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Largely as a response to a rapid bear market and an evolving pandemic, central banks have gone all-out and thrown out the kitchen sink: everything from conventional monetary policy taken to the most aggressive level possible, such as the Federal Reserve lowering nominal interest rate targeting to essentially zero — to more unconventional monetary options: the Federal Reserve restarting quantitative easing, and the European Central Bank announcing that it would purchase distressed commercial assets on its balance sheet.
Much of the post Great Recession response has been reactivated in this latest round of monetary policy with surprising speed and ferocity. Central banks around the world are being aggressively proactive and deploying every tool they have. This includes reactivating currency swaps between different central banks — one tool that the Financial Times called the “most important Fed action so far” in an opinion piece.
What are currency swaps, and why do they matter so much to the global financial system?
Currency swaps allow central banks to open channels between one another, transferring domestic currency for foreign currency and letting foreign central banks loan out the exported currency at their own policy preferences and terms. This is specifically important for the Federal Reserve and the US dollar, since USD acts as a safehaven asset of sorts during financial contractions. Banks and other entities around the world that operate in USD will suddenly find their costs elevated and in order to fund operations that require USD, they will themselves increase the price for USD — potentially undermining Federal Reserve policy.
Currency swaps are important for exactly that reason. From this example, one can see how foreign demand for the US dollar affects US monetary policy outcomes — in order to assuage broken markets for foreign demand, the Federal Reserve cannot legally extend loans to non-American banks that are not under its jurisdiction — so it must rely on foreign central banks to provide that liquidity under their rules and procedures.
In short, if there is global demand for US dollars, and a global imbalance for them, the Federal Reserve must work with other central banks to resolve these issues.
The Federal Reserve has just launched a new program of currency swaps with nine other central banks, promising to exchange US dollars for foreign currency to alleviate US dollar demand in different markets. They are “capped at $60 billion for six central banks in Australia, Brazil, Mexico, Singapore, Korea and Sweden. The exchange lines are capped at $30 billion for central banks in Denmark, Norway and New Zealand.” As part of the response to the Great Recession, the Federal Reserve extended currency swap lines to old political allies, such as the Bank of England, the European Central Bank, and the Bank of Canada.
Currency swaps and their implementation were something that some central banks piloted with blockchain experiments. The Bank of Canada cited distributed ledger technology or DLT as one way central banks could save up to “$20 billion a year in global back-office costs”, especially with cross-country currency swaps.
This was a major focus of the Bank of Canada’s DLT experiment with Project Jasper. Though the Bank of Canada had mixed feelings about their DLT experiment in contrast with existing systems, it lead them to comment that “together we can support a smooth evolution to tomorrow’s financial system – safe, sound and serving the people who rely on it.”
The Monetary Authority of Singapore then connected their payments network with the Bank of Canada’s payments network to effect a small cross-border currency swap of about 105 Singapore dollars.
Practically speaking, it’s a small amount — but this does auger well for the new reality we live in. Central banks are aggressively extending currency swaps to one another, a trend seen just recently in the last two decades. In doing so, they are already turning central bank orthodoxy on its head — highlighting and perhaps furthering the need to incorporate new approaches to currency swaps.
After all, here, we’re talking about central banks transferring values among different national ledgers and systems. DLT and blockchain could be used to settle differences between those two different accounts more rapidly and with cost savings, allowing for central banks to extend their decisions to other cooperating central banks, and allowing for more fluid global responses.
There are also political and trust considerations for currency swaps, which is why central banks usually impose a limit and are careful about choosing which countries to extend currency swaps with.
This matters all the more now, with the COVID-19 pandemic driving extreme volatility in markets. A global response requires fluid coordination with minimum delay. It’ll be interesting to see if central banks rely on DLT and blockchain more often. The reactivation of emerging currency swaps once again prove that distributed ledger technology and blockchain can help with unprecedented financial and economic problems.
The market is no longer responding very strongly to individual central banks taking extremely proactive actions: it now takes a global coordinated response to spark rallies lasting longer than 30 minutes. In this environment, currency swaps may be one of the most important and potentially still effective monetary tools available for central banks to help support the response to the COVID-19 pandemic — and blockchain can help.
