In Between Days

by CC December 1, 2011 1:15 am • Commentary


What essentially happened is that the Fed cut the interest rate it charges the European Central Bank to borrow dollars.

The ECB wants the dollars so it can lend them out to European banks, which have been having trouble borrowing dollars at affordable rates due to fears about their financial health.

It’s worth taking a moment to see what actually happens with these swap facilities because they can create the illusion we’re sending boatloads of dollars overseas and the ECB is sending us boatloads full of euros.

Would-be pirates will be disappointed that no currency flotillas cross back and forth on the Atlantic.

What really takes place, for the most part, is down on Maiden Lane in Manhattan’s financial district. That’s where the headquarters of the Federal Reserve Bank of New York is located.

Like most interbank transfers these days, everything is done electronically.

When the ECB wants dollars, it gives notice to the New York Fed. The notice contains how many dollars the ECB wants, when it wants them, what the exchange rate is at the time, when it will pay back the dollars, and what the interest rate will be.

Until today, the interest rate was one percent plus something called the US dollar Overnight Indexed Swap Rate. Today’s announcement cut the spread in half, so that the ECB now borrows at just half a percent over the OIS. (It’s very telling that only the ECB has to pay interest. There’s no price for the Fed getting to hold euros.)

Next—and this is important—nothing happens. Not really, that is.

Nothing moves anywhere. No currency flotillas leave for the high seas.

All that happens is that an account at the NY Fed that the ECB has designated as its swap account gets credited with the dollars. This account is really just a line on a spreadsheet in a computer in that Fed building on Maiden Lane. Crediting the account just means that someone enters numbers into a spreadsheet.

At the same time, the ECB enters numbers onto a spreadsheet housed in a computer in Frankfurt, Germany, where the ECB is headquartered.

Those numbers represent Euros that are now “in” an account for the NY Fed.

Neither the dollars nor the Euros come from anywhere. They aren’t moved or debited from anywhere. They are invented right on the spot with a few taps on the key pad. And that’s all. There’s no printing press fired up to make new dollars or euros.

This is sometimes called “fiat money.” But that makes it sound as if some command from a sovereign created the money. It’s really closer to “keyboard money,” since it is created by data entry in a computer.

While the swap is outstanding, the ECB can lend the dollars in its account to European banks. It does this simply by telling the NY Fed that it wants to credit the account of a European bank and debit its account. This all happens, again, by someone typing the data into a computer.

Flash forward to the maturity date—the date when the swap is supposed to be unwound. On that day, the Fed simply zeros out the ECB’s account. This means there are no dollars left in it to be lent out to banks, although that’s really just a metaphor. What it really means is that the Fed will not credit the accounts European banks if asked to do so out of the zero’d out account.

If the ECB’s account on the maturity date has the right amount in it, then the swap is closed off. If there’s a shortfall, then a new swap is created to represent this amount. This means that it’s pretty much impossible for the ECB to default on this loan, since any shortfall is just rolled over into a new loans.


That said, the announcement today is good insofar as it will help avoid a dollar-LIBOR blowout like in 2008-09, and this was indicated by swap spreads moving down around 15bps (that’s fifteen, not fifty!). In reducing the risk of a repeat interbank funding crunch, it is a positive, but it does little to address fundamental issues, and the idea that (as the Fed states) this will help households, businesses, or foster activity is a joke — it helps the megabanks and large financial institutions and throws the weakest ones a life preserver.


Since these are loans between central banks — the U.S. Fed will not lend to any foreign banks directly — there is essentially no risk to the U.S. If the Fed makes a loan to the European Central Bank, and the ECB lends the money to a bank that later fails, it is the ECB that is on the hook for losses, not the U.S. The European Central Bank would still be obligated to pay back the U.S. in full.

The other possible downside is that the short-term expansion in the Fed and other central bank balance sheets that would come with these loans will stoke inflation fears. But since these loans have an expiration date (i.e. the balance sheet will be expected to contract at some point in the future), this shouldn’t be a big problem.

Finally, note that while this move can ease financial market conditions, it does nothing to address the underlying problems creating those conditions. So this is no substitute for the difficult decisions that Europe must make to overcome its troubles.

Tomorrow’s Tape- WSJ


  • 8:30 a.m. ET: Weekly jobless claims. Economists expect claims to fall to 390,000 from 393,000 the week before.
  • 10:00 a.m.: ISM manufacturing index for November. Economists expect this to rise to 51 from 50.8 in October.
  • 10:00 a.m.: Construction spending for October. Economists expect this to rise 0.3% following a 0.2% gain in September.
  • All day: November auto sales.


  • We hear from Kroger and H&R Block.