The $300 billion question of central banks
Ousmène Mandeng is a visiting researcher at the London School of Economics. In this article, he talks about a potential side effect of the decision to cut off the Russian central bank from a significant part of its foreign exchange reserves.
The sanctions imposed by Western authorities on the Central Bank of Russia were worth it. Yet they may also cause other central banks to rethink how and where their foreign exchange reserves are held.
Central bank reserves are the ultimate rainy day fund, kept as insurance against market turbulence. They are also big.
The world’s monetary authorities have together accumulated about $13 trillion, or 14% of global GDP, in foreign exchange reserves. The largest amounts are believed to be held by China, Japan, Switzerland, India, Taiwan, Hong Kong, Russia, South Korea, Saudi Arabia and Singapore. This group is believed to have around $9 billion to defend its currency, including to meet its foreign obligations.
Reserves are held mainly in the form of higher quality securities, generally government debt securities, denominated in the currencies most used in international financial transactions. According to the latest IMF data, 59% of reserves are held on average in dollar-denominated securities, 20% in euros, 6% in yen, 5% in pounds sterling and the rest in other currencies. US Treasury securities are considered the most widely held foreign reserve asset. At the end of 2021, based on US Treasury data, foreigners held about $7.7 billion in US Treasury debt, or one-third of the total held by the public. The biggest holders are Japan and China.
As large customers, the attitude of central banks towards holding dollar-denominated government bonds is important. Indeed, they matter to the extent that, in 2009, then-US Secretary of State Hillary Clinton felt compelled to remind the Chinese that US debt continued to be safely bought. The sanctions imposed on the Bank of Russia could now prompt a rethink.
At present, securities held by central banks are generally held in central securities depositories (CSDs), often in the country of the issuer or with a major international CSD. Government bonds are normally traded over-the-counter but cleared through central counterparties (CCPs). Access to securities depends on the arrangements governing the CSD, and often the central counterparties, and will normally depend on local conditions.
US securities are held and transferred in the National Book Entry System (NBES) operated by the Federal Reserve which acts as both CSD and fiscal agent for the US Treasury. Most Treasury transactions are settled on a delivery versus payment basis, with the securities being deposited electronically in the receiving institution’s account at the NBES and the corresponding payment is deposited in the issuing institution’s account at the Federal Reserve. . The Depository Trust and Clearing Corporation and its subsidiary, the Fixed Income Clearing Corporation, have recently lobbied to advance centralized clearing to reduce counterparty and credit risk by clearing between CCP members.
The small number of institutions governing the market for the assets underlying foreign exchange reserves implies considerable dependencies. On the one hand, it brings significant benefits by providing an efficient market infrastructure for trading. But the high concentration of market players means that only a few entities control the essential transactions that determine access to and transfer of securities.
While Russia is believed to hold only a few US Treasuries, it still has about $300 billion in foreign exchange reserves held in other securities. US and EU sanctions now prevent it from using most of it.
If they can be denied access, central banks around the world could reconsider the usefulness of foreign exchange reserves and the conditions under which they are held.
The anxiety of central banks at not being able to access the necessary resources abroad is not new. From 2013 to 2017, the Bundesbank, not an obvious sanctions target, repatriated around 300 tonnes of gold from New York and 374 tonnes of gold from Paris to Frankfurt with the aim of keeping more than half of its gold in his own installation to “build confidence and confidence at home”.
If others do follow the Bundesbank in repatriating reserves, this could trigger a move away from the centralized financial market infrastructure in place today. This entails a risk of market fragmentation and may impede effective collateral management. Yet it would also reassure that the titles are accessible at all times. If $300 billion can suddenly disappear, some central banks and perhaps other big investors might see that as a fair trade-off.