Cross-Currency Basis: What is it and where does it come from?

CROSS-CURRENCY BASIS: WHAT IS IT?

As a reminder, the cross-currency basis is an additional spread on top of the interest-rate differential that impacts FX and rate transactions between currencies. It can be thought of as the difference between the actual tradable market rate of a forward or swap rate and the rate implied by difference in the interest rates of the two currencies.

WHERE DOES IT COME FROM?

The basis results from a variety of factors that have developed since 2008 and have permanently changed the market structure and conditions. It fluctuates over time but almost always has a negative impact for foreign investors hedging US dollars.

Before 2008 and the Great Financial Crisis the cross-currency basis was almost always very close to zero for most major currency pairs. This was partly because the effective cost of capital for large banks was very low, which meant that they were able to use their own capital to arbitrage away small anomalies in market pricing, and partly because the perceived risk between the different financial systems (US, EU, Japan, UK, Switzerland...) was seen as pretty much uniform.

After 2008, a few things changed. Banks have faced stricter capital requirements under regulations like Basel III. As a result the cost of providing liquidity has risen, directly impacting swap pricing. Additionally,changes in market structure, such as the consolidation of banks and the reduced capacity for proprietary trading, have also limited liquidity in many markets. So-called XVA adjustments, which account for the risks and costs of credit, funding, and capital, have made the amount of capital required to support trading more complex and costly.

When we talk about interest-rate differentials, we are usually referring to the difference between a reference interest rate in each currency. The events of 2008 made it obvious that not all banking systems were the same and that the way reference rates (mainly LIBOR at the time) were calculated was not always very reliable. In an extreme crisis some banking systems were evidently stronger than others. US dollar Libor - reflecting rates charged to one another by participants in a banking system ultimately backed by the Federal Reserve - was not quite the same as Swedish krona Libor for example. The reference interest rates are formed differently nowadays and can be considered a more accurate reflection of actual rates practised in the different markets, but there is still a difference in perception of the credit quality of the entire banking systems.

WHY DOES IT PERSIST?

In an efficient market with no cost of capital for market participants, the basis would always be close to zero as it could be arbitraged when discrepancies arose between the implied interest rate from the FX swap market and the actual interest rates in the respective currencies. 

In practice, only investors with a low cost of capital, a lot of excess liquidity and/or the ability to borrow cheaply from central banks could arbitrage these spreads but even then the opportunity cost is usually too high.

As a result, factors like supply and demand imbalances, funding pressures and regulatory issues regularly put upward pressure on the basis, in particular around month-, quarter- and year-end. Central banks have become attentive to the topic and more recently the Fed has played an important role in alleviating times of stress by making dollars available to foreign central banks who can then lend them to local banks.

IMPLICATIONS FOR INVESTORS

The result of all this is that Swiss investors tend to face a structural additional cost for hedging on top of the already high negative cost of carry due to the interest-rate differential alone. The cross-currency basis can fluctuate wildly so investors should monitor it and adjust their hedging programs accordingly, for example by extending maturities when the basis is low and trying to avoid entering or extending hedges during periods when there are spikes in the hedging costs.

Finally, it should be noted that if the cross-currency basis is a penalty for Swiss investors it represents an opportunity for investors based in US dollars in particular. For example, a dollar-based investor could buy a corporate bond in CHF issued by an international borower, hedge back to USD and end up with a higher credit spread than what would be available by directly investing in dollar bonds issued by the same company.

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