DEFI BLOG SERIES
Celebrating the 40th Anniversary of Currency Swaps
So far, we have explained the importance of the yield curve for building capital markets, which enables loans and swaps. Our goal is to build long-term forward markets for cryptocurrencies and digital assets, which could scale to a trillion-dollar business. This article describes how the currency swap emerged and explains why the World Bank and IBM entered into the first swap to establish a sophisticated borrowing technique, which led to the 40-year historic success in building the $600 trillion derivatives industry.
Disclaimer: The complete details of the swap have never been published in full. All information, assumptions, and scenarios provided here are created and simplified for educational purposes.
The World Bank’s Currency Swap Program
From August 1981 to the end of the fiscal year 1983, the World Bank carried out 58 currency swap transactions. The bank has raised about the equivalent of $2.5 billion in Swiss francs, Deutsche marks, Dutch gilders, Pounds sterling and Austrian schillings. About two thirds of swaps have been into Swiss francs (Staff Working Paper 640: World Bank Group).
The currency swaps lowered the Bank’s average cost of borrowing from 10% to 8.9% — David Bock
Reducing Risks for International Businesses
Swaps added liquidity and contributed to the development of the long-term forward market, which reduced the risk in trade finance and provided more effective asset/liability management (ALM) opportunities.
For importers/exporters, swaps offered advantages in increased certainty and lowered offshore fundings. For enterprises, swaps enabled offshore investments in domestic currency by reducing exposures from currency mismatch.
The Currency Swap Schematic Representation
The following 4 steps are typical transactions from the Bank’s perspective.
- The Bank issued a bond to borrow USD in the US capital market
- Sold USD in the spot foreign exchange market for another currency (CHF) or exchanged USD for another currency with a swap counterparty
- Entered into a long-term forward exchange contract
- Received USD from a swap counterparty and made coupon and principal repayments to the bond holders
The First Swap in 1981
The World Bank Situation with Interest Rates
In 1981, the USD borrowing rate was at very high, around 14 to 16%, due to the government’s anti-inflation monetary policy. On the other hand, the Swiss francs (CHF) borrowing rate was around 6 to 8%, which made it the best choice as a borrowing currency.
In the Swiss capital market, the World Bank had borrowed CHF and other non-dollar currencies approaching the Bank’s official access limits. Because the Bank has been a major CHF bond issuer for many years, ‘scarcity value’ played a large role; it had to pay more due to market saturation. Therefore, some US corporations could borrow at lower rates.
In the US capital market, the World Bank continued to attract the US domestic and Eurodollar markets, allowing the Bank to borrow USD at lower rates than US corporations such as IBM. However, it is not desirable for the World Bank to borrow at much higher rate in USD.
IBM Situation with Currency Exchange Rates
IBM borrowed CHF 200M in mid-1970s. At that time, USD was strong, and the USD/CHF currency exchange rate was around 2.5, so the liability amount in USD was 80M. From 1977 to 1978, the rate sharply dropped by 40% to 1.5 and the liability unexpectedly increased to USD 133M.
Along with the US rate hike, USD became strong again in 1981. On August 11, IBM found the great currency-risk hedging opportunity with an attractive USD/CHF rate of 2.2. IBM and the World Bank entered into the first currency swap with the same interest and principal payment dates for the CHF bond until its maturity in 1986. Thanks to the strong USD, the CHF 200M liability was locked at reduced size of USD 90M, making IBM happy to pay 16% interest rates in USD.
A Win-Win Situation Created by Salomon Brothers
Salomon Brothers was the arranger of the swap who found the capital market inefficiency such as ‘scarcity value’ and turned into a business opportunity by swapping mutually attractive liabilities. It was a remarkably creative solution for the Bank to save borrowing costs as high as 1% and access more easily to the preferred currencies while avoiding tapping the capital market.
The first swap deal opened up a new era of finance by pioneering a long-term hedging technique for international trades and overseas investments. Since the beginning of the currency swap in 1981, we have seen rapid growth in the development of the long-term forward market, which was largely due to the volatility of interest rates and exchange rates, and the development of global capital markets. Corporations inevitably sought better investment opportunities and hedged foreign assets and liabilities.
The ability to hedge cross-border capital transactions contributes to the economic efficiency of international investment — David Bock
Other Benefits of Currency Swaps
Exchange Rate Stability
Forward markets create links between future transactions and today’s spot rate and provide arbitrage opportunities from wide swings in prices, therefore reducing the volatility of exchange rates.
The development of a long-term forward exchange market can be expected to have generally favorable effects on exchange rate stability — David Bock
Credit Quality Enhancement
The existence of hedging opportunities for foreign currency liabilities and investments reduced the currency mismatch risks; therefore, swaps would improve the international competitiveness of domestic firms and the overall quality of credit in the domestic capital market.
The World Bank’s currency swap program created a foundation of a long-term forward market and established a sophisticated finance technique using capital market inefficiencies. The swap’s rapid growth established the standard risk management practices in international business and investments. The risk management ensures confidence in cross-border capital transactions under highly volatile market. By developing forward markets, finance industry has achieved exchange rate stability and credit quality enhancement. Secured Finance is celebrating the 40th anniversary and admiring the continuous advancement in financial technology. We are fully committed to developing long-term forward markets for cryptocurrencies and digital assets to unlock innovation in finance.
Public policy considerations of the swap in digital assets
Mastering swaps to enhance your business
A handbook of Secured Finance derivative solutions
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Bock, David R.; Wallich, Christine I. 1984. Currency swaps : a borrowing technique in a public policy context (English). Staff working paper; no. SWP 640 Washington, D.C. : World Bank Group. (link)
Susmel, Rauli. 2015. Lecture 11: Case: IBM-World Bank Swap, lecture slides, International Finance (MBA FINA 7360), University of Houston (link)