Understanding the cross currency basis is crucial because it reflects the cost or premium associated with borrowing or lending in different currencies. But what drives the cross currency basis, it's influenced by factors such as supply and demand for funding, credit conditions, and market liquidity, making it a key indicator of funding stress and capital flows in global markets. To see how this plays out in practice, let's look at how the five year Euro US dollar cross currency basis has evolved over time. As you can see, the basis was relatively close to zero before the onset of the global financial crisis in the second half of 2007. However, it turned sharply negative during the crisis and reached similarly distressed levels again during the European sovereign debt crisis in 2012, what was happening? The situation is similar to what was observed in FX swap markets, but with one key difference. While FX swaps allow for short term synthetic borrowing, typically for three or six months, cross currency swaps allow for longer term synthetic US dollar borrowing. As shown here in the five year tenor. During the crisis, European banks faced a unique challenge. Many of them held US dollar denominated assets that had become illiquid, but they still needed to meet their US dollar funding obligations. Unlike US banks, which had direct access to dollar liquidity, through emergency facilities, many European banks could only obtain Euro liquidity from the European Central Bank, the ECB. However, their pressing need was for US dollars, not euros. To solve this problem, European banks turned to cross currency swaps. They took the euros they had access to from the ECB and synthetically converted them into US dollars by entering into long-term cross currency swaps with institutions that had access to US dollar funding. Effectively, they were lending out euros and borrowing dollars, but since so many banks were on the same side of this trade, desperately trying to borrow US dollars, while those with US dollar liquidity became less willing to lend it in swaps, the cost of US dollar borrowing increased sharply. The price of this borrowing was pushed far from what would be considered fair under normal market conditions.

At the peak of the crisis, European banks were effectively paying a severe penalty to borrow dollars for five years via cross currency swaps. In other words, the rate they received on their Euro investment in the swap was significantly below market levels.

This occurred because demand For US dollar liquidity was extraordinarily high, creating significant pricing pressure in the cross currency swap market. Fast forward to 2012 and the situation repeated itself. The European sovereign debt crisis created another US dollar funding crunch for European banks once again driving the cross currency basis further into negative territory. This highlights a key characteristic of the cross currency basis. It tends to widen during periods of financial stress reflecting heightened demand for US dollar funding. That's why market participants closely monitor it.