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The 'Hidden Debt' From Using FX Transactions to Manage Exchange Rate Risk

By Frances Coppola

Many international businesses use FX forward contracts, FX swaps and currency swaps to manage exchange rate risk. According to the Bank for International Settlements (BIS), at the end of December 2016 the value of outstanding FX forward contracts, FX swaps and currency swaps worldwide totaled $58 trillion. Most of these were held by financial institutions, including large banks.

But $7.5 trillion worth were held by non-financial corporations engaged in international trade. Reflecting the fact that the U.S. dollar is by far the most widely used currency in international trade, $5.1 trillion of these contracts were denominated in USD.1


Researchers at the BIS say that the accounting treatment of FX forward contracts, FX swaps and currency swaps may be inconsistent; they are treated as financial derivatives that do not appear on balance sheets, even though they are essentially the same type of transaction as repurchase agreements (repos), which count as debt on balance sheets. Because of this, they say, as much as $14 trillion of notional debt has "gone missing" from the balance sheets of corporations and financial institutions.2


Using FX Swaps/Forwards and Currency Swaps to Manage Exchange Rate Risk


To see how this may affect international businesses, consider that corporations can use forward contracts to eliminate exchange rate risk on a future foreign currency payment or receipt. For example, a U.S. business that must pay its British supplier £10,000 in three months' time can enter into a three-month forward contract to buy £10,000 at the current USD-GBP spot price, thus protecting itself from the possibility of the pound's exchange rate falling versus the U.S. dollar in the next three months. Alternatively, if the British supplier decides to accept payment in U.S. dollars, it can enter into a similar three-month forward contract, thus protecting itself from the possibility of the pound's exchange rate rising versus the dollar in the next three months.


According to the BIS, FX swaps are more widely used than forwards.3 In an FX swap, a business exchanges one currency for another now, while simultaneously entering into an agreement to reverse the exchange at a future date. This equates to a simultaneous spot sale and forward purchase, or spot purchase and forward sale. The spot sale or purchase will be at the current exchange rate, while the forward purchase or sale will be at an exchange rate agreed between the two parties.


Currency swaps manage both exchange rate and interest rate risk. In a currency swap, a business exchanges both the principal and the interest payments on a loan in one currency for another, with an agreement to swap them back into the original currency at an agreed future date. As with an FX swap, the initial sale or purchase will be at the spot exchange rate, while the future purchase or sale will be at an agreed exchange rate.


Currently, accounting standards allow all of these to be treated as financial derivatives, where the gross position is off balance sheet. Because derivatives are generally settled on a net basis – i.e., only the price difference is paid – they are taken as a profit or a loss when they settle. But FX forwards, FX swaps and currency swaps differ from most derivatives in a key way: the full amount must be delivered on settlement, not the net difference. For example, if a firm swaps $10 million for £7.6 million pounds with a contract to repurchase the $10 million in three months, it must repay the full £7.6 million on the settlement date.


Presumably it has spent the £7.6million originally exchanged, so it must find a way to fund the sterling repayment. The firm may anticipate a large payment from a customer, for example; but it is the firm that is obligated to repurchase dollars for sterling, regardless of whether its customer pays on time. Thus, the firm in this example has hedged its exchange rate risk, but has not eliminated all business risk.


The Connection Between Repos and Managing FX Risk


Think of a repo as similar to pawn brokering. A repo is the simultaneous sale of a security and commitment to buy it back at a future date at an agreed price. Its opposite, a "reverse repo," is the simultaneous purchase of a security and commitment to sell it back at a future date at an agreed price. Because the combination of a spot sale and committed future purchase amounts to a short-term loan, under international accounting standards repos are treated as secured lending. Both current and forward cash movements are on balance sheet, and a contingent claim (off balance sheet) is recorded against the securities.


Repos and reverse repos are widely used by financial institutions to obtain funding. Consider a bank looking to obtain $25 million for one month. It can enter into a repo in which it "sells" sufficient dollar-denominated securities to obtain $25 million. One month later, the bank must pay $25 million to get its securities back. As the whole point of obtaining funding is to pay it out, the bank does not have that $25 million. It must obtain it to settle the deal.


Now, suppose a business enters into an FX swap to sell $25 million U.S. dollars for sterling at the spot price and buy them back in three months' time at 1.13. As with a repo, the whole point of a swap is to pay out the currency obtained. Thus, the business has a short position in sterling. In three months' time when the swap matures, it must pay about £22 million that it does not currently have. The collateral in this case is cash (U.S. dollars) rather than dollar-denominated securities, but the transaction is otherwise the same. The BIS researchers say, therefore, that an FX swap is secured lending, just like a repo.4


In the case of a forward contract, there is no spot leg, but the business still must settle the contract in full, and must therefore obtain money it does not currently have. For example, if a U.S. business fails to pay its British supplier on time, and the British supplier has entered into a forward contract to exchange the dollars it expects to receive from the U.S. business, the British supplier will have to buy dollars on the spot market to fulfil the contract, just as if it had taken out a three-month dollar loan which it now had to repay despite not receiving the expected funds. The BIS researchers say that the forward contract should be regarded as debt.5


The BIS researchers stop short of explicitly recommending that international accounting standards be changed to harmonize the treatment of FX transactions and repos. But they warn that the "missing debt" could have consequences for global financial stability, and call for a deeper investigation of the risks incurred by corporations that use FX transactions for funding or hedging.6



FX forward contracts, FX swaps and currency swaps can be useful for hedging exchange rate risks, and they can also help reduce funding costs. But they always involve taking a position, and this can expose the business to other forms of risk. Businesses may want to consider strategies for proactively managing credit and market risks arising from using FX transactions for hedging or funding.

Frances Coppola - The Author

The Author

Frances Coppola

With 17 years’ experience in the financial industry, Frances is a highly regarded writer and speaker on banking, finance and economics. She writes regularly for the Financial Times, Forbes and a range of financial industry publications. Her writing has featured in The Economist, the New York Times and the Wall Street Journal. She is a frequent commentator on TV, radio and online news media including the BBC and RT TV.


1. “Outstanding FX swaps/forwards and currency swaps, end 2016,” Table 1, “FX swaps and forwards: missing global debt,” Borio, McCauley & McGuire, Bank for International Settlements;
2. “FX swaps and forwards: missing global debt,” Borio, McCauley & McGuire, Bank for International Settlements;
3. Ibid.
4. Ibid.
5. Ibid.
6. Ibid.

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