Swap lines are agreements between central banks to exchange their countries' currencies with 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 that 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 markets 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 Swap Lines Work
The Federal Reserve provides U.S. dollars to a foreign central bank. The foreign bank provides the equivalent amount of its currency to the Fed at the same time. The value is based on the market exchange rate at the time of the transaction.
The two banks agree to swap these quantities of their two currencies back at a specified date in the future. The date could be as soon as the next day, or it could be as far ahead as three months. They use the same exchange rate as in the first transaction. These swaps carry no exchange rate or other market risks for this reason.
The Purpose of Swap Lines
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.
Liquidity is necessary to keep financial markets functioning smoothly during crises.
This 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).
Examples of Swap Lines
There are two types of swap lines: the dollar swap line and the currency swap line. The Fed provides dollars to a foreign central bank in a dollar swap line. The foreign central bank provides its currency to the Fed in a currency swap line.
The Dollar Swap Line
The Federal Reserve opened a dollar swap line with the European Central Bank (ECB) and the Swiss National Bank on December 12, 2007. 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. This followed the bankruptcy of Lehman Brothers and the unprecedented bailout of the American International Group (AIG.)
The Fed then extended its dollar swap to Australia, Norway, Denmark, New Zealand, Brazil, Mexico, Korea, and Singapore from September 24 to October 29, 2008. This move 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 had to take to support the U.S. dollar's position as the world's global currency. The dollar would have collapsed at that time if it were ever going to do so.
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.
The Fed added swap lines with the banks of Australia, Brazil, Denmark, Korea, Mexico, New Zealand, Norway, Singapore, and Sweden. These agreements were for at least six months and ensured that there were no monetary crises during the pandemic.
Foreign Currency Swap Line
The Fed announced currency swap lines with the central banks of England, ECB, Japan, and Switzerland in April 2009. It wanted to reassure U.S. banks that there would be enough of those countries' currencies on hand if they needed it. These swap lines terminated on February 1, 2010.
The Fed authorized new swap lines with Canada and the above countries in November 2011. The central banks made the agreements permanent until further notice in October 2013. These are bilateral agreements among the six banks to ensure that their countries have enough of all currencies involved.
How Swap Lines Affect You
Central bank swap lines keep the global financial system functioning by providing the credit it needs for day-to-day operations. Grocery stores couldn't pay truckers to deliver food without this credit. Gas station owners wouldn't be able to order new gas to refill tanks that go dry. Your employer would ask you to work without being paid.
You might think that these crises could never happen, but they 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.
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.