Let's now look at the cross currency basis. A concept very similar to the FX basis found in the FX forward market. In the interbank market, cross currency swaps are typically structured as cross currency basis swaps. This means that the interest rates on both swap legs on both currencies is floating. For example, a five year euro US dollar cross currency basis swap would involve exchanging floating interest rate payments linked to ESTR and SOFR. Now, in theory, one might expect an equal exchange of euro floating versus US dollar floating rates, but in reality, this is rarely the case. Cross currency basis swaps do not always trade flat, meaning they don't always exchange floating rates one for one without any adjustment. But why is this? It's because there is often a difference in demand for borrowing in one currency versus the other, and this imbalance affects pricing. When there is higher demand to borrow US dollars relative to euros, the market adjusts the pricing of the swap to reflect that. This leads to an important market convention. In practice, the adjustment is typically applied to the non-US dollar leg. So in a euro US dollar basis swap, the adjustment would be made to the euro leg.

But why is this adjustment placed on the non-US dollar currency? The reason is that US dollars is the dominant global funding currency. Demand for dollar liquidity tends to drive the market making US dollar funding the base. To account for this, the adjustment is applied to the other currency rather than US dollars. This adjustment is effectively what traders quote in the cross currency basis swap market. For example, if the five year euro US dollar cross currency basis trades at minus 16 to minus 12 basis points, this means that as a market taker, you could enter into a five year swap where you pay SOFR flat and receive ESTR minus 16 basis points, or receive SOFR flat and pay ESTR minus 12 basis points. While SOFR and ESTR will reset daily throughout the life of the swap, the basis itself is determined at trade inception and remains fixed for the duration of the swap.