The global dimension of US prime MMFs: The unsecured funding for non-US banks and the implications for FX swap markets

Abstract

The US-Dollar (USD) holds a paramount position in the hierarchy of the International Monetary System (IMS). The significance of this currency has experienced a remarkable surge, leading to non-US banking systems to adopt new strategies for integrating themselves into the USD funding structure. Consequently, non-US banks have turned to new financial instruments and institutions to hedge their balance sheets effectively. While previous research has primarily focused on the Eurodollar market and FX swaps, the role of US banks in providing USD funding liquidity to these markets and instruments has been curtailed due to post-GFC regulations. This funding gap has been filled by US prime MMFs. Therefore, this paper investigates the emerging global dimension of unsecured funding liquidity provided by prime MMFs through wholesale funding instruments, namely commercial papers (CPs) and certificates of deposit (CDs), to the European and Japanese banking systems. Moreover, it examines the implications of this unsecured funding for JPY/USD and EUR/USD FX swaps markets. The paper argues that rates associated with CPs and CDs have become pivotal indicators of liquidity conditions in the offshore USD system. Disruptions in these markets can result in significant vulnerabilities in FX swaps markets, as evidenced during the pandemic crisis. Only through the Fed’s backstop strategy, implemented via swap lines and the Money Market Mutual Fund Liquidity Facility (MMLF), have the liquidity conditions of prime MMFs improved, yielding favorable outcomes for non-US banks.