High-Rolling Central Banks

Swaps trading is increasing as nations defend their currencies.

The foreign-exchange market has become more leveraged in the past three years. Investors can thank central banks for that -- and hope that the world avoids major shocks, since the very institutions that are supposed to maintain stability are adding risk to the system.

Spot currency trading fell 19 percent to an average of $1.7 trillion a day in April, the first decline since 2001, the Bank for International Settlements said Thursday in its triennial survey of the market. The use of swaps, however, climbed 6 percent to $2.4 trillion.

Behind the shift probably are central banks, which have become big users of these derivatives -- especially in emerging markets -- as a cheaper way to control currency volatility. The People's Bank of China, for one, has become increasingly active

Or take Brazil. The central bank had a net long position of 199.4 billion reais ($61.2 billion) in swaps for its own currency on June 30. That was less than half the net 463.9 billion reais long it held at the end of December, just after the real reached the lowest point since it was introduced in 1992. That position in turn was more than 100 times the 4.2 billion reais at the end of 2012.

Leveraged Defense

As the Brazilian real was pressured, the central bank became a big player in the local foreign-exchange swaps market

Source: Banco Central do Brasil filings

That example shows why central banks have become such heavy hitters in the swaps market. The Brazilian bank's $117 billion position in derivatives at the end of December was equivalent to 32 percent of the country's foreign reserves at the time. In other words, to achieve the same intervention in the currency, the nation would have burned one-third of its reserves in the spot market.

Frazzled But Standing

The Brazilian real dropped 33 percent last year but the country's reserves remained steady -- thanks to swaps

Source: Bloomberg

Exhausting so large a chunk of reserves has consequences: Investors can start seeking the exits, exacerbating the selloff. Swaps do much less damage, which is why central banks have become so fond of them. 

But a swap is a leveraged investment. At the moment of establishment of the contract, no money is required from either party. As the currency moves, the party on the losing side deposits a margin that will later be used to pay the winner. Until settlement, both sides need only hand over the difference on their bet.

That's where the risk resides. If at settlement one of the parties can't make good, the default can reverberate through the market, especially if the party happens to be a central bank.

It's hard to see the institution responsible for printing money missing a payment but again, Brazil is a good example. Most of the time, the central bank was repaying swaps that matured by issuing new ones. If at any point it were to find no buyers, it would have to dip into reserves. The sudden drain could do even more harm than a slow erosion caused by spot intervention.

But that's just fearmongering, right? What could go wrong when the central banks of the biggest emerging markets use leverage to intervene in the world's most liquid market? Let's hope nothing.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

    To contact the author of this story:
    Christopher Langner in Singapore at clangner@bloomberg.net

    To contact the editor responsible for this story:
    Paul Sillitoe at psillitoe@bloomberg.net

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