VoxEU Column International Finance

Money market tensions and international liquidity provision during the crisis

The world’s major central banks used underpublicised swap agreement to address mismatches in their currency-specific liquidity needs during the crisis. This column says these measures where highly effective and came at a very low cost.

The recent crisis has triggered a wide spectrum of policy responses, including many policies that were unthinkable two years ago. One of these unthinkable policies was the decision of the world's major central banks to engage in reciprocal swap agreements, which involve a central bank handing out liquidity denominated in foreign currencies to its counterparties.

In this column, we document that these swap agreements have been a very effective tool in addressing the mismatch of banks’ currency-specific liquidity needs. In contrast to most other policies, these measures had no direct costs. We also argue that the indirect cost – the loss of control over money supply – is highly contained since the spikes in the demand for foreign-denominated-funds are driven by liquidity demand shocks and are thus unlikely to have any inflationary effects.i

Systemic dollar and Swiss franc shortages during the crisis

In international currency markets, any bank can potentially obtain financing in any foreign currency by either directly going to the interbank market or by obtaining funds from its central bank and swapping the received funds into the foreign currency. In principle, the latter should ensure banks lend to other banks at rates that do not depend on the transactional currency.

Recent market turmoil, however, has highlighted that interbank money markets have temporarily not functioned smoothly. For example, Figure 1 documents the strains in the Swiss franc (CHF) money market arising in October 2008. The figure plots the difference between the unsecured and secured overnight interbank rate for CHF and euro funds. While these two spreads are historically rather low and co-move closely, the spread on Swiss francs rose steeply during October 2008, reaching values up to 300 basis points. The spread between the unsecured and secured overnight interbank rate for euro funds experienced no such spike.

Figure 1. Overnight interbank rate spread, Swiss franc vs. euro

The two horizontal lines correspond to the announcement (bright blue line) and the value date (dark blue line) of the EUR/CHF Foreign Exchange Swaps conducted by the SNB, ECB and NBP.

The Swiss-franc-specific spike in the cost of obtaining unsecured funds was caused by a combination of the need of foreign banks to continuously roll over maturing interbank loans and the drying up of supply for these funds. Given that the Swiss franc is a low interest rate currency, it is commonly used in Central and Eastern Europe (CEE) and Austria in private households as an underlying currency for mortgages and other debt (Auer and Wehrmüller2009).ii The banks active in these nations, in turn, finance a large share of their Swiss-franc-denominated loans on the unsecured interbank money market. Many of those banks are domiciled outside Switzerland and do not have access to the Swiss repurchase agreement (repo) market and, consequently, increasingly turned to unsecured funding leading to the spike in the rates on this market.

In a calm market environment, all Swiss domestics banks, as well as a considerable number banks of domiciled outside Switzerland that do have access to the Swiss repo system, would have immediately exploited this profit opportunity and provided unsecured funds to banks without access to the repo system. However, against the backdrop of the global financial crisis and the fear of counterparty default risk, this did not happen and the spread between secured and unsecured Swiss franc funds remained elevated for several trading days. Since the lack of access to the Swiss repo system implies that even banks with ample collateral cannot necessarily obtain secured funding, the local central banks could not control these developments.

To overcome this market friction, the Swiss National Bank (SNB) jointly announced with the ECB and subsequently with the Narodowy Bank Polski and the Magyar Nemzeti Bankiii that all these central banks would directly distribute Swiss-franc-denominated funds to their counterparties. Since nearly all banks that have to fund some Swiss franc exposure are registered with one of the four central banks and the conditions at which these funds are auctioned are equal, in effect the banking system instantly gained near universal access to primary source of Swiss francs, the SNB.

As can clearly be made out from Figure 1, the Swiss franc tensions in the unsecured market ceased once the first EUR/CHF swap auctions were implemented by the partner central banks.

Similar currency-specific tensions had arisen in the market for US dollar (USD) funds already during September 2007, which was addressed in December 2007 by the joint announcement of the Federal Reserve, the ECB, the SNB, the Bank of England, and the Bank of Canada. The direct distribution of USD to banks domiciled outside the US was necessary to address the liquidity tensions arising from the substantial short USD position of European banks (see Gyntelberg 2009). Liquidity tensions eased shortly after the first auctions of USD by the European central banks.

What is the cost of such agreements?

Central banks can effectively address international liquidity mismatches using these international swap agreements, but what are the costs of these agreements? Since they are just a means to distribute liquidity more effectively, they involve no direct costs.iv

The main worry is that such swap agreements could create inflationary pressure since opening new means to distribute liquidity can increase the total demand for and consequently the supply of money. Moreover, the maximum amount of a swap agreement is agreed upon several months in advance or may even be unlimited. Since the receiving central bank may auction off the maximum amount but can only supply as much funds as are effectively demanded by its banking system, the uncertainty in the growth of the money supply increases.v

There are, however, two main reasons why the loss of monetary control is rather contained. First, the central bank that is originating the funds can sterilise the effect on the monetary supply by issuing own debt certificates or conducting liquidity-absorbing operations.

Second, even if complete sterilisation of excess liquidity is not possible, closer inspection of the volumes and maturities involved in the swap agreements show that the potential inflationary pressure is likely to be negligible. In Figure 2, we list the outstanding volume of USD repo outstanding in Switzerland at different maturities. Once interbank tensions levelled off, central banks started to apply a penalty surcharge on the interest rate. As shown, banks thereafter turned to the cheaper liquidity sources, namely the interbank market, and consequently the demand for foreign liquidity went to levels near zero.

The fact that demand for foreign-denominated-currency spikes only when liquidity tensions are high implies that the inflationary effect of these swap agreements is very contained. When liquidity demand spikes, banks tend to hoard any funds they receive and increasing the money supply does not create inflationary pressure. In contrast, in calm times, the swaps are not used since banks finance themselves on the interbank market. Since swap agreements are essentially not used precisely in circumstances were increasing money supply would create inflationary pressure, their effect on inflation is minimal.

Figure 2. Outstanding USD repo volume and maturities


When liquidity demand spikes, small frictions in the private sectors' means of distributing liquidity internationally can have large effects on the interest rate paid.

While such international liquidity mismatches are of little concern at the current juncture, they could become elevated again. Already now, the prospect of a global recovery is starting to lure investors back into the carry trade in currencies such as the Brazilian Real or the Australian Dollar (see Shah 2009), despite the high risk that such positions entail. Also foreign-denominated loans in CEE and Austria – which came to a virtual halt in the face of the global financial crisis – might soon see a revival.vi

These developments have to be carefully scrutinised, since the stability of the financial system is far from being fully restored. A revival of the carry trade could create tensions on international money markets. However, central banks will refrain from making these swap agreements a permanent tool, as the refinancing of such high-risk positions should be conducted on the interbank market.


i The Study Group established by the Committee on the Global Financial System (CGFS) analysed the central bank’s response to the money market tensions that emerged in August 2007 and how effective those responses were. See BIS (2008).

ii The aggregate exposure of these nations to low-interest rate currencies has already caused losses of around 60 billion USD for these nations (see Auer and Wehrmüller 2009).

iii On 15 October 2008, the SNB and the ECB jointly announced that they would conduct EUR/CHF swaps providing Swiss francs against euro. The Narodowy Bank Polski and Magyar Nemzeti Bank joined the concerted auction starting 17 November 2008 and 2 February 2009 respectively.

iv A potential worry is that these agreements could entail a larger counterparty default risk. This is not the case. First, there is no risk involved for the central bank handing out the funds, since the receiving central banks guarantee these transactions. Second, there is also no effect on counterparty default risk for the receiving central bank since it transacts with its regular counterparties against the regular range of eligible collateral or against another currency.

v While giving away some control over monetary policy to other central banks is of little concern in the current low-inflation environment, such concerns will definitely become a first order political topic once inflationary pressures pick up and central banks have to refocus on their core task of maintaining price stability.

vi For example, despite the high risk entailed in these products, Kerschbaumer (2009) has argued in a nationwide Austrian newspaper has recently argued that Austria’s financial supervisory bodies, the Finazmarktaufsicht and the Austrian National Bank, should discontinue their advise against the issuance of loans denominated in foreign currencies.


Auer, Raphael and Simon Wehrmüller (2009). “$60 billion and counting: Carry trade-related losses and their effect on CDS spreads in Central and Eastern Europe”. VoxEU.org, 20 April.

BIS (2008), “Central bank operations in response to the financial turmoil”, Committee for Global Fianacial Stability, CGFS Publications No 31, Bank for International Settlements, July.

Gyntelberg, Jacob, Patrick McGuire, and Goetz von Peter (2009). “Highlights of international banking and financial market activity”, BIS Quarterly Review, June.

Kerschbaumer, Andreas (2009). “Keine Fremdwährungskredite: "Banken sind Nutznießer", Die Presse, 9 August.

Shah, Neil (2009). “Why the 'Carry Trade' Is Back“, Wall Street Journal, 18 August.

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