In order to understand how a shortage of USTs as collateral affects the whole world, we need to first understand how Dollars are the lifeblood of the global economy.

To put it in very simple terms, everyone needs Dollars.

Why?

Because most of the world’s international trade is conducted in USDs, which is why it is termed the “global reserve currency”.

While a lot can be written (and has been) about this topic, for our purposes it is enough to know that one of the reasons the USD is the global reserve currency is that people trust that it will hold its value more than other currencies. 

Unfortunately, while using the USD solves the problem of having a common currency to denominate transactions in, it creates others. The most troubling of which is that now everyone needs to be able to either easily borrow Dollars or easily swap their domestic currency for Dollars.

Why is this problematic?

Because in times of crisis, Dollar funding markets freeze up.

Which is a fancy way of saying that banks, or other counterparties who have Dollars, are no longer willing to lend them. This unwillingness is rooted in fear, either of needing to use those Dollars themselves, and/or not being able to get them back should the party they lend to default.

When this happens, central banks, especially over the last few decades, feel compelled to step in. However, since the problem here is a lack of Dollars circulating in the global financial system, the only central bank that can alleviate the situation is the Fed.

This is simply because the Fed is the only one which can supply bank reserves denominated in Dollars for use in Fedwire, the Fed’s Dollar payment system.

By extension, the only banks which have direct access to these Dollars are those which have accounts at the Fed – American banks and foreign banks with US branches (in general).

Consequently, the rest of the world is dependent on a global reserve currency, the USD, which they are not able to access during times of emergency.

This is not a new problem, and has flared up in different parts of the world over the past few decades; the Asian financial crisis in 1997 being a good example. The crises in 2008 and 2020 were more global in nature, and while each had their own set of causes, Dollar funding problems were a big part of both.

Which is why the Fed had to step in and provide Dollar liquidity to selected foreign central banks through its USD swap lines, eventually establishing the standing FIMA facility.

To be continued…