Currency Swaps, the Dollar, and a Tilted Playing Field
Some pretty big news came out on Thursday (9/24/09) regarding a seemingly obscure program to end what were called "currency infusions."
In fact, these are "currency swaps," and you might want to pay attention to them, because of their high degree of correlation with the rise and fall of the dollar. Currency swaps also offer the perfect vehicle for central banks to engage in currency intervention and manipulation, especially if one of the parties (*cough*US*cough) has a massive trade imbalance and lacks sufficient FOREX reserves to use in daily market intervention activities.
Here's the news:
WASHINGTON (Reuters) - Major world central banks announced on Thursday that they planned to scale back massive injections of U.S. dollars into their banking systems as financial markets stabilize after a devastating crisis.
The U.S. Federal Reserve said it would begin to scale back short-term cash auctions in early 2010, while the European Central Bank, the Swiss National Bank, and the Bank of England announced they would curtail steps taken to ensure dollar liquidity.
This isn't part of the exit strategy per se," said Chris Rupkey, an economist for Bank of Tokyo/Mitsubishi UFJ in New York. "It just recognizes that banks have less need for liquidity."
What are currency swaps? Erik deCarbonnel provides this description:
How currency swaps work
The easiest way to understand currency swaps is to think of them as two separate zero-interest loans. For example, let’s say the fed and the ECB arrange a 80 billion euros ($107 billion) swap. The ECB then lends the 80 billion euros to the US, and the US loans $107 billion dollars to the ECB. Later, at an agreed date, the currency swap is reversed: the ECB returns the $107 billion dollars to the fed, and the fed pays back 80 billion euros.
How central banks use currency swaps
Central banks use the foreign currency from swap agreements to prop up their domestic currency by:
A) Providing the foreign currency to domestic financial institutions. (If those institutions were forced to go to the exchange markets for funding, it would drive down the value of the domestic currency.)
B) Using the foreign currency to directly intervene in exchange markets.
Why currency swaps are so popular
Currency swaps allow central banks to borrow foreign currencies without revealing that their country's banking system or currency is in trouble. In other words, since both central banks involved in a currency swap borrow foreign currencies at the same time, it is difficult to tell which central bank needed them the most. It is this lack of transparency which makes currency swaps so attractive to central banks.
In late 2008, the Federal Reserve entered a massive currency swap arrangement with a variety of central banks all over the globe. Here's how the Fed describes that program:
Currency Swaps At the same time it introduced the TAF, the Federal Reserve announced it would extend currency swap lines with the European Central Bank and the Swiss National Bank. The swap lines provide these central banks with dollars, which they can use to supply liquidity to credit markets in their jurisdictions that are based on dollars. In September 2008, the currency swap lines with the ECB and SNB were increased, and new swap lines with other central banks were authorized, including the Bank of Japan, the Bank of England, and the Bank of Canada.
And here's the reason that we might care to track such programs carefully. Note the strong correlation between the currency swap program and the USD index:
Here we might note that the startling run of dollar strength that caught so many investors off guard (but not Goldman Sachs or JP Morgan, it should be noted) began just in front the steep, half-trillion US dollar currency swap operation that began in earnest in fall of 2008.
Note also that the double top in the USD and its subsequent slide all line up nicely with the swaps additions and withdrawals. Correlation is not causation, but this is a pretty cozy relationship, and it possibly explains one of the more unusual periods of dollar strengthening in recent history.
Speaking of cozy relationships, the one between the NY Federal Reserve and big Wall Street institutions stands out, as do the outsized trading returns that quite conveniently repaired more than a few large firms during this same period of time.
I would humbly submit that Goldman Sachs 97% trading win ratio for 2Q09 is perfectly acceptable evidence that the playing field is not level and that, at the very least, we can agree that the appearance of insider trading exists.
Even now Goldman is "struggling" with the PR nightmare of how to explain an "embarrassment" of riches:
For Goldman Sachs CEO Lloyd Blankfein, an embarrassment of riches has turned into embarrassing riches.
Goldman's bonus pool is expected to swell to an estimated $16 billion after what's expected to be another stellar quarter, and Blankfein is struggling to figure out how to pay his employees in a way that keeps them happy while avoiding another round of populist and political outrage like the bank experienced over the summer.
It really is up to the Fed to prove that they did not tip off a few favored struggling big banks (which magically repaired their balance sheets with magnificent winning trading-desk results over this time frame), than it is up to anybody else to prove that they did.
After all, in a supposedly free market economy, it is critical that the appearance, if not the fact, of an even-playing field be maintained.
This next story, which I carefully saved because I thought it provided critically important insights into the cozy relationship between Wall Street and the Federal Reserve, makes it pretty obvious that the free flow of information between the two is not a matter of speculation, but is a matter of normal daily operations:
NEW YORK -- The low-slung cubicles wrap around the ninth floor of a building three blocks from Wall Street, each manned by a young staffer staring at flashing numbers on a flat-screen computer monitor and working the phones to gather the latest chatter from financial markets around the world.
It could be any investment bank or hedge fund. Instead, it is the markets group of the Federal Reserve Bank of New York, which has been on the front lines of the government's response to the financial crisis. Federal Reserve and Treasury Department officials make the major decisions, but the New York Fed executes them.
The information gathered there provides crucial insights into the financial world for top policymakers. But the bank is so close to Wall Street -- physically, culturally and intellectually -- that some economic experts worry that the New York Fed puts the interests of the financial industry ahead of those of ordinary Americans.
"The New York Fed sticks out as being not just very, very close to Wall Street, but to the most powerful people on Wall Street," said Simon Johnson, an economist at MIT. "I worry that they pay too much deference to the expertise and presumed wisdom of a sector that screwed up massively."
Even some former insiders at the Fed say the bank does not pay enough attention to the fundamental flaws in the country's financial system or to the risks associated with bailing out financial firms -- for instance, the chance that banks will be encouraged to take more unwise gambles. These experts worry that the New York Fed has adopted the mindset of a trading floor: well attuned to ripples in financial markets but not to long-term trends and dangers.
Last month, for instance, Wall Street bond traders wanted the central bank to ramp up its purchase of Treasury bonds, which would help the traders by driving up prices. But Fed officials in Washington and around the country concluded that such a move would be counterproductive in the longer run, in contrast to some New York Fed staffers, whose views more closely mirrored those on Wall Street.
New York Fed employees "play a very valuable role, day in, day out, with detailed contacts with the big financial firms," said William Poole, a former president of the Federal Reserve Bank of St. Louis who is now at the Cato Institute. "What I think is missing is a longer-run perspective. They tend to be sort of short-term in their outlook, which is true of a lot of the financial firms. Traders have a horizon of a few hours or a few weeks, at most."
The announcement of the unwinding of the dollar swaps seems largely to be a matter of announcing something that is already mostly over. More than 90% of the program has already been unwound, and there is only roughly $50 billion left to go.
Noting the tight correlation between the dollar index and the dollar swaps, anybody with insider information to these programs would have been ideally situated to thoroughly clean out the other market traders, who were in the dark as to the timing and magnitude of the program. It could merely be coincidence that the very same Wall Street firms with daily contact with the NY Fed staff secured outsized gains during this period of time, but it is hard to trust that this was mere coincidence, given all that we've recently learned about Wall Street's inability to control its greed.
Let me not just pick on Wall Street. Steven Friedman, the NY Federal Reserve board head in 2008, somehow could not stop himself from buying shares in Goldman Sachs, even as he was overseeing their dramatic rescue. He resigned over the scandal, but good luck locating much analysis or discussion of this amazing turn of events outside of the blogs.
Because a level playing field is vital to our market structure, it would be an enormous relief to both audit the Fed and secure testimony under oath about whether or not certain large Wall Street banks received information that allowed them to game the trading system in unfair ways.
This is not a small matter. One of the consistent reasons given for why foreigners favor our capital markets with their money is because they are large, liquid, and trusted.
As it turns out, there's no real competitive advantage or barriers to entry in capital markets. There's nothing to prevent any other capital center from taking over New York's functions. There are clever people willing to work hard for paper wealth all over the world, every bit as eager and clever as those in the US.
A vital pillar remaining at the forefront of this particular industry rests on trust. And sometimes trust requires a little transparency, especially if appearances have been compromised.
If the Fed and Wall Street have nothing to hide, then they should welcome an audit and investigation with open arms.
Otherwise, investors all across the globe may come to the unfortunate conclusion that the playing field is tilted.