Around $13-$14 trillion in global debt is missing from balance sheets because of foreign exchange (FX) derivatives, mainly FX swaps, currency swaps and the closely related forwards, according to researchers at the Bank for International Settlements.
In the BIS Quarterly Review, the researchers explained that every day, trillions of dollars are borrowed and lent in various currencies. Many deals take place in the cash market, through loans and securities. But foreign exchange (FX) derivatives, mainly FX swaps, currency swaps and the closely related forwards, also create debt-like obligations. For the US dollar alone, contracts worth tens of trillions of dollars stand open and trillions change hands daily.
Three closely related instruments allow off-balance sheet foreign currency borrowing and lending: FX swaps, currency swaps and (outright) forwards. In an FX swap, two parties exchange two currencies spot and commit to reverse the exchange at some pre-agreed future date and price.
Currency swaps are like FX swaps, except that the two parties agree to exchange both principal and interest payment streams over a longer term. FX swaps mature within a year (providing "money market" funding); currency swaps have a longer maturity ("capital market" funding).
A forward is a contract to exchange two currencies at a pre-agreed future date and price. After a swap's spot leg is done, what is left is the agreed future exchange - the forward leg.
These transactions are functionally equivalent to borrowing and lending in the cash market. Yet the corresponding debt is not shown on the balance sheet and thus remains obscured.
Why such a difference in accounting treatment? The researchers explained that one reason is that forwards and swaps are treated as derivatives, so that only the net value is recorded at fair value, while repurchase transactions are not.
Since the value of the forward claim exchanged at inception is the same, the fair value of the contract is zero and it changes only with variations in exchange rates. Yet, unlike with most derivatives, the full notional amount, not just a net amount as in a contract for difference, is exchanged at maturity. That is, the notional amounts are not purely used as reference for the income streams to be exchanged, such as in interest rate derivatives.
Another reason is the definition of control, which for cash requires control over the cash itself (eg a demand deposit) but for a security just the right to the corresponding cash flows. This determines what is recognized and not recognized on the balance sheet.
All this greatly complicates any assessment of the missing debt's total amount and distribution, and hence of its implications for financial stability.
“A fuller assessment would require better data to help evaluate the size and distribution of both currency and maturity mismatches. The analysis also points to deeper and more complex questions about the accounting conventions themselves. At issue is the definition of derivatives and control, which gives rise to the asymmetric treatment of cash and other claims in repo-like transactions. These questions, together with their regulatory implications, would merit further consideration,” say the researchers.