On 17 March 2020, the US Federal reserve launched a series of emergency measures to ease international demand for US dollars as a result of the Covid-19 outbreak. These measures included opening swap lines to foreign central banks, allowing them to borrow dollars from the Federal reserve in exchange for their own local currency. The Federal reserve also said that it would lend foreign central banks dollars in short-term loans backed by Treasury securities.

These measures had two impacts, the first being that the Fed effectively acted as global lender of last resort, the second being the change of supply of US dollars available to international banks from scarce to plentiful.

They also had a significant impact on one of the lesser-known financial market instruments: a cross-currency basis swap. In this article we are going to look at what a basis swap is and how it works.
What is it?

A cross-currency basis swap is a member of the interest rate swap family and has the following properties:

• Two counterparties, who agree to swap two sets of cash flows in different currencies for an agreed period. In our example we are going to call our counterparties:
  • Party 1 who needs US dollars and has €10m available to swap for a period of one year.
  • Party 2 who has US dollars and needs €10m for a period of one year.
  • In a cross-currency basis swap, the two principals are exchanged on the effective date and repaid on the maturity date of the swap.
• The principals are calculated at the spot rate prevailing at the time that the quotation is sought.
  • In our example, Party 1 is seeking to swap €10m for US dollars. Party 1 would ask for a quote to “receive US dollars and pay €10m principal”. The US dollars principal would be calculated by multiplying €10m by the spot rate of 1.0875 to give a principal of US$10,875,000.
• In a basis swap both sets of interest rates are floating and may be in:
  • The same currency, for example 3-month USD LIBOR for 6-month USD LIBOR, or 1-month USD LIBOR for 1-month commercial paper, in which case it is simply a ‘basis swap’ (BS); in this case the principal is not exchanged, or:
  • In two different currencies, for example 3-month USD LIBOR for 3-month EURIBOR, in which case it is a ‘cross-currency basis swap’ (CCBS) and the principal is usually exchanged.
• Market convention is to quote the spread against the non-US dollar leg. Thus, in a standard CCBS, an investor would pay (receive) US$3m LIBOR and receive (pay) the relevant 3m deposit rate in the other currency plus a spread which is agreed at the time of the trade and may be negative or positive depending upon supply and demand for the two currencies.
• The market calls the quote (or price) the ‘basis’ and in our example is quoted at minus 0.65% per annum and is quoted:
  • “EUR USD basis is - 0.65% on €10m with spot at 1.0875” which means that one counterparty will receive (pay) US dollar principal and pay (receive) euro principal on the effective date and reverse or repay the cash flows on the maturity date. The other counterparty will do the opposite.
  • During the life of the CCBS, the party that has received the dollars on the effective date pays the nominated USD LIBOR and the party that has received the euros on the effective date pays the nominated euro interest rate plus the ‘spread’.
  • In our example:
    • Party 1 pays 3-month USD LIBOR on US$10,875,000 and receives 3m EURIBOR minus 0.65% on €10,000,000.
    • Party 2 pays 3-month EURIBOR minus 0.65% on €10,000,000 and receives 3-month USD LIBOR on US$10,875,00

The term sheet

The relevant dates for the first period

The usual foreign exchange market date conventions apply to basis swaps and therefore effective dates are usually two business days after the trade of fixing dates. Exceptions to this rule are currencies such as the Canadian dollar (CAD) which do not follow a two-day spot convention.

The cashflows throughout the swap for Party 1The cashflows for Party 2 are exactly opposite.

Cashflows for Party 1 for the first periodThe cashflows for Party 2 are exactly opposite.

Cross currency basis swap conventions

The Credit Suisse Fixed Income Research Department published a paper titled ‘Credit Suisse basis points: cross-currency basis swaps’ in 2013, including a table titled ‘cross-currency basis swap conventions’ on page 4. The publication shows the market standard for the non-US reference rates for the following:

• The index used and whether it is a secured rate as in the case of the AUDUSD or unsecured in the case of EURUSD.
• The spot rate convention and the effective date. The spot rate convention will determine the fixing dates after the first period has completed.
• The way that interest is calculated (the day/count convention for each currency)
• Some historical 5-year maturity spreads.

Mark to market or non-mark to market CCBS?

CCBSs come in two varieties, mark to market and non-mark to market.

• Mark to market CCBSs are marked to market on each fixing or reset date to take into consideration any mark to market profit and loss caused by foreign exchange movements. This mark to market profit or loss is added to the settlement amount and is paid at that time. At the same time the principal for the non-dollar currency principal is reset at the mark to market rate to reflect the loss that has been paid. The main reason for including foreign exchange exposure in the process is because swaps can have maturities of five years or more and spot rates change a lot over time. Capital charges to banks for long dated forward foreign exchange risk is high and may tie up capital, making these swaps unattractive, however if foreign exchange losses are paid every three months it reduces the capital requirement and makes the swaps a much more attractive product.
• Non-mark to market CCBSs do not take the foreign exchange risk into consideration. The example above is a non-mark to market CCBS.

Why is the quote negative or positive and what does it mean?

In our example we can see that Party 1 has to make two payments in the first period:

• US$31,063.23 interest cost on the dollars received on the effective date.
• €6,319.44. This is a payment because Euribor is negative 0.25%, if Euribor was positive it would be a cash receipt.
• €16,430.56. This payment represents the negative spread to Euribor which is charged by the market to supply US dollars and take euros on a basis swap.
• Making the total cost of the basis euro payment is €22,750 swap at negative 0.65% for the first period is €16,430.56

Let us look at a simpler example that does not contain negative interest rates and let us set the spread at zero to understand the logic of the trade. Let’s also ignore bid/offer spreads for simplicity.

Using a £10m USD CCBS with the spot rate at 1.25, £3m LIBOR at 0.50% and US$3m LIBOR at 1.32% and if Party 1 wanted US dollars, the cashflows would be:

So, the logic of this trade is simple to understand: I have British pounds and need US dollars, you have US dollars and need British pounds. Let us swap currencies and pay each other the market rate for the respective currencies that we borrow.

If we expand the example from two companies to the market, we can bring supply and demand and reflect this through the spread.

• If the market needs US dollars and does not need sterling and is offered the deal above, it will want to pay a lower rate on the sterling leg of the basis swap, for example US dollars flat versus sterling minus 0.10%. The higher the need for US dollars or the lower the need for sterling, the wider the negative spread becomes.
• If the market does not need US dollars and does need sterling and is offered the deal above it will have to pay a higher rate on the sterling leg of the basis swap, for example US dollars flat versus sterling plus 0.10%. The lower the need for US dollars or the higher the need for sterling the wider the positive spread becomes.
• The main driver of the spread is supply and demand, although there are some other small technical factors which will influence the spread, such as credit risk between the two reference rates.