Last week in London Valdis Dombrovskis, the European Commission’s vice president for the financial services sector, stated delphically and in relation to financial stability, that “there are questions related to the enforceability of swap lines between ECB and Bank of England if the UK is to move out of the jurisdiction of the European Court of Justice.”

This was news on three fronts (i) what swaps? (ii) what wouldn’t be enforceable upon whom? (iii) who would lose out from that?

Publically-available information is not very helpful, other than to say that the Bank of England has swap lines with several other central banks, aimed at provision of foreign currency to one if it is in short supply, against provision of the domestic currency to the other. For example, if the US Fed was short of GBP, it could credit the Bank of England’s USD account in its books and receive the GBP equivalent on its own account at the Bank of England, and presumably at the prevailing spot exchange rate.

The Bank of England’s lines – the ones that might be affected by Brexit – are with (i) the European Central Bank and (ii) the Central Bank of Ireland, and there are no drawings under either currently.

All the same Mr Dombrovskis’ words indicate that there is a written agreement contemplating swaps being carried out, but it is unclear what elements might not be enforceable (i) the initial availability of the swap or (ii) the adherence to the terms of the agreement once there are outstandings.

The amounts that would be exchanged initially would be paid onto Vostro accounts held by central banks with each other, and presumably the re-exchange would be debited to the same Vostos, but there is little information about timing and rate for the re-exchange, or what happens if the re-exchange pushes the Vostro account into debit. This points to a “swap” where the re-exchange of principal is done at the then prevailing spot rate, and not at a rate fixed at the time of initial exchange.

Indeed, these deals do not seem to be a complete swap, but half of one: the central banks are extending forms of mutual overdrafts, but by creating credit balances in the Vostro account of the other central bank, with the other central bank doing the same – crediting a Vostro account, which the first central bank would call its Nostro. No accounts go overdrawn, but nevertheless a credit balance held on a Vostro account in the books of another central bank is an asset on the balance sheet of the Bank of England, should have a credit line to cover it, and – in a commercial bank anyway – would have Capital Adequacy allocated to it to cater for the associated credit risk.

The issue from a UK perspective becomes a credit risk and a mark-to-market risk. If the Bank of England holds large credit balances in EUR with (i) the ECB and (ii) the Central Bank of Ireland, whilst both of those central banks have either (a) used up the GBP that the Bank of England put on their accounts as the other leg of the swap (b) left the GBP on their accounts, the Bank of England is exposed.

The Bank of England, having for example put GBP500 million at the disposal of the ECB and received – at 1.17 – EUR585 million on its Vostro, finds the exchange rate at re-exchange is 1.30: it re-debits the ECB’s Vostro in its books for GBP500 million but then finds that its EUR585 million only generate GBP450 million. The Bank of England just lost GBP50 million.

Furthermore, in situation (a) above where the other central bank has used up the GBP on its Vostro, the Bank of England has an exposed position, with large balances-at-risk in both the ECB and Central Bank of Ireland and no GBP in its own books to offset them.

In situation (b) the Bank of England may have the full cash positions as per the initial exchange and a net positive or negative position on paper caused by exchange rate fluctuations, but the net position is on paper: for that to be the outcome in case the other central bank went down, the Bank of England would need to be able to take and defend a position where it could extract its credit balance from the bankruptcy estate of the other central bank, exchange that into GBP and use the proceeds to extinguish the other side of the swap…and in the case where the other central bank’s Vostro in GBP might still have a credit balance i.e. the amount being extracted from the bankruptcy estate is not identical to an overdraft balance in the books of the Bank of England.

It would be nice to see the documentation and to note whether the central banks feel they can do to one another what they have precluded commercial banks from doing: executing On-balance sheet netting of balances in mutual Nostro/Vostro accounts held in one another’s books, rather than where simultaneous credit/debit balances exist on the same books: in this case if the Bank of England could show a credit balance in a Vostro account in EUR in its own books in the name of the ECB, and a simultaneous overdraft in a Vostro account of the ECB in its books in GBP, the offset should be achievable.

There has got to be more to come out on this.