As a follow-up to a recent very timely post by PonzyFinance on basis swaps spread, we discuss how European banks are employing this tool. A basis swap is a quick way of converting a "floating rate" asset or liability from one currency into another.
Let's say I run a dollar denominated fund that wants to purchase a sterling loan. The sterling loan pays sterling LIBOR plus a spread. I can enter into a dollar/sterling basis swap where I receive sterling (that I use to purchase the loan), pay out dollars, and agree to return the same amount of sterling in return for dollars in the future. The exchange rate for the "spot" transaction and the reverse forward transaction are the same and would be locked on the day of closing. Until maturity I would be paying sterling LIBOR on my swap and receiving dollar LIBOR - plus/minus the basis spread. So I start with something that had a sterling notional and pays sterling LIBOR plus spread (the loan that I purchased) and convert it to something that has "synthetically" a dollar notional and pays dollar LIBOR - which is more appropriate for my dollar fund and has no F/X risk.
The chart below shows how one would could borrow euros and convert the loan into dollars via a basis swap. Note that the basis spread is driven by the supply and demand in the market.
This is the basis spread that market participants use to ascertain how "healthy" the financial system is. European banks have access to euro funding, but are quite limited in their ability to borrow dollars. This creates significant demand for the swap structure above. That demand translates into higher basis spread (often called the "Euro basis"):
As PonzyFinance pointed out, the 150bp level is approaching. So how is it that European banks get access to so much euro liquidity? Unfortunately the answer is disturbing - many are tapping the ECB. In particular the French banks are starting to borrow significant amounts of euros from the ECB, some of which they convert into dollars to fund the dollar component of their balance sheet (driving up the basis spread). The chart below from Barclays Capital shows the recent increases in the funding provided by the ECB to banks from Italy, Spain, and France.
As US money market funds turn away from Europe, dollar funding becomes dependent on the combination of the ECB and the basis swap market.
Here is an old GS write-up that goes through some detail on basis swaps.