A Primer on the Fed's Swap Lines With Europe
HOW IT WORKS: The swaps involved two transactions. At initiation, when a foreign central bank drew on its swap line, it sold a specified quantity of its currency to the Fed in exchange for dollars at the prevailing market exchange rate. At the same time, the Fed and the foreign central bank entered into an agreement that obligated the foreign central bank to buy back its currency at a future date at the same exchange rate. Because the exchange rate for the second transaction was set at the time of the first, there was no exchange rate risk associated with the swaps. The foreign central bank lent the borrowed dollars to institutions in its jurisdiction through a variety of methods, including variable rate and fixed-rate auctions. In every case, the arrangement was between the foreign central bank and the institution receiving funds. The foreign central bank determined the eligibility of institutions and the acceptability of their collateral. And the foreign central bank remained obligated to return the dollars to the Fed and bore the credit risk for the loans it made. At the conclusion of the swap, the foreign central bank paid the Fed an amount of interest on the dollars borrowed that was equal to the amount the central bank earned on its dollar lending operations.
