Please see the last page of this publication for important disclosures.

August 29 2011
US Rates Strategy | Special

Cross-Currency Basis Swaps: The

Supply Effect
„ The EUR/USD currency swap is being used by European financial
institutions to fund USD assets when repo lines or raising USD
through commercial paper, CDs, or other funding sources becomes
too expensive or inaccessible (borrowing dollars). This market is
showing signs of funding stress which we look at in some detail
below.

„ European corporations, agencies, supranationals and sovereigns use

the cross-currency basis swap to swap USD issuance back into Euro
(lending dollars).

„ The EUR/USD cross currency basis swap is currently attractive for

European issuers looking to issue in dollars and swap it back to
euros. For instance, as highlighted below, some issuers could do
this and improve their funding levels by over 40 bp.

„ The attractive levels could prompt USD issuance to fund the

European bailouts, and if this occurs, we expect the basis to narrow.

„ An increase in the use of the Fed and ECB’s swap lines could also
narrow the basis.

„ The main factors that have resulted in a more attractive basis swap
include European bank funding concerns, demand for USD from
European financial institutions, and a decline in USD issuance from
European corporate and SSA issuers.

Potential Source of New European USD Supply

Our European strategists continue to expect the lending capacity of the
European Financial Stability Facility (EFSF) to increase from EUR 256
Eric Hiller bn to EUR 440 bn 1 . The increase is subject to parliamentary approval
Head of Derivatives Strategy
in the EU which is expected to be completed by the end of September
or the beginning of October at the earliest. Our European strategists
+1 203 897 2652
currently think about 25% of the issuance could be in USD which would
eric.hiller@rbs.com
equate to as much as $158 bn at current FX rates. The exception
would be if EFSF issuance ended up being fairly low (i.e. EUR 50 bn or
Ryan Graf less).
Rates Strategy
+1 312 664 7085
As we outline below, the cross currency basis makes USD issuance
relatively more attractive for EFSF and other European issuers. If they
ryan.graf@rbs.com

www.rbsm.com/strategy 1
See The All New and Improved EFSF by our European strategists for more details.
Bloomberg: RBSR<GO>
The Royal Bank of Scotland

are able to fund in USD at similar local spreads, current basis swap
levels would makes it very attractive for the EFSF to ramp up USD
issuance. In addition, it is highly likely that such issuance and the

US Rates Strategy | Special | August 29 2011

swapping activity would push the currency basis back toward less
stressed levels.

Longer Tenor Cross Currency Swaps Affected by Issuance

Longer-term cross currency basis swaps are strongly related to supply
and demand of USD and have been less volatile than shorter maturity
basis swaps as seen in figure 2. In fact, the longer term EUR/USD
basis swap levels closely track USD issuance from European
corporations and SSA as highlighted below. When a European issuer
issues in USD and uses the basis swap to convert the USD into EUR, it
supplies USD to European financial institutions causing the basis to
become less negative. The lopsided demand for USD funding drove
the basis negative and an offsetting flow from issuers would reduce the
supply/demand imbalance.

Figure 1: Yankee issuance from Euro area corporations and SSA

has had a tendency to push the term EUR/USD basis closer to zero

50 0
45 -5
40

Avg Monthly Basis Swap Level (bp)

-10
35
-15
Issuance ($bn)

30
-20
25
-25
20
-30
15
10 -35

5 -40

0 -45
Jan-10 Apr-10 Jul-10 Oct-10 Jan-11 Apr-11 Jul-11
Issuance Avg 3yr EUR/USD Basis Swap 2M Moving Avg. (Issuance)

Source: RBS, Dealogic, Bloomberg

2
The Royal Bank of Scotland

Figure 2: The EUR/USD basis provides a funding advantage to

Yankee issuers which has varied with time and time to maturity

US Rates Strategy | Special | August 29 2011

20

EUR/USD basis (bps)

-20

-40

-60

-80 26-Nov-10 28-Feb-11

26-May-11 26-Aug-11
-100
0.0 2.5 5.0 7.5 10.0 12.5 15.0 17.5 20.0 22.5 25.0 27.5 30.0

Maturity (years)

Source: RBS

Fed Swap Lines Affected the Basis

Another factor which affected the basis in the past was the Fed’s USD
swap lines with foreign central banks. As part of its effort to deal with
the liquidity crisis of late 2008, the Fed ramped up its USD swap lines
with foreign central banks, and open lines reached almost $600 bn at
the peak. This led to a normalization of the cross currency basis to
pre-crisis levels. If the current funding situation were to worsen, USD
from the Fed’s central bank swap lines could collapse the basis.

Figure 3: Fed Swap Lines versus 3m EUR/USD Basis Swap

700 0
-20
600
-40
Fed USD Swap Lines ($bn)

500 -60

Basis Swap (bp)

-80
400
-100
300
-120

200 -140
-160
100
-180
0 -200
7/2/08 9/2/08 11/2/08 1/2/09 3/2/09 5/2/09 7/2/09 9/2/09 11/2/09
USD Swap Lines EUR/USD 3m

Source: RBS, NY Fed, Bloomberg

Benefiting from the Wide Basis

For European issuers, the benefits of issuing in USD and utilizing the
basis swap include diversification of funding and potentially more
attractive funding levels. Whether or not it ultimately makes sense for a
European issuer to issue in USD depends not only on where the basis
swap is but also funding levels in each currency. For example, by
3
The Royal Bank of Scotland

issuing in USD and using a basis swap to convert to EUR, the

European Investment Bank (EIB) can currently recognize a 44 bp
funding advantage over where their 5yr EUR debt is trading as seen

US Rates Strategy | Special | August 29 2011

below 2 .

Figure 4: A Cross Currency Funding Example with EIB

EUR Eqivalent of USD

5yr Levels USD EUR Funding Level
Spread (bp) Libor + 5 bp Euribor + 5 bp Euribor - 39 bp

Source: RBS, NY Fed, Bloomberg

Figure 5: Steps to Convert USD Funding to EUR Funding

1) Issuer sells a USD debenture
2) If fixed rate, issuer uses a vanilla USD interest rate swap to convert those cash flows to floating
rate (3mL + spread)
3) Cross-currency basis swap converts USD 3mL payments to 3m Euribor + spread
4) A Euribor 3s6s basis swap converts 3m Euribor + spread to 6m Euribor + spread
5) All of these swaps can be done as one transaction

Source: RBS

EFSF has issued three EUR deals to date totaling EUR 13 bn, but it is
unclear where USD debt would trade. In EUR, 5yr EFSF currently
trades at Euribor + 8 bp or 3 bp wider than EIB. A similar spread in
USD would imply a level of L + 8 bp. This level would represent a
significant funding advantage for EFSF as it equates to Euribor – 35 bp.
Turning this around, it also means that EFSF (and other European
issuers could issue at significantly wider levels in dollars than in euros
and the funding would still be attractive.

What does the basis tell us about funding stress?

One of the main drivers of the 3m EUR/USD cross currency basis swap
is USD demand from European banks or other institutional investors.
These investors need to fund USD assets but repo lines or raising USD
through commercial paper, CDs, or other funding sources may be too
expensive or inaccessible. While these institutions could sell EUR, buy
USD and own the assets, this would instantly convert a credit decision
into a major currency risk. Instead, these institutions turn to the FX
market, selling euros for dollars on a spot basis and simultaneously
selling the dollars back at a future date in an FX swap. This lets the
institutions fund dollar assets until the forward rolls off or assets mature
or are sold.

EUR/USD Basis Swap Mechanics

To borrow USD, one can enter into a 3m FX swap (or a 3m cross

currency basis swap which is effectively the same). The institution sells

2
Note: The cross currency basis swap converts 3m Libor to 3m Euribor. Spreads to Euribor for EUR bonds are spread to 6m
Euribor. Thus, the Euibor 3s6s basis swap also contributes to the funding advantage.

4
The Royal Bank of Scotland

EUR and buys USD spot and also agrees to the unwind 3-months later.
Given that the market is overflowing with institutions trying to raise
dollars in the same direction, the forward foreign exchange transaction

US Rates Strategy | Special | August 29 2011

occurs at a less attractive effective funding level. Parity arguments
suggest that the effective cost is supposed to reflect the funding
differential (actually the discount function ratio) derived from US and
EUR rates. However, the actual funding rates are not equivalent to
Libor and Euribor, so the basis, which is described as a spread on the
Euribor side versus Libor flat, is not zero. Thus, the basis swap level
reflects the value of a money-market account in one currency divided
by the money-market account in the other currency which is then
converted back into a spread to Euribor. The single period cross-
currency basis is the relative difference in funding rates as follows:

If e = Euribor and u = US Libor (both in percent) then the usual

assumption for the basis swap spread, x, in percent (for a T day
period) is the following:

(1+u*T/360)*eur/eurfwd = (1+(e+x)*T/360)

In words, I give you a dollar on the spot date versus euros, and you
agree to pay me back the same number of dollars plus interest
computed at Libor. I agree to give you back the same number of euros
plus interest computed at Euribor plus a spread. Economically, I
should be indifferent whether we enter a basis swap or an FX swap
which means that the basis swap spread x neutralizes the effect of the
rate settings and the effective funding in the currency swap.

An FX swap also converts dollars to euros at the spot rate and then
converts the euros back to dollars a new rate when the swap ends (the
new rate is the forward rate at the time the swap is entered into). The
FX swap expresses the economics in a drop instead of an interest rate
spread. One difference however, is that the market drop reflects the
fact that the borrowing of USD does not happen at “u” nor the lending
of EUR at “e” but at two other effective rates u’ and e’. Thus, the FX
swap reflects actual funding rates that can vary significantly from Libor
and Euribor.

eurfwd/eur = (eur + drop) / eur = (1+u’*T/360)/(1+e’*T/360) = 1 + (u’-

e’)*T/360 + higher order terms.

With these two expressions we can compute the 3-month basis spread
from the 3-month drop. Putting it in terms that translate directly into
Bloomberg functions and custom expressions, the basis spread x, in
basis points is:

X = 10000 * (((1 + US0003M Index * 92 / 36000) * EUR Curncy / (EUR

Curncy + EUR3M Curncy / 10000) - 1) / (92 / 360) - EUR003M Index /
100)

5
 The Royal Bank of Scotland

Where EUR3M is the 3-month FX drop and T was set to an average day
count of 92 days as an approximation for the 3-month period 3 . The
same basis expression can easily be computed versus USD OIS and

US Rates Strategy | Special | August 29 2011

Eonia by replacing US0003M with USSOC and EUR003M with
EUSWEC. The basis to the OIS curves is significantly smaller which
may better focus the attention on the source of the distortion—Libor or
Euribor and the remaining bias to receive dollars.

Figure 6: EUR/USD Basis Swap (Calculated with Figure 7: Implied EUR/USD Basis Swap spread to
Libor and Euribor) Eonia versus OIS

0
0

-10 -10

-20 -20

-30 -30

Spread (bp)
Spread (bp)

-40 -40

-50 -50

-60 -60

-70 -70
-80 -80
-90
-90
Jan-10 Apr-10 Jul-10 Oct-10 Jan-11 Apr-11 Jul-11
Jan-10 Apr-10 Jul-10 Oct-10 Jan-11 Apr-11 Jul-11

Source: RBS Source: RBS

Moving from a 3-month basis swap (or FX swap) to the longer

tenor basis swap
Adding periods to the basis swap appends a forward starting version
of the above calculation. The forward discounting rates embed a pair
of FX forwards which is economically converted into a spread to the
Euribor side. The mid-market basis spread is the spread that brings the
total value of the multiple cash flows to zero. For a 3-month period, the
FX swap market tends to be more liquid than the currency basis. For
much longer-terms or multiple resets, the cross-currency basis swap
tends to be much more convenient and converts the full economics
into a spread to funding.

3
This expression can be used to generate a custom Bloomberg index. However, Bloomberg’s historical convention defaults for
currencies must be set to display points rather than outrights. To ensure this, on PDFN <GO>, under the “Defaults only apply to
CURRENCIES” section, set the Forward Rates option to 1.

6
The Royal Bank of Scotland

US Rates Strategy | Special | August 29 2011

Contributors

John Briggs Treasury Strategist (203) 897-4689 john.briggs@rbs.com

Michelle Girard Senior US Economist (203) 897-2818 michelle.girard@rbs.com

Ryan Graf Agency Strategist (312) 664-7085 ryan.graf@rbs.com

Eric Hiller Head of Derivatives Strategy (203) 897-2652 eric.hiller@rbs.com

Margaret Kerins, CFA Head of Agency Strategy (312) 664-7085 margaret.kerins@rbs.com

Jim Lee Head of Short Term Markets and (203) 897-4652 jim.lee8@rbs.com
Futures & Options Strategy

Natan Magid Short Term Markets Strategist (203) 897-4666 natan.magid@rbs.com

William O’Donnell Head of Treasury Strategy (203) 897-9803 william.odonnell@rbs.com

John Richards Head of Strategy, North America (203) 897-9430 john.richards@rbs.com

Omair Sharif US Economist (203) 897-2818 omair.sharif@rbs.com

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