Fed to go to Congress and ask for a $700 billion bailout to reassure the financial industry a worse collapse. In this case, the swaps were not enough to reassure markets. For more, see 2007 Financial Crisis . Article updated December 21, 2014.

Source: useconomy.about.com

Category: Forex

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