Dollar Funding

Dollar funding is the borrowing of US dollars by banks, companies and public bodies that sit outside the United States and have no direct access to the Federal Reserve. They need dollars because much of world trade, commodity pricing and cross-border lending is invoiced in the currency, so a Japanese insurer buying US bonds or a European bank lending to an oil trader must find dollars somewhere and keep rolling that borrowing over.

The term covers the whole set of channels used to raise those dollars, not a single product. It is closely tied to the offshore eurodollar market, where dollar deposits are held at banks outside the US, and to the currency mismatch that appears when dollar assets are financed with short-term dollar debt or with another currency. A "dollar funding gap" is the amount of such dollar assets that must be refinanced in the short run.

Picture a shop in Paris that sells goods priced in dollars and keeps a stock of dollar goods on its shelves. It does not earn many dollars of its own, so every few weeks it borrows them from a neighbour, promising to return them soon. As long as neighbours are relaxed, the arrangement costs little and nobody notices it.

The trouble starts when the neighbours get nervous and all want their dollars back on the same day. The shop cannot print dollars, and selling its stock in a hurry means taking a loss. Dollar funding is that everyday borrowing habit, repeated by thousands of banks and firms worldwide. When it works it is invisible; when lenders pull back, the scramble can spread from one market to the next within days.

Institutions outside the US typically combine several sources, each with its own cost and fragility:

• Deposits and interbank borrowing. Banks take dollar deposits from customers and borrow from other banks in the offshore market.
• Short-term securities. Commercial paper and certificates of deposit are sold to investors, historically including US money market funds.
• Repo. Holders of US Treasuries or other high-quality bonds raise cash through a repurchase agreement, priced off rates such as SOFR.
• FX swaps. A bank lends its own currency and borrows dollars for a fixed term through an FX swap or longer-dated currency swap, then reverses the exchange at maturity.

The swap channel is the largest and the hardest to see, because it is recorded off balance sheet. A December 2022 study by the Bank for International Settlements estimated that obligations to pay dollars through FX swaps, forwards and currency swaps exceeded $80 trillion, most of it short-term, and that banks headquartered outside the US owed about $39 trillion of it.

When dollars are borrowed through an FX swap, the effective interest rate is implied by the spot and forward exchange rates. With rates quoted as dollars per unit of foreign currency, the implied dollar rate for one year is:

• $S$ is the spot exchange rate, in dollars per unit of foreign currency.
• $F$ is the one-year forward rate agreed for the reverse exchange.
• $r_{\text{foreign}}$ is the one-year interest rate on the currency given up.

Suppose the euro trades at $S = 1.1000$, the one-year forward is $F = 1.1220$, and the euro rate is 2\%. Then $1.1220 \div 1.1000 = 1.02$, and $1.02 \times 1.02 - 1 = 0.0404$, or 4.04\%. If dollars could be borrowed directly at 3.80\%, the swap costs 0.24 percentage points more, a gap of 24 basis points. That gap is the cross-currency basis, and it widens when dollars become scarce.

Before the 2008 financial crisis, European banks had built large holdings of US securities financed with very short-term dollar borrowing, much of it from money market funds and swap markets. When those lenders withdrew after the collapse of Lehman Brothers in September 2008, the banks struggled to roll their dollar debt and the cost of swapped dollars jumped far above direct borrowing rates.

A second squeeze came in March 2020, when the pandemic triggered a rush for cash. Companies drew credit lines, investors sold even US Treasuries, and foreign holders sought dollars at the same moment. The cross-currency basis widened sharply again until official action restored calm.

The main backstop is the central bank swap line. The Federal Reserve lends dollars to a foreign central bank against that bank's own currency, and the foreign central bank lends the dollars on to its domestic banks. Lines with the Bank of Canada, Bank of England, Bank of Japan, European Central Bank and Swiss National Bank were made standing arrangements in October 2013. On 19 March 2020 the Fed opened temporary lines with nine more central banks, and drawings across the lines peaked at about $449 billion in late May 2020.

Later that month the Fed added a repo facility for foreign official holders of Treasuries, letting them raise dollars without selling bonds. Countries outside the swap network rely on their own foreign exchange reserves or on the IMF. Critics note that this makes the Fed a de facto international lender of last resort whose help is selective, and that it can encourage further reliance on short-term dollar borrowing.

• Federal Reserve: Central bank liquidity swaps
• Bank for International Settlements: Dollar debt in FX swaps and forwards: huge, missing and growing