Friday, 26 September 2008

Beware rising custody holdings

As RebelEconomist has previously discussed, the US financial system lifeboat (now officially known as the troubled asset relief program, or TARP) ought to damage US sovereign creditworthiness, and - because the easiest way for America to lighten its growing debt burden is to allow inflation to reduce its real value - increases the likelihood of dollar depreciation. Not surprisingly, there has been speculation that Asian and oil-producing country central banks and sovereign wealth funds, which are some of the largest holders of US public sector debt, will start reducing their dollar reserves. Since many of these national institutions do not publish details of the currency denominations and types of assets they own, skilled observers of international capital flows like Brad Setser study the weekly Federal Reserve balance sheet report for details of the Federal Reserve Bank of New York custody holdings on behalf of other central banks, which include US Treasury and agency bonds, for clues about changes in the size and composition of dollar reserves.

As Brad Setser noted overnight, Fed custody holdings have been increasing in the last couple of weeks, which suggests that the foreign central banks are not reducing their holdings of dollar reserves, but RebelEconomist suspects that the custody holdings may be a misleading indicator at the moment. This is because the custody accounts are probably being used in the dollar lending operations conducted by various developed-country central banks cooperating with the US authorities to cope with the present elevated global demand for dollar liquidity.

The dollars being lent by the participating central banks (the European Central Bank plus the central banks of Britain, Switzerland, Japan, Canada, Australia, Sweden, Denmark and Norway) are lent to them by the Federal Reserve, in return for a loan of their own currency, under a reciprocal swap lines arrangement. Being risk-averse institutions, central banks normally lend only against relatively good collateral when conducting liquidity-providing operations. When lending dollars to their own commercial banks, although central banks may be happy to take domestic currency bonds, they are likely to request additional collateral to do so, to provide additional protection against the currency mismatch. For example, the Bank of England requires 4% more collateral if non-dollar securities are pledged. In view of this, some of the central banks’ counterparties may pledge dollar bonds, including US Treasury and agency securities. If so, like the Bank of England, the central bank may request that the collateral be delivered into its Fed custody account for safekeeping. As it appears that the Fed custody holdings are reported on a settled basis (as opposed to a done basis), to the extent that the foreign central banks do take treasuries and agencies as collateral, their custody account holdings can be expected to increase.

Since the reciprocal swap arrangements have been expanded three times already this month, on the 18th, 24th, and 26th, and because the central banks involved have increased their dollar lending, other things equal, it would not be surprising to see an increase in Fed custody holdings at the moment. But this would not necessarily mean that central banks are accumulating dollar reserves, and may conceivably be concealing a reduction in dollar reserves holdings.

Addendum: how the swaps work:

The question of how the swaps work has arisen in the comments on this post.

Initially, I had imagined, for each increase in the reciprocal swap programme, a single foreign exchange swap between the Fed and each central bank involved, which effectively loaned the stated amount of dollars to the foreign central bank until April 30th 2009 (the programme's planned horizon at present) against collateral of their own currency, to be lent by them as the need for dollars arose from their commercial banks. I therefore thought that the swaps must be off-balance sheet, because there was no item on the Fed's H.4.1 report sufficiently large (ie $290bn from September 26th) to account for either side of the swap. After further consideration and discussion elsewhere, I now think that the announced size of the swap programme (which has since increased to $620bn) actually represents the maximum size of a portfolio of swaps. My guess is that, for each dollar loan auction by a foreign central bank, the dollars are drawn from the Fed via a matching currency swap of the same size and term as the loan. These dollar loans from the Fed are probably included in the “Other Federal Reserve Assets” line of H.4.1, but since they have yet to build up to their limit, that item remains much smaller than the reported size of the reciprocal swap programme.

I had been wondering about the pricing of the swaps, which would be a huge issue if the swap is for seven months and the dollar lending is for shorter periods, but I would expect that the terms of the swap are arranged so that their pricing reflects the dollar interest rate achieved in each auction. Nevertheless, it must be said that this kind of detail should be given in the notices (including from the foreign central banks involved) that announce these operations. Now that the swap programme is so large, the potential interest differentials (depending on how the swaps are arranged) are in the order of billions of dollars over the planned life of the programme.


Anonymous said...

Rebel --

My sense is that the swaps worked the other way: the ECB/ others posted euro collateral to borrow dollars from the fed. so the net effect was even more dollar credit extension, as the ECB/ BoE others supplied dollars to European institutions.

I don't think this would have an impact on the custodial data.

but let me work through this more

RebelEconomist said...


Here is what I think is going on: The swaps, which (now) involve a Fed dollar asset comprising $290bn in the central bank accounts at the Fed and a Fed foreign currency liability of equal value, presumably in accounts created for the Fed in the corresponding central banks, do not seem to appear on the H.4.1 report (there is no item that large which is not obviously something else). There will therefore be no trace on the balance sheet when the foreign central banks draw down their swap-related dollar accounts to lend to their banks. This lending by foreign central banks does represent dollar credit extension, but the Fed will offset it in their own operations (eg by lending less), so there will not be a rise in reported Fed dollar liabilities as a result. Nevertheless, any treasuries or agencies taken as collateral by the foreign central banks will probably be placed in safe custody with the Fed, and so will appear in the custody holdings (which are also off balance sheet).

MW said...

IIRC, the swap lines now stand at $620bn, with a wider range of foreign CBs, so presumably there'll be a commensurate effect on custody holdings.

Thank you for a very useful post.

HoosierDaddy said...

If I were a Sovereign looking to reduce dollar exposure without triggering a rush to the exits it seems like for a time you could game the system by holding steady or slightly boosting the amount stored at the NY Fed while cutting back on the purchases of (or even selling) dollar assets through other intermediaries

Anonymous said...

this crisis is making the US wealthier in comparison to rest of the world, and to Europe.

Here is briefly why:

1. US bonds have risen in price (lower yield).
2. Dollar has strengthened.
3. Dum money managers from overseas are holding the bag handed to them via mortgages, and low or worthless stocks they bought at the top.
4. Stock/corporate bonds can be destructed, but not the dollar (at least so far).

5. Corrollary: cash is in the hand of USA. Rest of the world has lost, and US can raise money (by selling bonds at low yield).

So all is good for USA when compared to others.

Insight is from:

Flow5 said...

Explanations: Report lines & T account flows:

“Modern Money Mechanics” — Changes in Foreign-Related-Factors:
#41 & #38 SWAP LINES

RebelEconomist said...


Nice idea. A central bank wishing to disguise a pull-out of treasuries could sell them and reinvest the proceeds in treasury repo (reverse repo, to be precise) to avoid the impact of their sales appearing in the custody holdings. To the extent that this increased the overall central bank (settled, but not done) holdings of treasuries because another central bank bought some of the treasuries sold, this might increase Fed custody holdings overall. However, it seems to me that any central bank with a large enough holding of treasuries to care about the impact of their sales on the custody holdings report would face a larger problem concealing the extent of their sales from the market.

A similar explanation might be that some central banks are wary about letting the private sector, or their custodian at least, know what they are holding, and therefore direct new purchases, or even transfer existing holdings, to the Fed.

An altogether more sinister reason for increases in Fed custody holdings that might interest your suspicious mind is that the Fed might be being used in a repo squeeze. If you want to fund your holding of a particular treasury issue in repo without the issue being lent in the specials market, lend it to a central bank that invests in reverse repo and does not lend its securities (in which case they are likely to be held at the Fed).

RebelEconomist said...

anonymous at 05 October 2008 22:38,

You are right that the crisis is hitting foreign holders of US assets, but it seems to me that this is going to amount to far less than the impact that it will have on US-owned assets. This includes both domestic assets, from financial assets like company shares to tangible assets such as idled factories etc, and foreign assets such as US holdings of emerging market stocks (ie "dark matter"), which have in many cases fallen further than the US market. I doubt that the Americans deliberately generated the crisis to stuff foreigners!

Another point that I often make (see my first ever post) is that the market tends to win in the end. If the US cheats its foreign creditors, they will demand a risk premium in future that may well end up costing the US more than its immediate gain. The only way of getting away with cheating your creditors is to avoid depending on them ever again (or at least until they forget what you did), and frankly, I cannot see the Americans having the grit to abruptly stop consuming more than they produce and not relapsing.

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