FX Swap

An FX swap (foreign exchange swap) pairs two transactions between the same counterparties: they trade amounts of two currencies on one date, usually the spot date, and commit at the outset to trade them back on a later date at a rate set when the deal is struck. The first exchange is called the near leg and the second the far leg. In economic terms an FX swap is a loan of one currency secured by a deposit of another: each party borrows the currency it receives and lends the currency it pays, and the difference between the near and far rates reflects the interest rate differential between the two.

FX swaps are the most heavily traded instrument in the foreign exchange market. According to the Bank for International Settlements' Triennial Central Bank Survey, they accounted for about USD 3.8 trillion of the roughly USD 7.5 trillion in average daily foreign exchange turnover in April 2022, more than spot transactions.

An FX swap combines a spot transaction with an opposite forward contract for the same amount of one currency. The near-leg rate is normally close to the spot rate, and the far-leg rate equals the near rate plus or minus forward points, which are determined by the interest rates in the two currencies through covered interest parity. Common tenors range from overnight and "tom-next" (tomorrow to the next day) to one year, although longer swaps exist.

Example

A European company has surplus euros but needs USD 11 million for three months to pay suppliers. It enters an FX swap with its bank: in the near leg it sells EUR 10 million and receives USD 11 million at 1.1000; in the far leg, three months later, it buys back EUR 10 million and pays USD 11.055 million at 1.1055. The extra USD 55,000 is the effective cost of borrowing dollars against euros, reflecting higher dollar interest rates, adjusted for any cross-currency basis. The company has funded its dollar needs without taking on exchange rate risk on the principal, because the far-leg rate is fixed at the outset.

• Funding: banks and companies raise one currency against another, especially US dollars, without borrowing unsecured.
• Rolling positions: dealers and payment firms use tom-next swaps to roll spot positions forward each day rather than settling them.
• Hedging: investors holding foreign assets use rolling FX swaps to hedge currency exposure, and treasuries use them to adjust the timing of existing forwards.
• Liquidity management: payment providers holding customer balances in one currency can meet payout needs in another while keeping their overall currency position flat.
• Central bank operations: central banks use FX swaps to inject or absorb domestic liquidity, and a central bank swap line is structurally an FX swap between two central banks.

An FX swap differs from a cross-currency swap, often grouped with currency swaps, which usually has a longer maturity and involves periodic exchanges of interest payments between the near and far exchanges of principal. It also differs from an interest rate swap, which exchanges interest payments in a single currency on a notional amount without exchanging principal. In the precious metals market, a gold swap works similarly, with gold exchanged for currency and later reversed. The FX swap's economic function also resembles a repurchase agreement, in which securities rather than a currency serve as collateral.

Both legs involve the full principal, so settlement risk is significant: one party could pay its currency without receiving the other. Much of the market therefore settles through CLS on a payment-versus-payment basis. Counterparty credit risk on the far leg is managed through credit limits and collateral.

Because FX swaps and forwards are recorded off balance sheet under most accounting standards, the dollar obligations they create are not visible in standard debt statistics. BIS researchers have estimated that this "missing" dollar debt amounts to tens of trillions of dollars, concentrated among non-US banks and institutional investors. During the 2008 financial crisis and again in March 2020, disruption in dollar FX swap funding forced the Federal Reserve to extend swap lines to other central banks to relieve shortages, illustrating how important the instrument is to the global dollar system.