Crypto Twitter was abuzz over Reuter’s report that pension funds and other 'non-bank' financial firms have more than $80 trillion of hidden, off-balance sheet dollar debt in FX swaps, citing the Bank for International Settlements (BIS) records.
The warning was described as the FX swap debt "blind spot" that risked leaving policymakers in a "fog". FX swap markets occur where for example a Dutch pension fund or Japanese insurer borrows dollars and lends euro or yen before later repaying them.
Reuters noted that FX swap markets have a history of problems. For instance, the markets experienced funding squeezes during both the global financial crisis of 2008 and in March 2020 due to the COVID-19 pandemic. Both cases required central banks such as the U.S. Federal Reserve to intervene with dollar swap lines.
We spoke with Jason Brannigan of WOO Network Ecosystem team, to fully understand the implications of this news to the crypto industry. For starters, Brannigan noted that there’s always this hype on Crypto Twitter when headlines like this pop up with incredibly large numbers that indicate the world of traditional finance might be collapsing before us. However, he noted that while the news was alarming, there's often more to the story than these headlines.
Checking the figures: Should we be worried?
“Debt instruments are commonly used in TradFi and often in a far more conservative way than it looks on paper. FX swaps are a regular tool for pension funds and other investors to hedge the currency risk when making an investment overseas,” he said.
When a UK pension fund invests in US stocks, for example, they naturally assume the risk that USD will fluctuate against their local currency, in this case, GBP. If your investment goes up 10% but your currency rises 10% against the USD, you effectively break even on paper.
In order to access the true returns of the asset you invested in, you can take out an FX swap which hedges you versus currency fluctuations. If you hedge 100% and you need to pay $1m to cover the hedge, your investment will be up by $1m on paper purely due to currency movements so you're unaffected.
Now scale this up at a global, institutional level where trillions are invested, and it's easy to see how you can get such significant levels of FX debt, which in reality are simply proper risk management.
Watch out for the catch
Brannigan explained that some institutions will be hedging illiquid investments such as property or private equity as well as taking more directional bets on the currency.
This means returns may be up on paper for the illiquid assets, but if you are repeatedly paying for the currency hedge, you may start to run out of liquid assets to pay back the hedge when called.
This is where there could be potential for disaster, but not to the scale you may expect by looking at the numbers.
Proper risk management should prevent this, but with the wild currency swings in recent months, you start to see how some can be easily caught off guard.
“With USD dominance, some pension funds will be paying a lot on their hedges, which can become an issue when their USD investments are illiquid. So on paper, they’re up, but in reality, don’t have assets they can liquidate to cover the hedge.”
So what does this mean for Crypto Twitter and what should we take away from all this?
Well, whilst there are often scary numbers in the press, particularly when it comes to global debt, there is often more than meets the eye, he said.
"Do these headlines mean that the traditional finance world will collapse and crypto immediately sweeps in to replace it? Probably not in this instance. There are many risks in the traditional finance world and many ways crypto will disrupt it over the coming decades, but for now, we must simply continue to innovate and build for a brighter future so crypto is ready when we really need to worry about traditional finance markets," he noted.
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