BIS analysis shines light on persistent risks in foreign exchange trades, hidden dollar debt: BIS Quarterly Review

• New BIS analysis of the 2022 Triennial Central Bank Survey shows shifts in trading patterns and market structure in foreign exchange and over-the-counter interest rate derivatives markets, identifying risks deserving attention.
• Foreign exchange swap positions point to over $80 trillion of hidden US dollar debt, reported off-balance sheet. 
• The volume of daily foreign exchange turnover subject to settlement risk remains stubbornly high despite mechanisms to mitigate such risks.  

The Bank for International Settlements (BIS) today published new insights on global foreign exchange (FX) and over-the-counter (OTC) interest rate derivatives markets. This December 2022 Quarterly Review provides detailed analysis of the recently published Triennial Survey, which aims to help central banks and market participants to monitor global financial markets. The authors analyse shifts in trading patterns and market structure and identify risks that warrant further attention.

The new data show that $2.2 trillion worth of currency trades  are exposed to settlement risk on any given day, potentially undermining financial stability. FX settlement risk involves one counterparty to a currency trade making a payment to the other but not receiving the currency it is buying. This can lead to significant losses for market participants. Authors Marc Glowka and Thomas Nilsson say the amount at risk in April 2022 represents about one third of total deliverable FX turnover and is up from $1.9 trillion three years earlier. 

The survey also put a spotlight on growing off-balance sheet US dollar borrowing in the form of FX swaps, forwards and currency swaps. Claudio Borio, Robert McCauley and Patrick McGuire explain that these instruments currently give rise to future payment obligations equivalent to over $80 trillion worldwide. But since the obligations are not reported on banks' balance sheets, standard debt statistics fail to capture them.

BIS analysis of the Triennial Survey continues to shed light on some corners of global financial markets that would otherwise go unnoticed. The rich data set allows us to detect important trends for policymakers, researchers and market participants. In particular, there is a staggering volume of off-balance sheet dollar debt that is partly hidden, and FX risk settlement risk remains stubbornly high.

Claudio Borio, Head of the Monetary and Economic Department

The Quarterly also includes the regular BIS analysis of recent market developments. In this issue, the BIS notes that investors remained focused on central banks' inflation fight amid risks to growth in the period under review.¹  Through mid-October, short-term sovereign yields rose on higher expected policy rates, which weighed on risky assets and supported the US dollar. Following a weaker than expected inflation reading in November, equities recouped losses and the dollar fell relative to most currencies from multi-decade highs, as the market reassessed downward the extent of policy tightening ultimately needed to contain inflation.

Earlier this year, the US dollar strength, combined with high commodity prices, created a double whammy shock to many countries struggling with inflation in their domestic currencies. The recent depreciation of the dollar could help alleviate some of these strains.

Hyun Song Shin, Economic Adviser and Head of Research

Additional features analyse interest rate derivatives markets, trading of emerging market currencies and settlement risk:

• "The post-Libor world: a global view from the BIS derivatives statistics", by Wenqian Huang and Karamfil Todorov, documents how the transition from Libor to "nearly risk-free" rates has led to structural changes in OTC interest rate derivatives markets. The benchmark reform led to material shifts in the instrument mix, geographical distribution and currency composition of OTC interest rate derivatives turnover. The reform reduced some risks from the Libor era but gave rise to new ones.
• "The global foreign exchange market in a higher-volatility environment", by Mathias Drehmann and Vladyslav Sushko, discusses the Triennial Survey results obtained amid more volatile markets than in 2019. FX trading continues to shift away from multilateral platforms, where price information is available to all participants, towards "less visible" venues. Less visibility hinders policymakers from appropriately monitoring FX markets.

• "The internationalisation of EME currency trading", by Julián Caballero, Alexis Maurin, Philip Wooldridge and Dora Xia, discusses the increased participation of non-residents in the trading of emerging market economy (EME) currencies. This is one of several trading patterns indicating that EME and advanced economy currencies have become more alike.
• Finally, two boxes analyse liquidity risk in mortgage-backed securities markets and draw lessons from the gilt market turmoil about systemic risks stemming from the pension fund and insurance sectors.

¹ The period under review extends from 13 September 2022 to 25 November 2022.