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Monday, August 3, 2009

The Federal Reserve, and the Shadow Currency and Interest "Markets"

That's a video that everyone that cares about the future of this nation should watch carefully. It's Democratic Rep Alan Grayson from Florida grilling Fed Chairman Bernanke about something called "liquidity swaps". Ask one thousand people what a liqudity swap is and I doubt more than one will have heard of it. All one thousand will have no experience trading them. That's because a "liquidity swap" is something only central bankers trade. That should scare everyone.

That's because, according to the testimony, Rep Grayson said that between 2007 and the end of 2008, liquidity swap trading increase from $23 billion to $553 billion and there was virtually no trading in liquidity swaps prior to 2007.

Think of a liquidity swap as a way for the Central banks of the world to trade currency without having those trade affect the currency market. In other words, through liquidity swaps, Central banks trade currency outside the currency system. Instead of a central bank buying dollars on currency exchanges, they buy dollars from the Federal Reserve which keeps them in reserve. Does that sound like a good idea? Does it sound like a good idea to allow central unelected bankers trade currency without having those trades affect the currency markets? Whether or not this does or doesn't have an impact is entirely up for debate? Congressman Grayson asked if it was mere coincidence that the nominal Dollar exchange rate shot up 20% at the exact same time that the Fed was making these swap transactions in earnest. The Federal Reserve chairman answered that it was.

Central banks, lead by the Fed, have their own shadow lending market created and run just by themselves. The Federal Funds Rate, for instance, is only available to banks in the Fed System. They even have their own shadow currency market as illustrated by the "liquidity swaps". These selected groups of central bankers simply create financial tools that are available only to themselves and then trade these vehicles amongst themselves. Here in the U.S. at least, their activities are left largely unscrutinized. There is very little oversight of our central bank, the Federal Reserve.

H.R. 1207, the act that would force a full audit of the Fed, is very popular but has little hope of passing. As such, the people of the country know very little of the trillion dollar transactions that the Fed engages in. Furthermore, the Fed uses dubious authority to create all of these shadow markets. In the clip referenced, Bernanke alludes back to the Federal Reserve Act of 1913. That was created nearly a century ago and it gave no specific authority for a "liquidity swap" because a liquidity swap was a figment of the imagination of bankers then. Yet, it's now being traded in half trillion dollar amounts by a group of central bankers that have absolutely no oversight.

Again, in the clip, Bernanke acknowledges that authority was given by the Federal Open Markets Committee. That is the group of Federal Reserve regional chairmen and the Chairman himself. None of these people is elected. More than that, they face little scrutiny. The Fed has never gone through the sort of forensic audit that most other government institutions are required to go through.

This exchange received nearly no scrutiny itself. Shouldn't everyone be concerned that our central bank has suddenly decided to make a monumental new investment in a shadow currency market? Such a monumental transaction should require the greatest of transparency. Instead, its hidden, given the least of acknowledgement, and downplayed by the chairman when questioned about it.

Everyone must understand once and for all that the most powerful force in the world today is the Federal Reserve bank. It controls the money supply. There is no more greater power than that. Unlike the president, the bank faces no election. It barely faces an audit. Almost none of its financial transactions are ever scrutinized. This exchange is a rarity and most exchanges amount to financial worship. Until the Federal Reserve is reigned and controlled so that its power is signficantly diminished the future of our economy is in constant threat by a central bank that is drunk on power.


Anonymous said...

Questioning Fed accountability is reasonable. Unfortunately, your post demonstrates that you know very little about FX, or FX swaps, which greatly undermines your argument. One could say the same about Mr. Grayson.

Perhaps you should read Alea ( or Macroblog ( to try and understand what an FX swap is and why the Fed initiated these.

mike volpe said...

Well that may be so, but if that's the case, show how I am wrong. Don't point me to two blogs that no one has heard of and say that I am wrong and they are right. That's not an argument. That's just silly.

If I don't know what I am talking about, just say where I am wrong. Don't point me to two blogs that have a different opinion, presumably.

You make a series of accusations about my lack of knowledge and point to nothing that is inaccurate. If I know little about fx swaps, then, there should be plenty to pick apart. Instead, you simply say it and say that I need to read two blogs to know more. Do you really consider that an effective argument?

Anonymous said...

"show how I am wrong"

You wrote about trading on "currency exchanges". I do not know of any "currency exchanges" (feel free to provide examples). Perhaps you meant futures exchanges, such as the CME or BMF? In which case you would do well to note the following: total turnover in the FX market is c. $2tn/day (please see the BIS triennial survey, last published in 2007, freely available online); and a very small percentage (at a guess, less than <5%, but you can verify the numbers by looking at CME turnover data) is transacted on futures exchanges.

Another example: "Think of a liquidity swap as a way for the Central banks of the world to trade currency without having those trade affect the currency market."

Of course the "trades" (somewhat in appropriate terminology, better to say "use of the FX swaps") affected the market. They affected the FX and the rates market. If the Fed lends $ to the BoE and the BoE then lends $ to UK banks, this means the banks do not go to the market to buy $ as they can get them from the BoE. How is this avoiding affecting the market?

Another example: the dollar rallied last year (and early this year) because investors were unwinding short dollar positions (see the IMM data or the BIS cross border lending data). The Fed's FX swap lines were designed to DAMPEN this effect, not amplify it. While it is an unprovable hypothesis, I would venture that the Fed's actions likely REDUCED the rally in the dollar and REDUCED volatility in the FX and interest rate markets. It seems to me that Grayson's reactions to Bernanke's statement, and your choice to highlight one of those reactions in particular, suggest that you are sceptical of Bernanke's explanation. This in turn suggests a lack of understanding of what happened in the FX markets during the crisis.

I suggested you read those blogs because I am trying to point you in the direction of material that might help you understand the topic at hand. Macroblog, at least, is well known within the markets, so I would not call it a blog "that no one has heard of". I have no idea if the blogs have different opinions - I'm not trying to give you an opinion, I'm trying to point you toward some factual information about FX swaps, which both blogs provide.

Anonymous said...

One other point --- Wiki contains plenty of incorrect information about financial products (e.g. OIS). If you can't judge for yourself whether Wiki's information is correct, I would suggest finding another source to corroborate.

mike volpe said...

Your first point is absurd. Of course, there's a foreign currency exchange.

Your second point is sloppy. Both Grayson and I pointed out that Dollar moved significantly at the exact same time that all these swaps were traded.
So, your point was pointed out by me.

For you to say that we don't know how forex reacts is even more absurd. These swaps went from 50 billion to 500 billion in a year. There is no history to judge.

Maybe you should read up some more because so far you haven't shown anything that I have said that was wrong.

Anonymous said...

You seem to be confusing an exchange with a market. They are NOT the same thing. An "exchange" implies a centralised marketplace that provides clearing.
The FX market is decentralised and clearing is done bilaterally. It is a market, but not an exchange.

Maybe I don't understand what your point was (or what Grayson's laughter was supposed to convey). Perhaps you could clarify what you think the Fed's motives were for initiating the lines, and what effect you think they had?

Where did I say "we don't know how forex reacts"? And who is "we" in this context?

If you want to learn more about FX, please go to the Bank For International Settlements website ( and read some of the materials there. Seriously Mike, I am trying to help by pointing you in the direction of materials that would better your understanding!

mike volpe said...

First, I don't even think I referred to it as an exchange but if I did it was a marginal error that you are picking at. Second, both Grayson and I point out that the Dollar moved significantly at the same time these trades were made and so neither of us know what Bernanke's motivation was. Only he knows.

Third, I wrote a detailed article about the foreign currency market and I don't think I need any more education for what I am trying to do.

I don't think you've read my work before. You are now nitpicking over an error that if made was entirely accidental. You have shown no substantive errors. You seem to be saying that because I used exchange instead of market I don't know what I am talking about. That's nonsense. If I don't know what I am talking about, please show me. A small accidental error doesn't mean I don't know what I am talking about.

Anonymous said...

I started reading your piece. You wrote, "This means that the strength or weakness of the dollar is determined by just how many buyers and sellers there are at any given time". This is just plain wrong. Strength/weakness is determined by how aggressive buyers/sellers are, NOT how many of them there are.

Furthermore, you wrote "For a currecy [sic] trader, all that matters is predicting the relative strength or weakness of a particular currency." I can tell you it's not that simple, and it's not really about forecasting (it's about good risk/reward trades)! But, in fairness, those are reasonable mistakes to make.

You then wrote, "while quantitative easing is one way to expand the economy, it's also an effective way to weaken the dollar.". Perhaps, but the BoE and SNB are also engaged in QE. Since they started doing QE, and the Pound and the Franc are STRONGER since then - my point being that it is but one of many factors. (And the BoE QE is larger as a % of GDP than the Fed's program.)

On the topic of the dollar and inflation, the Fed's estimates are that passthrough to CPI is c. 10%. So yes, a weaker dollar is inflationary, but the effect is not that pronounced. Of course, there may be an ancillary effect via inflation expectations.

You then wrote "if rates are low in America that will in turn create more demand for dollars". That is very contentious and would certainly go against received wisdom in the markets! The most popular trading strategy in FX is "carry", which means buying high yielding currencies and selling low yielding currencies. Still, interest rates are but one of many factors, and there are periods where currencies with low rates are strong.

You write that, "I don't think I need any more education for what I am trying to do." You made a number of simple mistakes that demonstrate a lack of understanding of what you're writing about. Perhaps you will argue they're not substantive.

I have tried to help by pointing out errors and suggesting useful background reading. If my tone suggests otherwise, I apologise. As I wrote, I've read the blog (though you doubt that!), and I wouldn't bother to do so if I didn't find value in it.

Another good resource for FX is I have no affiliation with the site, but it's a well known trading platform and it provides plenty of free reading material should you be interested.

I will let you have the last word!

mike volpe said...
This comment has been removed by the author.
mike volpe said...

Wow, not only is that nitpicking but you take everything I said out of context. For every policy matter I made sure to say "everything else being equal" That means that while that particular policy may affect the dollar in one way the dollar can move the other way because everything is not equal. You then point out ways in which the dollar moved opposite to the policy. Well, of course, because everything else is not equal.

When I said the number of buyers, you know exactly what I meant. Are there more units of currency that are being bought or sold? That's what I meant and you knew it and you simply couldn't find anything else to criticize so you criticized that.

Yes, the dollar can be weak when interest rates are low but that's because everything else is not equal. Low interest rates isolated strengthen demand for the dollar because its easier to get dollars. Everything else is not equal so of course you can find a scenario where that won't work. Yet, you don't point out that I clearly say that for every scenario everything else must remain equal. Of course, quantitative easing weakens the dollar. You are creating more dollars so each dollar is weaker. It's that simple. Can the dollar strengthen while the fed QE's of course, because everything else isn't equal. yet, you don't point out that I say this for each and every scenario.

You are reaching and stretching. You can't find anything legitimate to criticize so you simply nitpick with nonsense.

Anonymous said...

"Are there more units of currency that are being bought or sold?"

They are by definition equal.

mike volpe said...

No, they aren't. At the equilibrium price they are equal. Yet, when there are more buyers than sellers the price goes up and vice versa. You know exactly what I am saying and yet you are nitpicking and it's because you can't find anything legitimate to criticize.

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