Cross currency basics – Hedging options for dealers
In previous blogs I have looked at cross-currency swaps from the position of the end-users. In this blog, I will look at a critical change to the way in which the dealers have to operate since the markets switched to being SOFR-based.
Why does this matter? It matters a great deal because the potential, added costs associated with the new hedging options can become significant and change the pricing for end-users. Every basis point of cost needs to be recouped in some way and this can result in wider spreads for buy-side firms. Looking at the options available for dealers can help explain why this can happen and why additional spreads may actually be unavoidable.
The current markets
Let’s start with two typical markets in cross-currency: AUD and JPY versus USD.
In these examples, the USD side is SOFR, the AUD is BBSW and the JPY is TONA which are the current inter-dealer conventions.
The curves are quite clearly shaped and reflect the market flows I have previously described in my first blog on this topic. The AUD curve is interesting as it definitely shows the flow direction out to 20 years is for end-users to ‘borrow’ the AUD leg (i.e., swapping USD debt for AUD). This then dips down at 30 years where opposing flows (long-dated FX options) take the margin into negative territory.
The JPY curve is the opposite driven by end-users looking to swap USD investments to JPY.
The way things were (pre-September 2021)
In the ‘good old days’ when the role of the cross-currency dealer was based on the old conventions, the management of their books was a well-oiled and efficient process and the pricing to the buy-side reflected this situation.
So how did it work in the AUD/USD example?
Each rollover, the USD and AUD were rate set from LIBOR and BBSW, typically 3-month. (In this example, I will use Term SOFR to replace LIBOR so the curves still match.)
At the start of the relevant period, the Term SOFR and BBSW rate sets as well as the 3-month forward FX were all known, and the dealer could calculate the implied BBSW rate from the spot, 3-month forward FX and the Term SOFR. Using these inputs, we can see the calculations in the following table.
If the dealer had received the AUD/USD 5-year cross-currency swap at 6.5 basis points from a buy-side USD borrower (as described previously and from the chart above), the dealer could roll the position at -25 basis points in the 3-month and benefit 31.5 basis points from the curve shape for that rollover.
While this looks like an arbitrage, in reality the dealer is accepting the short-term rollover risk rather than hedging the swap with another 5-year swap. This technique is quite common among the dealer community and is critical in managing a book profitably. The FX spot, forward and rate sets risks offset, and the dealer is square for that roll.
Note the direction: the 5-year swap had the dealer short AUD spot which has to be rolled forward by a buy spot/sell forward 3-month FX swap. This is the equivalent of the dealer borrowing the AUD short and lending it long creating the maturity mismatch.
What happens now?
Staying with the AUD/USD example, the situation is now different because the USD refixes every day and compounds daily rather than fixes once at the start of the period.
What is the dealer to do? They could:
Lock in the USD rate with a 3-month OIS (Overnight Index Swap) and roll the FX 3 months as before. This would attract a spread as the dealer enters the OIS market and pays the OIS trader for the risk.
Roll the FX 3-months to offset the BBSW rate risk and let the USD float for the 3 months. This is cheaper but does leave the dealer with an unhedged USD 3-month rate set risk which they created from the 3-month FX forward.
Roll the FX O/N to offset the USD rate set risk and transact an AUD OIS to offset the BBSW rate set risk. This is unbelievably expensive: the AUD OIS spread is present as in point 1 but it is dwarfed by the implied interest rate spreads in O/N AUD/USD which can be 25 basis points from mid to bid/offer! This is the last resort.
Whichever way the dealer choses to proceed there is residual risk or a new spread to be paid. This additional risk or spread will have to be reflected in the original 5-year swap quote to the end-user.
The JPY example
In JPY we have the opposite side to the trade, but the challenges are essentially the same.
If the dealer had paid the JPY/USD 5-year cross-currency swap at -73.375 basis points from a buy-side USD investor (as described previously and in the chart above), the dealer could roll the position at -33.77 basis points in the 3-month and benefit 39.7 basis points from the curve shape for that rollover.
As we can see, the shape of the cross-currency basis curve is again typically in favour of the dealer rolling short-term and trading with end-users in the longer dates.
The options for the dealer are similar to the AUD example except both sides of the swap are now compounding rates.
So, we have:
Lock in the USD and JPY rates with a 3-month OIS and roll the FX 3 months as before. This would attract 2 new spreads as the dealer enters the OIS market and pays the OIS traders for the risk.
Roll the FX O/N to offset the USD and JPY rate set risk. This is again prohibitively expensive because the implied interest rate spreads in O/N USD/JPY are also very wide and costly. This, again, is the last resort.
Summary
The cross-currency markets have changed and have created new challenges for cross-currency dealers. Whichever option they take to roll their positions forward in the FX market they attract new spreads and costs.
These new risks and costs will have to be reflected in the pricing for end-users.