The $80tn “hidden debt” and what it really means

Dan Davies is a managing director at Frontline Analysts, and the author of Lying for Money, and co-author of The Brompton.

Every publication of financial statistics ought to have the same picture on the cover — Goya’s “The Sleep Of Reason Produces Monsters”. It would help to deter the tidy-minded truth seekers who are reliably driven mad by the crazy world of financial accounting.

People, for example, like Harvey Jones of the Daily Express, who reacted to the recent BIS Quarterly Review article on off-balance sheet FX forwards by concluding that “the world faces financial meltdown, with losses potentially exceeding the total number of US dollars in circulation”. That’s not true, by the way.

It’s an understandable shock reaction, though. For a normal person or company, finding out that you’ve got more debt than you thought you had is a horrible thing — quite apart from anything else, it raises the immediate question of how you’re going to pay it. If the global financial system really was running on a macro-scale version of Sam Bankman-Fried’s sloppy spreadsheets, that would be a reason to panic.

But the BIS doesn’t claim this; there’s no suggestion that anyone has been failing to record actual transactions. Their research is composed of an argument that some financial instruments should be classified as debt, and some clever work interpreting the gaps between different data sets to estimate how much difference it would make to global balance sheets if they were.

Calling something debt is a choice

That means that the joke once attributed to Abraham Lincoln is relevant. “If you call a tail a leg, how many legs does a dog have? Four, because calling a tail a leg doesn’t mean it is one”. The state of the world is what it is; if we were to decide to increase our estimate of the amount of debt in it by $80tn, then we would need to make an exactly offsetting adjustment in the extent to which every trillion dollars of global debt worried us.

Accounting is, unfortunately, a business of compromise. There are two things you want to get from an accounting system:

1) Accurate reflection of the underlying economics.

2) Consistency across different economic entities.

Brief consideration of these two principles immediately leads to the conclusion that in any even moderately complicated system, you can’t get all that you want. So any accounting system is a trade-off — it’s a choice that you make, reflecting how much consistency you need and how much inaccuracy you’re prepared to tolerate. Which in turn is going to be driven by the purpose that you’re going to use the numbers for.

The BIS’ estimate that there is about $80tn worth of off-balance sheet “debt” is fundamentally a consequence of the fact that the BIS doesn’t choose the accounting standards, and consequently the accounting standards are designed for purposes other than theirs.

As Richard Comotto put it (back in 2017, when this debate first went round, and when the missing “debt” was only $17tn), the core argument of the BIS is that if you have domestic cash and want to buy a foreign currency asset but hedge the currency risk, you have two ways of doing that:

1) Exchange your domestic cash for forex in the spot market, buy the asset and sell an equivalent amount of forex for domestic cash in the forward market.

2) Keep your domestic cash, and use the foreign repo market to fund the purchase of the asset.

(there is another way, using a currency swap, but for the purposes of this argument, it’s the same as the first. In fact, there are dozens and dozens of ways of achieving the same financial goal and some of them don’t create the kinds of exposures we’re talking about here, but these are the ones big enough to worry the BIS).

Option 2 feels like it’s obviously debt. You’ve got the asset, you’ve got an obligation to repay your repo counterparty, and you’ve still got your original cash. You’ve increased your leverage.

Option 1 doesn’t feel so much like debt. You’ve bought your asset, and you’ve entered into a contract which affects the returns on that asset. On the day you do the transaction, the value of that contract is zero — it might turn into an obligation or benefit in the future, but it’s not obvious that you should record something on your balance sheet today.

An alternative perspective

And that is, more or less, how the relevant financial accounting standards tell you to record things. But the BIS sees it differently. Back in 2017, they printed some stylised balance sheets to explain what they mean.

What this table is meant to illustrate is that the FX forward case is not quite as clear cut as it seems. Most derivatives are settled on a net basis: on the settlement date, the “winner” of the trade receives a payment from the “loser” reflecting the P&L. That’s the basis on which they’re recorded in the balance sheet.

Forwards, on the other hand, are settled gross, with an exchange of principal amounts. On the last day of the contract you send over the relevant amount of FX that you had sold forward, and receive the corresponding amount of domestic currency. That’s the significance of the second line in the “Gross basis” table.

The BIS argument is that this obligation for gross settlement looks a bit debt-ish. If something stops you from delivering the FX, then you’re in default.

Who’s right and who’s wrong?

The introductory section here should hopefully have made clear that the answer is going to be “it depends”.

If you’re putting together a set of financial accounts that are meant to reflect the risks and rewards of ownership, then an FX forward looks very like a derivative. Those risks and rewards are mainly driven by the P&L on the forex trade, which is something that is going to happen in the future rather than an obligation which exists on the balance sheet date.

Because it’s a forward rather than a derivative, there is an obligation, but it’s not much of a risk; if the counterparty doesn’t deliver their domestic currency, then you don’t deliver your forex, and your exposure to loss is determined by how much it costs you to get your books squared up again.

The gross settlement obligation only becomes a significant factor in an odd and bizarre situation, when for some reason one of the parties has delivered their side of the bargain, but then the other party doesn’t.

That can happen from time to time, because the bankers’ right to set off payments owed against payments owing isn’t always legally perfect, and because the two sides of the forward settlement aren’t always executed simultaneously. In fact, they might be executed several hours apart, particularly when the counterparties are in different time zones.

Which is the point at issue. The kinds of situations in which the settlement risk might manifest itself are exactly the sorts of things that it’s the job of the BIS to care about. The failure of Bankhaus Herstatt in 1974, while owing a lot of money in this manner, was one of the big reasons why the BIS collects these sorts of statistics today.

And when you take into consideration that we’re talking about unusual risks, it actually seems quite legitimate for the BIS to be worrying — the accounting issue is one for debates over coffee and beer, but the fact that the estimate has more than quadrupled in five years does feel like someone ought to be keeping an eye on it.

It’s not just a matter of settlement risk at the level of individual firms. The BIS team found that there are big national imbalances, which could mean that if one national market lost access to dollar funding, this could result in very large waves of default.

This isn’t just a theoretical possibility, either. The international central bank swap lines, dating back to the global financial crisis of 2008, are there precisely to manage this sort of risk; that of basically solvent counterparties being forced into default because they aren’t able to make payments and their domestic central bank can’t supply the kind of liquidity they need.

The availability of those swap lines (particularly those by which the Fed supports the international market in US dollars) means that the accountants are broadly right to treat FX forwards in the way they do.

Accounts are meant to give a true and fair view of the risks and rewards, and a figure which is made by adding up normal borrowings, repo, and the full gross settlement exposure of derivatives — that’s just not a useful number. Calling it “debt” doesn’t make it debt any more than calling a tail a leg makes it one.

But if we don’t get hung up on the d-word, then the BIS analysis is valuable too.

What it really describes is the extent to which the global role of the US dollar is dependent on the Fed being willing to act as the lender of last resort to the international market as well as the domestic one.

And the fact that this role — and the consequent international liability — has not only grown so fast, but done so in a way that’s heavily underestimated by the statistics, seems like it’s something worth knowing.