Cross-Currency Basis Swaps

What Are Cross-Currency Basis Swaps?

A cross-currency basis swap is an agreement between two parties to exchange principal and interest payments in different currencies. Unlike a simple FX swap, basis swaps involve exchanging floating-rate payments in both currencies, with the "basis" representing an additional spread paid by one party.

These instruments are fundamental to global finance. Banks, corporations, and institutional investors use them to access funding in currencies where they lack natural deposits, hedge foreign currency liabilities, and manage liquidity across borders.

Swap Mechanics

A standard cross-currency basis swap works as follows:

At initiation:

• Party A provides USD principal to Party B
• Party B provides EUR principal to Party A
• Exchange occurs at the current spot rate

During the swap term (e.g., 3 years):

• Party A pays EUR EURIBOR (floating) to Party B
• Party B pays USD SOFR + basis spread (floating) to Party A

At maturity:

• Principal amounts are re-exchanged at the original spot rate (not current rate)

Basis Swap Flow Diagram (Conceptual)

Initiation:
Party A ----[$100 million]----> Party B
Party A <---[EUR 90 million]--- Party B

During term (quarterly):
Party A ---[EURIBOR on EUR 90M]---> Party B
Party A <--[SOFR + basis on $100M]-- Party B

Maturity:
Party A <---[$100 million]---- Party B
Party A ---[EUR 90 million]---> Party B

The basis spread is the key variable. If the spread is -30 basis points, Party B pays SOFR minus 30 bps, meaning Party A (the USD provider) receives less than the benchmark rate.

The Basis Spread Explained

In a frictionless world with covered interest parity (CIP), the basis should be zero. Any deviation would create arbitrage profits that market participants would immediately exploit.

In reality, basis spreads are persistently non-zero. The EUR/USD basis typically ranges from -20 to -50 basis points, meaning:

• European banks pay a premium to access USD funding
• The USD lender receives less than the benchmark USD rate
• CIP "breaks down"

Why Does Basis Exist?

Several factors explain persistent basis spreads:

Credit risk differentiation: USD cash is predominantly held by US banks. Non-US banks accessing USD through swaps may pose different credit risks than direct USD depositors.

Regulatory constraints: Post-2008 banking regulations (Basel III, leverage ratios) limit banks' ability to arbitrage small pricing discrepancies. Balance sheet usage has a cost.

Funding preferences: Some investors prefer direct USD funding over synthetic USD created through swaps, creating natural demand imbalance.

Counterparty limits: Banks have limited capacity to face any single counterparty, restricting arbitrage even when profitable.

Structural supply/demand: Non-US institutions (European banks, Japanese insurers) have ongoing USD funding needs that exceed natural USD availability outside the US.

The USD Funding Premium

Non-US banks need US dollars to fund dollar-denominated assets (loans, bonds, derivatives). Their options:

1. Raise USD deposits directly (limited outside US)
2. Issue USD-denominated bonds (expensive, requires market access)
3. Use cross-currency basis swaps (swap local currency funding for USD)

Because options 1 and 2 are constrained, option 3 faces persistent demand pressure, pushing the basis negative. This negative basis represents the premium non-US banks pay to synthetically create USD funding.

Typical Basis Levels by Currency Pair

Basis spreads widen during stress periods when:

• USD demand spikes (flight to safety)
• Counterparty credit concerns increase
• Bank balance sheet capacity tightens
• Fed dollar liquidity decreases

The March 2020 COVID crisis saw basis spreads blow out to levels not seen since 2008, prompting the Federal Reserve to expand USD swap lines with foreign central banks.

Practical Implications

For Non-US Corporations

A European company with USD funding needs faces a choice:

Option 1: Direct USD borrowing

• Issue USD bonds at Treasury + credit spread
• Example: 4.50% + 1.00% = 5.50%

Option 2: EUR borrowing + cross-currency swap

• Issue EUR bonds at German Bund + credit spread
• Example: 2.50% + 0.80% = 3.30%
• Swap to USD, paying basis: -30 bps
• All-in USD cost: 5.50% - 0.30% adjustment = 5.20%

When basis is significantly negative, the swap route can be cheaper—though it introduces swap counterparty risk and complexity.

For Investors

Cross-currency basis affects:

Currency-hedged bond returns: A Japanese investor buying US Treasuries and hedging back to JPY pays the basis on top of normal hedging costs. With JPY/USD basis at -50 bps, hedged USD bond yields are reduced by 0.50% annually.

Relative value opportunities: Wide basis creates opportunities for investors who can provide USD funding without balance sheet constraints.

Macro signaling: Rapid basis widening indicates stress in global dollar funding markets, often preceding broader market dislocations.

For Banks

Basis represents a real cost of balance sheet usage. Banks with direct USD deposits have a competitive advantage over those relying on synthetic USD funding. This affects:

• Pricing on USD loans to non-US clients
• Competitiveness in USD-denominated markets
• Treasury and funding strategy

Monitoring the Basis

Several data sources track basis swap spreads:

• Bloomberg: EUBS (EUR/USD), JYBS (JPY/USD) tickers
• ICE: Published basis swap benchmarks
• Bank research: Regular commentary on funding markets

Key indicators to watch:

• Current basis level vs. historical range
• Direction of basis movement (widening = stress)
• Term structure (short vs. long-dated basis)
• Central bank swap line usage
• Year-end turn pressures (basis typically widens Q4)
• Regulatory reporting dates affecting bank balance sheets

Central Bank Swap Lines

During funding stress, central banks provide backstop USD liquidity through swap lines. The Federal Reserve has standing arrangements with the ECB, BoJ, BoE, and other major central banks.

When activated:

1. Foreign central bank draws USD from the Fed
2. Fed receives foreign currency as collateral
3. Foreign central bank lends USD to domestic banks
4. Arrangement reverses at maturity

These facilities set a ceiling on basis widening. If market basis exceeds the Fed swap line cost (typically SOFR + 25 bps), banks can access Fed liquidity through their central bank instead.

The March 2020 crisis demonstrated this mechanism. As basis widened to -80-100 bps, the Fed enhanced swap lines by lowering rates and extending maturities. Basis subsequently narrowed as the liquidity backstop restored confidence.

Basis Swaps and CIP Violations

Academic finance traditionally assumed covered interest parity held continuously. Post-2008 evidence shows persistent CIP violations, challenging theories of market efficiency.

Possible explanations:

Limits to arbitrage: Regulatory costs, balance sheet constraints, and counterparty limits prevent arbitrage from eliminating pricing discrepancies.

Segmented markets: USD holders and USD seekers don't perfectly overlap, creating natural supply/demand imbalances.

Risk compensation: The basis may compensate USD providers for counterparty risk, liquidity risk, or regulatory capital usage.

For practitioners, the key insight is that basis represents real economic costs. These costs affect:

• Corporate funding decisions
• Investment return calculations for hedged positions
• Relative value across currencies
• Stress signals in global funding markets

Understanding basis swaps provides insight into the plumbing of global finance—the infrastructure that allows capital to flow across borders and currencies. When that plumbing becomes stressed, basis widening often provides an early warning before broader market dislocations become visible.