Swap lines are agreements between central banks to exchange their country's currencies to one another. They keep a supply of currency available to trade with the other central bank at the going exchange rate.
Banks use swap lines for overnight and short-term lending only. Most agreements are bilateral, which means they are only between two countries' banks.
What Is a Swap Line?
Swap lines are arrangements between two central banks to keep currency available for their member banks in the reciprocal countries. These agreements stabilize markets when they become stressed. They reassure banks that there won't be a run on a specific currency that they won't be able to meet. Swap lines keep plenty of currency available during times of stress.
How It Works
For example, the Federal Reserve provides U.S. dollars to a foreign central bank. At the same time, the foreign bank provides the equivalent amount of its currency to the Fed. The value is based on the market exchange rate at the time of the transaction.
The two banks agree to swap back these quantities of their two currencies at a specified date in the future. It could be as short as the next day or as far ahead as three months. They use the same exchange rate as in the first transaction. For this reason, these swaps carry no exchange rate or other market risks.
The purpose of a swap line is to keep liquidity in the currency available for central banks to lend to their private banks to maintain their reserve requirements.
The liquidity is necessary to keep financial markets functioning smoothly during crises.
It reassures banks and investors that it's safe to trade in that currency. It also confirms that the central banks won't let the supply of that currency dry up. It's another monetary policy tool.
The Federal Reserve operates these swap lines under the authority of section 14 of the Federal Reserve Act. All swaps must comply with authorizations, policies, and procedures established by the Federal Open Market Committee (FOMC).
There are two types of swap lines: the dollar swap line and the currency swap line. In the dollar swap line, the Fed provides dollars to a foreign central bank. In the currency swap line, the foreign central bank provides its currency to the Fed.
Dollar Swap Line
On Dec. 12, 2007, the Federal Reserve opened a dollar swap line with the European Central Bank (ECB) and the Swiss National Bank. It subsequently. expanded swap lines with other nations' central banks.
The Fed worked in conjunction with other central banks around the world to stop the banking panic that temporarily shut down money market accounts.
It followed the bankruptcy of Lehman Brothers and the unprecedented bailout of the American International Group (AIG.)
From September 24 to October 29, 2008, the Fed extended its dollar swap to Australia, Norway, Denmark, New Zealand, Brazil, Mexico, Korea, and Singapore. It indicates how the banking panic, which started in New York, had spread throughout the world in just six weeks. It also shows the steps the Fed needed to take to support the U.S. dollar's position as the world's global currency. If the dollar were ever going to collapse, it would have done so at that time.
The Fed maintained a permanent swap line with the Bank of Canada, the Bank of England, the European Central Bank, the Bank of Japan, and the Swiss National Bank. The other swaps were allowed to expire after the crisis subsided.
On March 19, 2020, the Fed added swap arrangements to cope with the 2020 recession caused by the COVID-19 pandemic.
The Fed added swap lines with the banks of Australia, Brazil, Denmark, Korea, Mexico, New Zealand, Norway, Singapore, and Sweden. The agreements were for at least six months. It was done to make sure there were no monetary crises during the pandemic.
Foreign Currency Swap Line
In April 2009, the Fed announced currency swap lines with the central banks of England, ECB, Japan, and Switzerland. It wanted to reassure U.S. banks there would be enough of those countries' currencies on hand if they needed it. These swap lines terminated on Feb. 1, 2010.
In November 2011, the Fed authorized new swap lines with Canada and the above countries. These are bilateral agreements among the six banks to make sure their countries have enough of all currencies involved. In October 2013, the central banks made the agreements permanent, until further notice.
How It Affects You
Central bank swap lines keep the global financial system functioning by providing the credit it needs for day-to-day operations. Without this credit, grocery stores couldn't pay truckers to deliver food. Gas station owners wouldn't be able to order new tanks to refill the ones that go dry. Your employer would ask you to work without being paid this week.
You might think this could never happen, but it almost did on September 17, 2008. That's when credit started to dry up and businesses panicked. They started withdrawing their overnight cash deposits held in money market accounts.
The Fed created several tools to support liquidity in the money market accounts, restoring confidence at that time.
The U.S. Treasury Secretary Hank Paulson worked with the Fed to go to Congress and ask for a $700 billion bailout to reassure the financial industry. In this case, the swaps were not enough to reassure markets.