How Does Europe Borrow Dollars From the Fed?

The Federal Reserve and other banks announced Wednesdaythat they were engaging in acoordinated actionto provide liquidity to Europe's credit markets.

Euro coin in front of the giant symbol of the Euro outside the headquarters of the European Central Bank.
Thomas Lohnes | AFP | Getty Images
Euro coin in front of the giant symbol of the Euro outside the headquarters of the European Central Bank.

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

The ECBwants 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.

Why might there be a shortfall? Remember, the ECB is borrowing dollars so that it can lend them out to European banks. If those banks haven’t repaid those loans, it must “purchase” the dollars from elsewhere—most likely other banks.

What’s more, the ECB must pay interest on the swap—which means that it must always purchase a few dollars more than it borrowed or collect those dollars in interest from the banks it lent to. If it doesn’t purchase the dollars or get those interest payments, you get a shortfall.

By the way, there’s nothing in the swap agreement about what happens if the Fed doesn’t have the euros to refund the ECB. That’s because it is impossible for the Fed not to “have” those euros. You see, the ECB created the euros “held” as collateral for the loan by entering data on a spreadsheet. As far as I can tell, there is no provision at all for the Fed to “draw” from the “account” in which the euros are held.

They just “sit” there—although, again, since its just numbers on a spreadsheet, nothing is physically sitting anywhere.

To be honest, I don’t think there is an economic point to the existence of the Fed account with the ECB. What do we care if there is a spreadsheet in Frankfurt that represents the conceptual Fed possession of a bunch of euros?

I suspect the reason for this is entirely legal and optical. It’s good for all the central bankers to be able to tell the world that these loans are fully collateralized. Depending on how you read the regulations, the Fed may even be required to be able to claim it has collateral for the loans—even if that collateral is just a line entry on a spreadsheet in a computer housed in the very central bank that is borrowing dollars.

I’m not even 100 percent confident that anyone in Frankfurt does enter the numbers into a spreadsheet. Why would they? There’s no point at all to having them entered and automatically erased at the end of the swap.

And since the Fed doesn’t use those euros during the period of the swap, there’s no need to keep track of how many are in the account. If you’re a Frankfurt central banking clerk, why not just take a smoke break instead of opening the computer file that has this totally made up account in it?

(An earlier version of this post ran on October 20th, 2011)

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