Let's explore the concept of the FX basis using a numerical example. If we take a look at some market data from November of 2023, at this time, the Euro US dollar spot FX rate was 1.095. Also at this time, the six month US dollar interest rate was 5.395%, and the quoted six month euro US dollar FX forward rate was 1.1039. If we look at the interest rate parity formula, we can see that we have all of the input that we need with the exception of the euro interest rate. However, since the forward rate is also a quoted rate, we can rearrange the equation to solve for the missing value of the six month euro interest rate. If we do this, we'll arrive at an implied six month euro interest rate of 3.7549%. But here's the catch. In November, 2023, when this example was created, the actual six month euro money market rate was 3.885%, roughly 13 basis points higher than the implied rate we've just calculated. Now, while a small difference might be acceptable due to rounding weekends, bank holidays, and so on, a difference of 13 basis points is far too large to ignore.

So what's happening here? According to the interest rate parity principle and the no-arbitrage framework, the difference between the actual and the implied interest rate should be zero, but it clearly isn't in this case. This difference between the actual interest rate and the implied interest rate is what practitioners refer to as the FX basis.

So could this discrepancy be a one-off anomaly caused by a unique combination of price data, or is there a broader explanation? Before jumping to conclusions let's take a step back and look at the history of the FX basis to see whether such discrepancies are common. These two charts show some history of the six months euro US dollar basis over time, on the left from 2008 to 2012, and on the right from 2021 to 2023. On the right hand chart, you can see that the FX basis was at approximately minus 13 basis points in November, 2023, just as calculated earlier, but this was not just a one off occurrence. The euro US dollar basis has been persistently negative since the beginning of 2008. Now, if we go back even further, prior to 2007, the euro US dollar basis typically stuck very close to zero as we would expect based on the no arbitrage arguments that in a world with perfectly functioning markets, the FX basis should theoretically be zero. But as we see from the chart on the left hand side, something fundamentally changed during and after 2008, and the basis became significantly negative at several points.

So what caused the basis to go so negative, particularly in 2008? Let's consider the timeline. Autumn 2008 marked the peak of the global financial crisis. Banks across the globe faced severe liquidity shortages. European banks in particular, faced a unique challenge. Many of them held US dollar denominated assets that had become illiquid, meaning it was not possible to easily sell them to raise US dollar funds, but they still needed to meet their US dollar funding liabilities, which gets us to the crux of the issue. While US banks could access dollar liquidity directly through the Federal Reserve's emergency facilities, many European banks did not have the same access. Instead, these banks could only obtain euro liquidity from the European Central Bank, the ECB. However, their pressing need was for US dollars, not euros.

So what did they do? To solve this problem European banks turned to FX swaps. They took the euros they had access to from the ECB and swapped them into US dollars in the FX market.

Effectively, they were lending out euros while borrowing dollars, but since so many banks were on the same side of this trade, desperately trying to borrow US dollars, the price of this borrowing was pushed far away from levels that would be considered fair under normal market conditions.

At the peak of the crisis, European banks were effectively paying a penalty of 200 basis points below market rates to borrow dollars using FX swaps. In other words, the rate they were paid on the Euros they were effectively investing through these swaps was 2% below the market interest rate for euros. This occurred because demand for US dollar liquidity was extraordinarily high, creating significant pricing pressure in the FX markets. While 200 basis points seems extremely costly, when the alternative is insolvency due to an inability to meet US dollar payment requirements, it may begin to be seen as a much more reasonable price to pay. Now let's fast forward to 2012. What was happening then? The European Sovereign Debt Crisis created another US dollar funding crunch for European banks, leading to a repetition of the funding stress we saw in 2008. Again, the need for US dollar liquidity drove the FX basis further negative as funding pressures mounted. While the FX basis turned negative during major crises like 2008 and 2012, it has also shown sensitivity to more recent periods of market stress and heightened risk aversion.

For example, in February, 2022, the war in Ukraine triggered a broader risk-off move in markets further widening the negative basis.

Similarly, the banking crisis in March, 2023 led to another spike in the negative FX basis. The 2023 banking crisis was triggered by the collapse of several regional banks in the US and stress in key European financial institutions. These events fueled concerns about financial stability and led to heightened funding pressures as market participants scrambled for liquidity. As in earlier crises, the demand for US dollar funding surged pushing the FX basis further negative. All these events highlight that the FX basis is not merely a theoretical construct, but a dynamic metric that reflects the real world stresses of funding markets. Understanding its drivers can provide valuable insights into broader financial market conditions.