Central bank swap lines and CIP deviations

• Date: 01 October 2017
• DOI: http://doi.org/10.1002/ijfe.1596
• Author: Richhild Moessner,Gabriele Galati,William Nelson,William A. Allen
• Published date: 01 October 2017

RESEARCH ARTICLE

Central bank swap lines and CIP deviations*

William A. Allen

1

| Gabriele Galati

2

| Richhild Moessner

3

| William Nelson

4

1

National Institute of Economic and

Social Research, London, UK

2

De Nederlandsche Bank, Amsterdam,

The Netherlands

3

Bank for International Settlements,

Basel, Switzerland and National Institute

of Economic and Social Research, London,

UK

4

The Clearing House, Washington, D.C.,

USA

Correspondence

Gabriele Galati, De Nederlandsche Bank,

Amsterdam, The Netherlands.

Email: e.b.g.galati@dnb.nl

JEL Codes: E52; E58; F31

Abstract

We study the use of U.S. dollar central bank swap lines as a tool for addressing

dislocations in the foreign currency swap market against the USD since the

global financial crisis. We find that the use of the Federal Reserve's USD central

bank swap lines was mainly related to tensions in U.S. money markets during

times of financial crisis, and less to tensions that were confined to foreign

exchange swap markets. In particular, we find that the use of USD central bank

swap lines did not react significantly to the recent period of persistent devia-

tions of covered interest parity since 2014. These results are consistent with

the view that the Federal Reserve was guided by enlightened self‐interest when

providing swap lines to foreign central banks, in order to reduce dislocations in

U.S. financial markets and support financial stability. In recent years, foreign

exchange swap markets have not functioned properly, but it appears that now

that the crisis is over, the Federal Reserve and other central banks have decided

against trying permanently to fill the gap left by the dysfunction in the commer-

cial foreign exchange swap market.

KEYWORDS

central bank swap lines, covered interestparity, financial crisis, foreignexchange swaps

1|INTRODUCTION

We study the use of USD central bank swap lines as a

tool for addressing dislocations in the foreign currency

swap market against the USD since the global financial

crisis, and compare it with their use as a tool for

addressing tensions in U.S. financial markets during

the crisis. We measure dislocations in the foreign cur-

rency swap market by cross‐currency basis swap

spreads, which indicate deviations from covered interest

parity (CIP) if they are non‐zero. We measure tensions

in U.S. money markets by spreads of U.S. Libor over

overnight‐index swap (OIS) rates.

During the global financial crisis, central banks

responded to the sudden drying up of liquidity in interna-

tional financial markets by setting up temporary inter

central‐bank swap lines. In December 2007, the Federal

Reserve provided intercentral‐bank dollar swap facilities

to the European Central Bank and the Swiss National

Bank, and later extended them also to other central banks

(see Allen & Moessner, 2010, 2011), in order to prevent

serious disruption to U.S. dollar financial markets. In

May 2010, The Federal Reserve re‐established temporary

swap lines with major central banks (the ECB, the Bank

of England, the Bank of Japan, the Bank of Canada, and

the Swiss National Bank), to provide dollars in response

to the international liquidity stresses created by the euro

area sovereign debt crisis, as part of coordinated action

by major central banks. From 31 October 2013, the Fed-

eral Reserve's earlier temporary swap lines with the

ECB, the Bank of England, the Bank of Japan, the Bank

of Canada, and the Swiss National Bank were turned into

standing swap lines for U.S. dollar and foreign currency

liquidity swaps, at unlimited amounts.

The cross‐currency basis is the difference between the

interest paid to borrow currency A by borrowing currency

Received: 31 July 2017 Accepted: 23 September 2017

DOI: 10.1002/ijfe.1596

394 Copyright © 2017 John Wiley & Sons, Ltd. Int J Fin Econ. 2017;22:394–402.wileyonlinelibrary.com/journal/ijfe