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 Since many of these national institutions do not publish details of the currency denominations and types of assets they own, skilled observers of international capital flows like Brad Setser study the weekly Federal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.