How the Fed’s Fima addressed the 2020 dollar liquidity shortage

The unprecedented step followed weeks of market turmoil as volatility reached levels not seen since the financial crisis and liquidity dried up in the Treasury market. This episode has come to be known as the “dash for cash”. Amid the unprecedented uncertainty created by Covid-19, investors began precipitously to abandon Treasuries to get dollars. As this trend grew in size and speed, Treasury yields duly rose, a move that ran counter to the Fed’s policy goals. Earlier in March, the Federal Open Market Committee (FOMC) had cut the Federal funds rate to 0–0.25% with aim of preventing tighter financing conditions for the Federal government, businesses and households. However, the market was now going in the other direction.

The rationale behind participants’ behaviour differed, but all of them chose to sell the most liquid asset. In some instances, participants sold Treasuries to buy equities following the sharp fall in that market in previous weeks. Elsewhere, sales followed losses on other positions, or were made to honour short-term debt. The upshot was that as investors initiated a flight to safety, sharp capital outflows started to hit emerging markets. Then, in a bid to manage these flows and defend their exchange rates, central banks joined sellers of US government securities. The dash had gone global.

One example among emerging market economies was Indonesia. Between 31 January and 24 March, the rupiah fell almost 18% against the dollar. Bank Indonesia adopted a triple intervention strategy, one pillar of which were spot market interventions selling US Treasuries. These interventions were costly in the short term, and reserves in Jakarta fell by almost $10 billion to $121 billion by the end of March.

As they tried to sell, central banks and other market participants encountered buyers, but not enough to meet such a sharp increase in supply. This development hampered the execution of even mid-sized transactions, increasing costs. The price of derivatives, especially Treasury futures, became disconnected from the bonds they were linked to. In addition, the prices of both on-the-run and off-the-run Treasuries were so volatile that pricing them was difficult as buy and sell spreads became ever wider. The market for the world’s risk-free asset was creaking.

In this environment, the Bank of Mexico delayed the renewal of its strategic asset allocation for a few weeks. This exercise typically entails a rebalancing of the reserves portfolio, which was hard to implement amid high buy and sell differentials. “Many central banks sold part of their Treasury holdings, and I imagine the Fed became worried about it,” explained Gerardo García, director of international operations at Bank of Mexico, in May 2021.

The impact can be best seen in the numbers. In March 2020, foreign official holdings of Treasuries at the Federal Reserve declined by a record $128 billion from $2.98 trillion on 4 March²² Federal Reserve, “Factors Affecting Reserve Balances,” Federal Reserve Statistical Release, 5 March 2020 (available at https://www.federalreserve.gov/releases/h41/20200305/). to $2.85 trillion 1 April.³³ Federal Reserve, “Factors Affecting Reserve Balances,” Federal Reserve Statistical Release, 2 April 2020 (available at https://www.federalreserve.gov/releases/h41/20200402/). Over the same period, foreign official dollar cash holdings at the Fed increased from $5.2 billion to $17.2 billion.

“My impression is that the Fed created Fima due to these operations,” added Garcia. “What would the Fed prefer, that central banks sell their holdings under stress, contributing to affect rates and a disorderly behaviour in the market, or rather provide a facility through which these institutions can use repurchase agreements to access liquidity?”

From this perspective, Fima’s effectiveness with respect to its first goal of smoothing conditions in the Treasury market can be measured through the progressive increase in Treasury securities in custody for foreign official institutions at the Fed. One year on this had recovered, and was in fact higher at $3.1 trillion on 28 April 2021.⁴⁴ Federal Reserve, “Factors Affecting Reserve Balances,” Federal Reserve Statistical Release, 6 May 2021 (available at https://www.federalreserve.gov/releases/h41/current/).

Fima is essentially an overnight repurchase agreement. It offers greater security to central banks seeking swap operations in dollars during times of crisis because it features a fixed interest rate, which reduces costs. Normally, in this type of temporary operation, a reserve manager needs to contend with variations in asset prices, both when they sell Treasuries to provide liquidity to local agents, and then again during the repurchase once the operation is completed. Through Fima, these risks are under control.

This convinced Bank Indonesia to rapidly apply for access to Fima, which it secured on 9 April 2020.⁵⁵ Bank Indonesia, “Latest Economic Developments and BI Measures Against Covid-19,” News Release, 9 April 2020 (available at https://www.bi.go.id/en/publikasi/ruang-media/news-release/Pages/Perkembangan-Terkini-Perekonomian-dan-Langkah-BI-dalam-Hadapi-COVID-19–09042020.aspx). In addition, other emerging market central banks have confirmed to the author they have had access granted, including the Bank of Mexico, the South African Reserve Bank, the Central Bank of Colombia and the Central Bank of Chile.

All of these first went through the testing period the New York Fed required before on-boarding them in the programme. This is mainly because Fima is a new operation both for the Fed and the central banks. Therefore, New York decided to carry out small value transactions with every applicant to ensure all the technical plumbing worked correctly.

Further, some central banks had not had a great deal of experience carrying out repos, and the Fed wanted to make sure that once it on-boarded a central bank that its systems would work, and that their staff would understand the sequence of messages and instructions they needed to send. Another factor is that some institutions held few or no securities at the Fed. The testing process served to check whether they would be able to bring their securities from their private custodians to complete the repos. Due to Fima’s global reach, the Fed also wanted to make sure that timezone differentials would not prevent institutions in Asia, Africa or Europe from adequately accessing the facility from day one.

There have been no individual agreements to access the facility in the sense that all central banks entered into Fima under the same terms. The amount of dollars available for drawdown is constrained first by the amount of Treasuries an individual central bank has, and secondly by a daily per-counterparty cap set by the Fed’s foreign currency subcommittee. The interest rate on these operations remains unchanged regardless of the amount drawn.

If the amount of Treasuries is lower than the cap, holdings of government securities would be the limit. If instead Treasuries are above the cap, this would be binding. Notwithstanding this, the subcommittee “may approve changes in the offering rate, the maturity of the transactions, and counterparty limits,” says the Fima’s desk resolution.⁶⁶ FIMA, “Desk Resolution,” approved 15 December 2020 (available at https://www.federalreserve.gov/monetarypolicy/files/FOMC_FIMADeskResolution.pdf).

“The Fed’s announcement of the new repurchase agreement was welcome. In case of need, it offers the option of accessing dollar cash without having to sell your reserve assets at market prices, which in a low-liquidity environment can be very disadvantageous,” explained Diego Cifuentes, director of the international investment department at the Central Bank of Colombia in May 2021. “We presented the initiative to the central bank’s board, and our back office went through the test process with the Fed.”

Although a fully fledged member of the scheme, the Colombian central bank has not resorted to the facility during the crisis, a common approach among similar counterparts. The maximum usage has been a daily average over a week of $1.4 billion, although for most weeks the daily average has been zero.

In addition to contributing to an orderly Treasury market, Fima’s achievements with respect to liquidity have proved equally valuable. However, they are harder to measure. The facility became available right after the stress period of March 2020, which has not been repeated. This explains the limited usage of a tool designed for tumultuous times. Nonetheless, some argue that the fact that the market has remained stable is partly due to the facility’s existence. For them, it is a dog that didn’t bark.

Other factors have contributed to the limited number and size of the transactions. Reserve managers point out the usefulness of this facility for emerging market economies is determined to a large degree by the need to intervene in the foreign exchange market – ie, when they deploy reserves. This can vary widely between central banks depending on the buffers they and their governments have in place to absorb external shocks.

As in the case of Colombia, the Chilean central bank has not made use of Fima. Chile has a significant savings stock in its pension and sovereign funds, and the country’s solid macroeconomic framework is underpinned by an autonomous central bank. Additionally, authorities share the consensus that the exchange rate should be the prime shock absorber. Nonetheless, the Central Bank of Chile welcomed Fima as a very useful tool to access liquidity in US dollars. Diego Gianelli, head of financial markets operations at the central bank, noted Fima could be especially useful for the central bank to carry out swap operations with its domestic private sector especially if this is due to a deterioration of external financial conditions. The institution has implemented this measure twice over the past two years: once in November 2019 during a period of acute social unrest and peso depreciation, and again in March 2020 when the cost of funding in dollars for the private sector was very high.

On both occasions, the central bank deployed around $1.2 billion through swaps with the local banking system. “These operations entail selling part of our Treasuries and rebalancing the portfolio,” said Gianelli in May 2021. “Fima could have been useful to finance these operations at a low cost, but these have not been needed since we gained access to it.”

Even so, the circumstances under which the central bank would need to raise liquidity in the markets would be triggered either by internal instability or global financial stress. In both instances, Fima could serve the institution well, allowing it to secure dollar funding at sustainable conditions and preserving financial stability.

What Fima does not change is the overall level of reserves – and the Chilean central bank has prioritised this aspect in the wake of the foreign exchange interventions it carried out in late 2019 to defend the national currency. This crisis was swiftly followed by the pandemic a few months later. Against this backdrop, the institution decided it needed to increase its resources to better deal with these risks in the future. In May 2020, it secured a $24 billion two-year flexible credit line (FCL)⁷⁷ IMF, “IMF Executive Board Approves Two-year US$23.93 Billion Flexible Credit Line Arrangement for Chile,” Press Release No. PR 20227, 29 May 2020 (available at https://www.imf.org/en/News/Articles/2020/05/29/pr20227-imf-executive-board-approves-two-year-flexible-credit-linearrangement). with the International Monetary Fund (IMF), and in July it agreed to extend its peso–renminbi swap line⁸⁸ Central Bank of Chile, “Líneas de Financiamiento Internacional con Bancos Centrales,” press release, 24 July 2020 (available at https://www.bcentral.cl/en/web/banco-central/content/-/detalle/lineas-definanciamiento-internacional-con-bancos-centrales-2). with the People’s Bank of China. First signed in 2015 and renewed for three more years in 2018, it was increased last year from RMB22 billion ($3.4 billion) to RMB50 billion.

“These [the FCL and the renminbi swap line] allow us to exchange pesos for dollars or pesos for renminbi, which boosts our reserve portfolio. This lines are very important at this moment, as we are conducting a program of reserve accumulation,” said Gianelli.

In January 2021, the Central Bank of Chile announced a plan increase its reserves by $12 billion by February 2022. As a result of this process, the institution’s reserves have increased from $39.2 billion in December 2020 to $42.2 billion in April 2021, according to official data.⁹⁹ Central Bank of Chile, “Principales Estadísticas Macro” (available at https://si3.bcentral.cl/Siete/ES/Siete/Cuadro/CAP_ESTADIST_MACRO/MN_EST_MACRO_IV/PEM_BP_Res_Coy/PEM_BP_ Res_Coy). Once the Chilean central bank completes the reserves purchase programme, it is unlikely to renew the IMF’s FCL next year.

“In contrast, Fima offers us the option to exchange our Treasuries for dollars, which secures access to liquidity without having to sell these securities. It is important to highlight that our reserves are very liquid. At this moment 75% are denominated in US dollar treasuries and have a very short duration, of around three years,” explained Gianelli.

The Fed deems Fima a complement to the set of liquidity swap lines it has with a small group of major central banks worldwide. However, Fima serves to reach a much broader group of central banks, and the connection is more direct in the sense that through Fima the Fed directly takes central banks’ Treasuries as collateral, as opposed to a swap of foreign exchange.

Five central banks have permanent liquidity swaps with the Fed: the Bank of Canada; the Bank of England; the Bank of Japan; the European Central Bank; and the Swiss National Bank. Additionally, in March 2020¹⁰¹⁰ Federal Reserve Bank of New York, “Central Bank Swap Arrangements” (available at https://www.newyorkfed.org/markets/international-market-operations/central-bank-swap-arrangements). it entered into temporary liquidity arrangements with nine more central banks – these offer up to $60 billion for the Reserve Bank of Australia, the Central Bank of Brazil, the Bank of Korea, the Bank of Mexico and Sveriges Riksbank.

Additionally, it established new lines of up to $30 billion with the National Bank of Denmark, Norges Bank and the Reserve Bank of New Zealand. In July, the Fed first extended these temporary lines until 31 March 2021.¹¹¹¹ Federal Reserve, “Federal Reserve Board Announces the Extensions of its Temporary U.S. Dollar Liquidity Swap Lines and the Temporary Repurchase Agreement Facility for Foreign and International Monetary Authorities (FIMA Repo Facility) through March 31, 2021,” press release, 29 July 2020 (available at https://www.federalreserve.gov/newsevents/pressreleases/monetary20200729b.htm). In December 2020, it extended them again until 30 September 2021,¹²¹² Federal Reserve, “Federal Reserve Announces the Extension of its Temporary U.S. Dollar Liquidity Swap Lines and the Temporary Repurchase Agreement Facility for Foreign and International Monetary Authorities (FIMA Repo Facility) through September 30, 2021,” press release, 16 December 2020 (available at https://www.federalreserve.gov/newsevents/pressreleases/monetary20201216c.htm#:~:text=The%20Federal%20Reserve%20on%20Wednesday,)%20through%20September%20 30%2C%202021.). the current limit.

In contrast to Fima, these lines played a more significant role in addressing local demand for dollars in the early stages of the pandemic. “Fima is very useful in providing support to other countries that lack access to swap lines,” said Bank of Mexico’s García. “Nonetheless, I think it is backup measure of last resource. In terms of costs, most central banks would find better conditions to carry out repurchase agreements in the market, as long as conditions are normal.”

Having access to both a liquidity swap line and Fima, the Bank of Mexico leveraged the former to address liquidity needs in the national financial system. When the crisis started, as a precautionary measure major companies such as Coca Cola, Cemex and Bimbo activated credit lines they had with Mexican commercial banks. Most of these lines are in US dollars. To respond to this internal demand, the Bank of Mexico therefore leveraged its $60 billion liquidity swap line with the Fed to channel dollar resources to the local banks that they needed to honour their commitments with these companies.

“The Fed designs them so that when market conditions are adequate foreign central banks prefer to access liquidity in the market,” explained García. Due to improved financing conditions, the current usage of the swap line hovers around $1 billion. However, at the peak of the crisis the institution used slightly over $6 billion through the line. “It was not a lot, but proved enough to calm markets,” he added.

In South Africa, financial markets proved to be deep and liquid enough to navigate the last year without activating Fima. “South African corporates were fairly well hedged in terms of their foreign liabilities during the Covid-19 shock. This helped the market in the sense that there wasn’t a constant need to access dollars on a monthly basis,” explained Zafar Parker, head of financial markets department at the South African Reserve Bank in May 2021. “Companies here had hedged many of their funding exposures over a long period of time.”

He also points out that the unprecedented monetary stimulus major central banks have provided through asset purchases is boosting dollar liquidity worldwide. As a consequence, “dollar liquidity rapidly rose in many emerging markets,” said Parker.

Nonetheless, he favoured Fima becoming a permanent backstop policy tool. “The Fed’s consideration about keeping Fima as a permanent backstop facility for foreign central banks would be a good thing. It would give markets the overall sense of safety that even in cases of acute stress, central banks would always have access to dollars, and they would not need to sell their foreign reserves assets.”

Cifuentes from the Central Bank of Colombia agreed that a permanent status “would be a backstop in case of future liquidity shocks.”

As the Fed extended the new liquidity lines it set up last year, first in July and again in December, it also prolonged Fima. Now the facility is due to expire on 30 September 2021, unless the FOMC decides to extend it once more. On 15 April 2021,¹³¹³ Central Banking, “Fed may make Fima Permanent – SF President Daly,” 16 April 2021 (available at https://www.centralbanking.com/central-banks/monetary-policy/7823166/fed-may-make-fimapermanent-says-daly). the president of the Federal Reserve Bank of San Francisco, Mary Daly, said US officials were discussing the possibility of making Fima permanent.

Daly warned the Fed needs to be “the last, not the first, line of defence.” The FOMC member cautioned that “regularly relying on ‘save the day’ interventions by the Federal Reserve can be costly” to the public sector. Nonetheless, she acknowledged a permanent status for Fima “would provide assurance to markets that liquidity will be available in times of stress, but they could also leave financial markets more dependent on their existence,” she said. “So, further careful study is required.”

This is an extended and revised version of an article first published on centralbanking.com.