A wide range of economists from all schools of thought has warned about a dramatic shift in the global financial system, whether it is the worldwide de-dollarization campaign or central bank digital currencies (CBDCs) taking over cash. But could the international forex market destroy the current financial system instead? This could be a vital development to monitor heading into 2023, according to a new report from the so-called central bank for the world’s central banks.
The $80 Trillion Problem in the Forex Market
In the last couple of years, FX swap markets have exploded in volume and valuation size. This consists of a foreign pension fund borrowing US dollars and lending another currency before repaying the money. So, for example, a British insurer may borrow dollars and lend pounds before making repayments. Today, this trading method has run into a bit of a problem, an issue worth roughly $80 trillion.
The Bank for International Settlements (BIS) published its quarterly review on Dec. 4, warning that pension funds and non-bank financial institutions maintain approximately $80 trillion in hidden and off-balance dollar debt in the shape of FX swaps. The funding squeezes unfolding – coupled with a lack of information surrounding dollar debt – occurred during the 2008 financial crisis and in the early days of the coronavirus pandemic that forced the Federal Reserve to issue dollar swap lines.
In other words, the forex market is going through a worldwide liquidity squeeze, mainly due to the dollar representing 87% of foreign exchange transactions. Everyone has been trying to get their hands on the buck as the US Dollar Index (DXY), a gauge of the greenback against a basket of currencies, surged in September to a 20-year high of 114.00. The dollar squeeze has exacerbated FX conditions.
Report authors Claudio Borio, Patrick McGuire, and Robert McCauley purported that the $80 trillion in hidden debt surpasses the stocks of all dollar Treasury bills, commercial paper, and repurchasing agreements (repos) combined. It is estimated that non-US banks and non-US non-banks, like pension funds, possess FX swap obligations that are double what is listed on their on-balance sheets.
"The missing dollar debt from FX swaps/forwards and currency swaps is huge," the BIS researchers wrote in the report. "In times of crisis, policies to restore the smooth flow of short-term dollars in the financial system (e.g. central bank swap lines) are set in a fog."
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Meanwhile, the BIS concluded its report by alluding to how the global financial markets have largely averted a crisis amid higher interest rates and slowing money-supply growth, despite stocks and other investment segments having slipped into a bear market. While it had championed substantial interest rate hikes from central banks across the globe, BIS officials suggested that finishing the present tightening cycle early might be necessary amid soaring debt levels and borrower sensitivity.
"The simple answer is one is closer than one was at the beginning, but we don’t know how far central banks will have to go," the report explained. "The enemy [inflation] is an old enemy and is known. But it’s a long time since we have been fighting this battle."
Is FX Sending Signals?
The 24/7 forex market is the world's largest and most liquid component of the global financial system, accounting for about $7 trillion of trading volume each day. It is a crucial arena since it sends signals about the performance of a currency and supports payments of one currency into another. Due to the weakness of foreign currencies everywhere, the forex market already may be sending signals of a coming crisis, with a plethora of advanced currencies sliding this year, from the yen to the Swiss franc to the euro. Indeed, because of skyrocketing outstanding FX debt, other markets could be forced to print more of their currency units to swap for dollars. If this adds to higher inflation rates, the greenback may rise again, creating a vicious cycle in the foreign-exchange arena.
