Synthetic Dollar Funding

Abstract

Off-balance sheet foreign exchange (FX) swaps are a major source of US dollar funding for non-US banks that provide over half of global dollar credit. However, the frictions that lead banks to rely on these instruments and their broader impact on the financial system are not well understood. This paper shows that FX swaps emerge as alternative ("synthetic") funding instruments when banks face negative funding shocks from cash-market investors, such as US money market funds. The resulting increase in swap demand, combined with limits to arbitrage, leads to substantial deviations from covered interest parity (CIP) – the breakdown of a fundamental no-arbitrage pricing condition. I show a causal impact of banks’ swap demand on CIP deviations using an instrumental variables strategy that exploits idiosyncratic variation in money market funds’ investment in bank-level debt. This shift in aggregate demand is absorbed by non-bank users of FX derivatives in the form of higher hedging costs: I estimate the elasticity of non-bank investors' hedging demand to swap prices and find only a partial adjustment in quantities traded. My results indicate that frictions in the global market for the US dollar can provide a demand-based explanation for CIP deviations.

Keywords: FX swaps, US dollar, currency hedging, covered interest rate parity, financial frictions

JEL Classification: F31, G11, G15, G20, G12