A central bank swap line is a standing or temporary agreement between two central banks to exchange their currencies for a set period. The central bank that draws on the line receives the other's currency, typically US dollars, and hands over an equivalent amount of its own currency as collateral. It then lends the foreign currency to commercial banks in its jurisdiction that need it, at a time when private markets will not supply it on reasonable terms.
Swap lines extend the lender of last resort function across borders. Because a central bank can only create its own currency, it cannot directly support banks that have borrowed heavily in a foreign one; a swap line fills that gap.
How a central bank swap line works
Each drawing is structurally an FX swap between two official institutions. Using the Federal Reserve's dollar lines as an example:
- The foreign central bank, say the European Central Bank, sells euros to the Federal Reserve in exchange for dollars at the prevailing spot rate.
- Both agree to reverse the trade on a fixed date, often one week or three months later, at the same exchange rate, so neither side bears currency risk.
- The foreign central bank lends the dollars to its own banks against collateral and bears the credit risk of those loans.
- At maturity the foreign central bank returns the dollars, pays interest to the Federal Reserve, and receives its euros back.
The Federal Reserve's counterparty is the foreign central bank, not the commercial banks that end up with the dollars.
History
The Federal Reserve set up a network of reciprocal currency arrangements in 1962 to support the fixed rates of the Bretton Woods system. Swap lines took on their modern role during the 2008 financial crisis. European and other non-US banks had financed large holdings of dollar assets with short-term dollar borrowing, including in the Eurodollar market, and that funding dried up. From December 2007 the Fed opened lines with the ECB and the Swiss National Bank, and later extended them to more central banks, some with no fixed limit.
In October 2013 the Federal Reserve, the European Central Bank, the Bank of England, the Bank of Japan, the Bank of Canada and the Swiss National Bank converted their temporary arrangements into standing swap lines that can be activated in any of the six currencies. In March 2020, as the COVID-19 shock disrupted dollar funding markets, the Fed re-opened temporary lines with nine further central banks, including those of Australia, Brazil, Korea, Mexico and Singapore, and created a repo facility for foreign monetary authorities.
Other networks
Swap lines are not limited to the dollar. The ECB maintains euro lines with several central banks, and the People's Bank of China (PBoC) has signed bilateral currency swap agreements with dozens of central banks. The PBoC lines support offshore RMB liquidity and renminbi use in trade, and act as a backstop for RMB clearing banks, but they also serve diplomatic purposes and some are rarely drawn. Regional arrangements such as the Chiang Mai Initiative Multilateralisation among ASEAN+3 economies pool commitments for similar ends, complementing lending by the International Monetary Fund (IMF).
Effects on markets
Swap lines calm funding markets by assuring banks that dollars will be available, which narrows the cross-currency basis and lowers the premium for borrowing dollars through FX swaps. They also reduce the need for countries to sell foreign exchange reserves in a panic, which can disrupt markets for the assets those reserves are invested in, such as US Treasury securities.
Criticism and limitations
Access is selective. Standing dollar lines cover a small group of advanced-economy central banks, while most emerging and developing economies depend on their own reserves or the IMF. Critics argue that this reinforces the dominance of the dollar as the leading reserve currency and gives the issuing central bank, and indirectly its government, discretion over which countries receive support. Supporters respond that swap lines protect the issuing country's own markets and that the foreign central bank bears all credit risk on onward lending. For the Federal Reserve's regulatory role, see The Federal Reserve System regulator profile.