About the Global Financial System’s ‘$80 Trillion Blind Spot’

Evidently, the global financial system has an “$80 trillion blind spot” that risks spawning a financial crisis worse than 2008. That, at least, is how headlines in publications large and small have summed up a report on global financial institutions’ foreign currency derivatives exposure released by the Bank for International Settlements (BIS) last week. Known as the central bank for central banks, the BIS tries to tabulate seen and unseen financial risks and often reports on its findings in hopes of improving global policy and transparency. Last week’s report—an overall benign missive—was no different. But headlines took the juicy bits and ran with them, arguing these financial instruments could wipe out the world’s supply of dollars, which we think is a testament to how depressed sentiment is.

The report, which is worth a read if you are into such things, is a seven-page look at global financial institutions’ off-balance-sheet obligations. As it explains, banks and non-bank financial institutions (think pension funds and insurance firms) outside the US have increased their use of currency hedging instruments (e.g., foreign exchange or “FX” swaps, FX forwards and currency swaps) in recent years and, by the researchers’ calculations, have “$80 trillion-plus in outstanding obligations to pay US dollars.”^[i] Simply for scale, they note this figure “exceeds the stock of dollar Treasury bills, [repurchase agreements] and commercial paper combined.” While the dollar isn’t the only currency these institutions will hedge, it plays the biggest role because it is usually a stopover when non-dollar currencies are hedged against one another: “An investor or bank wanting to do an FX swap from, say, Swiss francs into Polish zloty would swap francs for dollars and then dollars for zloty.”

From there, the paper explains that since these institutions are largely using short-term contracts to hedge long-term positions, there is a “maturity mismatch” that could cause acute funding needs. This isn’t a glaring, constant problem since most institutions roll over their derivatives contracts. But the market to do so can seize up when financial systems get stressed. This happened during the short panic that accompanied COVID lockdowns in March 2020 and 2008’s global financial crisis. On both occasions, the Fed had to establish dollar swap lines with other major central banks to ensure these firms could get the liquidity they needed to roll over their contracts and settle obligations as needed.

The volume of outstanding derivatives is larger now, primarily because there has been much more movement in the dollar and interest rates to hedge against. Crucially, the paper doesn’t call this a crisis waiting to happen. Rather, it makes the salient observation that because these obligations are off-balance-sheet—not counted as official debt—policymakers don’t have good insights on which institutions in which countries will have a high likelihood of needing financing in a pinch. It also points out that because these are non-US entities, most won’t have access to the Fed’s discount window, which is where otherwise solvent banks needing liquidity can borrow from the Fed directly. This is why the Fed opted to create those dollar swap lines in 2008 and 2020—so that cash-strapped institutions outside the US could get the dollars they needed. Essentially, the BIS is pointing out that with better data on which firms have the biggest obligations, policymakers can probably create more targeted solutions. Hence, the paper calls for “statistics that track the geography of outstanding short-term dollar payment obligations” so that policymakers can better “anticipate the scale and geography of dollar rollover needs.”

Seems sensible to us! After all, fully informed policy has a higher likelihood of being well-tailored and beneficial than policy made “in a fog,” as the paper describes it. But derivatives are a complex topic and often associated with crises and the scary-sounding “shadow banking system,” so we guess it was inevitable that headlines would run with the most tantalizing nuggets and spin a financial-system-time-bomb narrative. After all, the BIS’s audience is primarily global financial policymakers and industry insiders, so they aren’t going to take the time to explain key terms or how derivatives markets work. Their audience knows, for instance, that not all of this $80 trillion is due at once, and that no one is suggesting international financial institutions would need to suddenly access the world’s entire supply of dollars to repay off-balance-sheet obligations. Their audience knows contracts get rolled over and 99% of the time it is seamless. It also knows that it is normal for international pension funds and insurers to use these instruments to hedge the currency risk in their investment portfolios, which are heavy on US assets. And that large multinational corporations use them to hedge their business for currency swings, mitigating the dollar’s impact on costs and revenues abroad.

The BIS’s intended audience also probably understands that keeping all this stuff off-balance-sheet is normal because it isn’t debt in the traditional sense. Banks’ derivatives positions often sound a lot bigger than they really are because the totals don’t account for contracts that offset each other. It isn’t unlike all the inflated estimates of the financial system’s exposure to Lehman Brothers in 2008, which made the mistake of looking at the gross instead of net notional value of derivatives contracts. That made it seem like the financial system had $400 billion of exposure to Lehman when the actual sum, after settlement, was $8 billion. The BIS makes it very plain that its figures could be similarly inflated, noting: “Positions are corrected for inter-dealer double-counting. However, the figure does not factor in any bilateral netting of payment obligations allowable under supervisory and/or accounting methodologies, which could more than halve net interdealer payment obligations.” Which is sort of the researchers’ point, if we are interpreting correctly—with better data, policymakers could know the actual net value and better tailor liquidity options the next time things get tough.

Some coverage folded in the UK’s recent pension market hiccup as evidence that off-balance-sheet derivatives are a major problem now, but in our view, this logic doesn’t really hold. The issue in the UK wasn’t derivatives contracts, but leverage. Several pension funds were using leveraged interest rate swaps to boost returns while UK Gilt yields were low, in hopes of better matching returns to eventual liabilities. When long-term rates jumped, it triggered collateral calls. Selling Gilts was the quickest way for the funds to meet them. We suspect this risk still exists in some corners of the financial system, as we doubt UK pension funds are the only entities with leveraged exposure. But calling this the norm, rather than the exception, seems to us like a stretch—and here, too, the BIS’s point applies, as more data and transparency would be welcome.

So, no, we don’t agree with the coverage that is trying to spin the BIS’s report as some kind of dire warning. But we also aren’t surprised that it went down like this, considering global stocks have spent basically the entire year in a bear market (typically a long, deep decline worse than -20% with a fundamental cause). We have written a lot lately about what we call the Pessimism of Disbelief, which is a common sentiment late in bear markets and early in new bull markets. One aspect of this, which we have focused on, is couching good news as bad. But seizing on any and all things that seem even remotely negative is another big piece, and we think the portrayal of the BIS’s report fits the bill. With big numbers, shadow banks and a mention of 2008, headlines had the perfect ingredients for a click-baity fear cocktail. It plays because people are scared. But we think the correct interpretation is far more boring: “International Banking Researchers Urge Creation of New Statistics.”