A Great Headline on Debt. But Should We Really Be Afraid?

A new white paper creates a storm. But there are nuances.

During my time working in the foreign exchange (FX) market, I realized that there were two distinct market maker personalities. Spot traders, those involved with buying and selling currencies for spot (cash) settlement, were mostly bold and brash. They would walk round the floor like movie stars, lapping up the attention for being a lynchpin in the market process. Forward traders, though, those involved with buying and selling currencies on a settlement date in the future (for example one week to one year), were mostly shy and reserved. They were the movie studio workers, doing their job in the background without any glitz or glamour. The irony, of course, is that it is the forward FX market where the biggest positions are.

A new study from the Bank for International Settlements (BIS) titled, “Dollar debt in FX swaps and forwards: huge, missing and growing,” has created a stir because it claims that there is $65 trillion of hidden debt in the FX markets. The main reason for this conclusion is because FX swaps and forwards are not recorded on balance sheets in the same way as other derivatives. This is true, but can we question whether an FX forward is, in fact, a debt?

A big part of my roles in the past when managing currency risk was to attend to the forward exposure the fund had. This is a simple example of how the process would work.

The fund, let’s say based in British pounds, would buy a U.S. asset, for example a Treasury bond. To pay for that asset, the fund also must buy U.S. dollars, which it does by selling British pounds. That’s the spot transaction. But the fund doesn’t want exposure to movements in the exchange rate between pounds and dollars, and so a forward agreement is entered (with a bank) whereby the same amount of U.S. dollars is sold against pounds for settlement in 1-month. The spot and forward transaction together constitute an FX swap. This hedges the currency risk.

In a month’s time, if the fund still wants to hold the U.S. asset (the Treasury bond), then the FX swap must be rolled forward for another month. So, the fund buys U.S. dollars, sells pounds to close its short dollar side, and then sells dollars, buys pounds for another month. Rinse and repeat.

By selling U.S. dollars for settlement in 1-month, the fund is essentially borrowing U.S. dollars. That sounds like a debt. But the fund is also effectively lending British pounds on the other side. So, the danger is not really whether the “debt” can be repaid, but rather in the cost of maintaining it. Forward FX traders are basically interest rate traders, monitoring the differentials in rates between currencies and, as the BIS paper makes clear, when there is a scramble for a currency such as U.S. dollars (e.g., 2008 and 2020), the cost of servicing forward FX transactions can go up a huge amount. But that’s the cost, not the default risk.

Also, consider an example of a British corporate, perhaps a retailer, which has revenue coming in from its operations in the U.S. These dollar “receivables” will be hedged by forward FX transactions in which dollars are sold now, at the forward rate, in order to hedge against currency movements. When the dollar revenue is received by the company, they go to settle the forward FX obligation.

These examples constitute the bulk of forward FX transactions and, as you can see, in each example there is an asset behind the hedge. So, should they be considered debt? There are arguments on both sides.

What is true, though, is that there is undoubtedly massive settlement risk in forward FX transactions because the principal amount must be delivered and settled. Therefore, if one counterparty to the agreement goes bust, it could get very ugly. In that sense, yes, there is a case for being concerned, but counterparty risk is involved in every transaction. Nevertheless, don’t get too hung up about the $65 trillion “hidden” debt. As the song goes, “It’s Christmas time, there’s no need to be afraid.” Then again, “be it heaven or hell, the Christmas we get we deserve.”