Why Cross-Currency Swap Basis Was Near Zero Before the Crisis

Summary

The answer offers a funding-based explanation for why cross-currency swap basis was close to zero before the 2008 financial crisis. It argues that European banks were structurally short US dollars and used FX swaps to obtain dollar funding. Before the crisis, LIBOR was treated as reflecting the dollar funding cost of those banks, so the quoted basis between LIBOR-linked currencies was correspondingly small.

The explanation also distinguishes emerging-market currencies, whose banks did not fund at LIBOR and therefore could have nonzero basis. The crisis exposed that LIBOR did not represent the actual funding cost of banks generally. Once that link broke while basis continued to be quoted against LIBOR, basis became material. This is a conceptual account from a brief answer, rather than a quantitative analysis of basis movements or a complete survey of post-crisis funding markets.

Key ideas

• European banks’ dollar funding needs were commonly met through FX swaps.
• The answer links near-zero basis to LIBOR reflecting those banks’ dollar funding costs before the crisis.
• Currencies whose banks did not fund at LIBOR could have nonzero basis.
• The crisis weakened the link between LIBOR and actual bank funding costs, making basis more material.

Tags

# Why were cross-currency swap basis so close to zero before the financial crisis?


# Why were cross-currency swap basis so close to zero before the financial crisis?












For instance, see the graphs below.

Before the 2008 financial crisis, they were extremely close to zero. Why is that so?

(https://www.sr-sv.com/wp-content/uploads/2019/02/CIP_01.png)

## Answer by river_rat (score 1)

https://quant.stackexchange.com/a/64158

The way I rationalize it is to consider the different meaning for what Libor was pre and post the GFC. Pre the GFC, Libor was the price of USD for European banks. They are structurally short USD and long either GBP or EUR. The instrument of choice for funding this shortage was the FX swap market. This relationship bled into the perceived cost of funding USD and thus the basis had to be close to 0 almost a priori. What is nice with this explanation is it explains why emerging currency basis was never zero, the cost of USD for non-European tier one banks has never been Libor and thus had to be non-zero. What the GFC showed was that Libor was not the cost of funding for any bank, and breaking that relationship (but quoting basis as floating libor vs floating other) meant that basis had to become material.

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This summary was written by Stratmill's research agent from the original; it is not a copy of the source.