Synthetic Dollar Funding (Job Market Paper)

Abstract: What happens to dollar credit when global banks' access to wholesale funding dries up? Wholesale funding is vital for banks’ dollar liquidity needs, but is subject to policy levers that can restrict access. This paper uses novel quantities data to show that foreign exchange (FX) swaps emerge as alternative (“synthetic”) funding instruments when banks face constraints in accessing wholesale dollar funding. Using an instrumental variables strategy that exploits idiosyncratic variation in the availability of wholesale dollars, I show that an increase in banks’ demand for swaps (i) causes deviations from covered interest parity (CIP)—a fundamental no-arbitrage asset pricing condition, and (ii) increases non-bank institutions' currency hedging costs, reflecting inelastic demand. I use my empirical estimates to calibrate a model in which global banks optimally substitute into synthetic dollars to offset funding shortfalls, generating CIP deviations in equilibrium. I show that a sharp decline in wholesale funding can disrupt global dollar credit, as the marginal cost of synthetic dollars quickly exceeds banks' asset returns. Conversely, relaxing funding constraints could halve CIP deviations with a modest increase in the default risk borne by wholesale investors. My findings highlight the externalities of domestic liquidity regulations on the pricing and availability of US dollar credit, as well as on the distribution of risks across the financial system.