What Is a Swap Network?

A swap network is a reciprocal credit line established between central banks. The purpose of a swap network is to allow central banks to exchange currencies with one-another in order to maintain a liquid and stable currency market.

Swap networks are also known as "currency swap lines," or as "temporary reciprocal currency arrangements."

Key Takeaways

  • Swap networks are credit facilities established between central banks.
  • They are an important tool for reducing and managing financial risks, because they allow central banks to increase liquidity in both international and domestic banking sectors.
  • During the 2007–2008 financial crisis, the U.S. Federal Reserve established large swap network facilities with other central banks throughout the world.

Understanding Swap Networks

The purpose of a swap network is to maintain liquidity in foreign and domestic currencies so that commercial banks can maintain their mandated reserve requirements. By lending currency between themselves and auctioning off the borrowed funds to private banks, central banks can influence the supply of currencies and thereby help lower the interest rate that banks charge when lending to one-another. This interest rate is known as the London Inter-Bank Offered Rate (LIBOR).

Swap networks can play a critical role in maintaining financial-market stability when liquidity is otherwise strained, such as in the midst of a credit crunch. The swap network can help increase banks' access to affordable financing, which in turn can be passed in to businesses throughout the economy in the form of bank loans. For this reason, central banks are sometimes referred to as "the lender of last resort."

In the United States, the Federal Reserve operates swap networks under the authority granted to it by Section 14 of the Federal Reserve Act. In doing so, the Federal Reserve must also comply with the authorizations, policies, and procedures established by the Federal Open Market Committee (FOMC).

During the 2007–2008 financial crisis, swap network arrangements were used extensively by central banks throughout the world. At that time, central banks worldwide were desperate to improve liquidity conditions in the foreign exchange market and among domestic banks.

Real World Example of a Swap Network

In Sept. 2008, at the height of the financial crisis, the Federal Reserve authorized a $180 billion increase to its swap network, thereby increasing its lines of credit with the central banks of Canada, England, and Japan. Central banks the world over worked closely with one-another to help prevent the crisis from spiraling out of control.

More recently, the European Central Bank (ECB) agreed in Oct. 2013 to establish a swap network with the People's Bank of China (PBOC). Under this agreement, the ECB extended euros worth about $50 billion to the PBOC, while the PBOC extended the same amount to the ECB in its own currency, the yuan.

While swap networks give central banks the ability to exchange currencies with one-another on demand, this does not mean that they will necessarily do so. Instead, the swap network provides a source of liquidity in the event of an emergency, reducing anxiety among banks and other market participants. In the case of the ECB-PBOC swap network, the arrangement reduces the risk for eurozone banks with an international presence to do business in yuan; and vice versa for Chinese banks doing business in the eurozone. In this manner, the establishment of a swap network is in part a way to instill investor confidence.