Global financial system rewired by sovereign debt and FX swaps
Hyun Song Shin of the Bank for International Settlements outlined how the global financial system has been rewired since the Global Financial Crisis. He highlighted the increased role of government debt, portfolio flows, and FX swaps as key drivers of financial conditions.
Sovereign debt takes center stage
Post-Global Financial Crisis, credit to government has consistently outpaced credit to the private sector, a trend significantly amplified by the policy responses to the Covid-19 pandemic.
Portfolio flows have now emerged as a central driver of global financial conditions, with private sector investors increasingly dominating holdings of US Treasuries since 2012, following a peak in foreign official sector holdings.
This shift underscores the integral role of currency choice in global sovereign bond markets.
The FX swap market, which facilitates collateralised borrowing across currencies, experienced rapid growth after the GFC, expanding from $21 trillion in the first half of 2009 to $130 trillion by mid-2025.
These predominantly short-term instruments enable hedged bond investments and ex-post hedging strategies, but their rapid expansion also introduces potential financial stability implications, particularly through the banking sector.
The ratchet effect of global dollar deposits
Central bank balance sheet expansions have significantly increased global dollar deposits.
A "ratchet effect" means these deposits have not declined proportionally even as balance sheets shrink, indicating new buyers have stepped in.
Nearly 30 percent of global dollar deposits reside at banks outside the US, widely dispersed geographically.
Private sector entities, particularly hedge funds, now hold increasing sway as sovereign bond investors.
Their growing market presence is enabled by extensive repo borrowing and low haircuts, fostering high leverage and contributing to the sustained growth of dollar deposits.
A complex and leveraged new normal
This analysis effectively highlights the profound structural shifts in global finance post-GFC, particularly the intertwined roles of sovereign debt and shadow banking.
The "ratchet effect" on dollar deposits and the increasing leverage of hedge funds in bond markets present significant, albeit often overlooked, vulnerabilities.
Policymakers must now contend with a more complex and interconnected system where traditional monetary policy transmission may face new challenges.
Source: Post-GFC rewiring of the global financial system
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