The Dollar Effect: Exploring the UK's Reliance on the US Financial System

How reliant is the UK on the US financial system?

Let’s start with the global reliance on US technology, the US financial system and the US dollar. On technology, 90 per cent of devices (personal computers, servers, smart phones, televisions, etc) run on Google developed Android, Microsoft Windows, or Apple iOS. Eight of the ten largest cloud computing providers are American – with the three largest accounting for two-thirds of the market. And a combination of Microsoft, Oracle, Salesforce, Adobe and a few others dominate productivity and enterprise software. While I am typing this sitting in London, I am doing it on a Dell computer running Windows 11 using Word, and I’ll send it off using Gmail from a Chrome browser.

Reliance on US technology creates a vulnerability that is analogous to the that associated with the power grid. Without electricity, everything stops – not just finance. So, there is a national security issue that supersedes everything else.

That said, let’s turn to issues related to finance and economics. As everyone knows, the US dollar is central to the global economy. Nearly 90 percent of foreign exchange transactions have one leg as the US dollar. Just under 60 percent of global foreign exchange reserves are currently in dollars. US equity and bond markets account for 40 percent of global market capitalization, and 40 percent of trade invoicing is in dollars.

The pervasive use of the dollar gives rise to an extraterritorial demand for US dollars. Financial institutions – especially banks – are meeting this demand and creating an entire US dollar financial system outside the United States. Looking globally, banks have just under $18 trillion in short-term US dollar liabilities. For UK banks, the number is currently $2.6 trillion. To put those numbers into context, the onshore US banking system has total assets of $24 trillion and (at current exchange rates) UK banks have assets of roughly $13 trillion.

In addition, UK entities have significant investments in US dollar assets. UK residents combined (official, institutional and individual) hold a total of over $3 trillion in long-term US securities (equities and bonds) and have $750 billion in foreign direct investment in the US.

Importantly, when we think of the UK financial system vulnerabilities to the US, we need to consider more than just direct exposures. Indirect exposures and spillovers are likely to be just as important. So, as we look at the risks these linkages create, it is essential to do it in a global context. Cooperation will be essential for building resilience to threats from the US.

What are the main risk scenarios that worry you?

There are significant risks arising from dependence on the US. On technology, there is what people refer to as the “kill switch” risk. This is the risk that the US simply turns things off. As it stands, they are collecting enormous amounts of data. It is important to stop that while the rest of the world finds ways to reduce dependence on American technology.

Turning to finance, I see two significant risks: a USD run and a partial default on US-issued assets.

Starting with the first, absent a lender of last resort, a USD run or panic would compel these non-US intermediaries to liquidate their dollar assets in a fire sale that would almost certainly spill over to the domestic U.S. financial system. For this reason, the Federal Reserve created central bank liquidity swaps. These allow foreign central banks to borrow US dollars from the Fed and then lend them to banks in their jurisdictions. At this writing the Federal Reserve maintains standing swap arrangements with five central banks: the Bank of Canada, the Bank of England, the Bank of Japan, the European Central Bank, and the Swiss National Bank.

We saw these swap lines in action twice: first at the height of the financial crisis in 2008 and 2009, and again at the onset of the pandemic in 2020. During these episodes, commercial banks outside of the United States faced sudden U.S. dollar withdrawals, prompting their central banks to draw on their swap lines. The total amount drawn peaked at over $500 billion in 2008 and nearly $450 billion in 2020, the primary counterparties were the European Central Bank and the Bank of Japan. Importantly, the Bank of England did draw on the facility, with the amount reaching $38 billion in May 2020.

In addition to swap lines, in 2020 the Federal Reserve created the Foreign International Monetary Authorities (FIMA) repo facility. Open to all, this allows central banks to take US Treasury securities and exchange them for cash – in effect providing access to a collateralized version of the swap lines.

This brings us to the first risk: What would happen if the US were to eliminate the swap lines and the FIMA repo facility?

The second big risk is the possibility that the US will decide to disadvantage foreign investors. They can do this either through a forced conversion of US Treasury debt –Stephen Miran’s proposal to forcibly swap official sector holdings of short-term U.S. Treasury securities for 100-year bonds – or by increasing tax rates on foreign holders of US securities. Since UK portfolio and direct investment in the US is close to $4 trillion – roughly the size of UK annual GDP – this risk is substantial.

How should the UK authorities — in particular the Bank of England’s Financial Policy Committee – respond?

UK authorities could consider various responses to these vulnerabilities. Starting with the problem of financial institutions’ US dollar liabilities, the most obvious is to find ways to reduce exposure. Several possibilities come to mind. These all involve adjusting a combination of capital and liquidity requirements. For example, regulators might consider imposing liquidity requirements by currency. That is, require that a bank issuing liabilities denominate in US dollars hold short-term assets also denominated in dollars. A related possibility is to raise capital requirements on dollar-denominated assets. So, the first option is to make issuance of dollar liabilities and the holding of dollar assets more expensive.

Second, the Bank of England could consider increasing its cash holdings in the US. This can be either at the Fed or at private US banks. Critically, however, authorities have precautionary cash buffers that substitute for the swap lines. Because the need for these dollars will come when the global financial system is under stress, securities that are convertible into cash through sale or repurchase agreements are not an option.

Yet a third possibility is for UK authorities to fashion cooperative agreements with foreign jurisdictions. These are of two types. The first is to pool dollar cash resources in the accounts in the US – in essence creating US dollar swap lines without the Fed. The second is creating a US dollar clearinghouse offshore. This involves connecting to a common clearinghouse that then clears dollar transactions internally, with only net external transaction going through the US.

Finally, the only way to insulate oneself from the potential for conversion of existing Treasury securities or an increase in taxation is to divest from US assets. This could be difficult, but it is surely worth considering reducing exposure.

Are there any opportunities for the City of London in this environment that the UK should be prioritising?

I see the shift in US policy as an opportunity for The City of London. London is the second largest financial centre in the world. Only New York is larger.  With its large financial institutions and markets, London is in an excellent position to take business away from the US.

To see how this might play out, consider two examples. The first is equity listing. Today, many non-US firms continue to prefer to list in the US. They do this because they believe markets are deeper, so they will be able to issue more easily and at higher valuations. But with the same level technological, financial and legal infrastructure, can’t the City of London take over some of this business? And, in light of the recent threat by US Securities and Exchange Commission Chair Paul Atkins to ban the use of IFRS by non-US firms, this seems like an opportune moment to encourage non-US companies to list in London.

Second, there are derivatives markets. The two largest derivative exchanges in the world are LCH in London and the CME in Chicago. Surely it is possible to slowly encourage movement from Chicago to London for some contracts.

Related to the last point, might it be worth revisiting the relationship with the EU? Since the UK left the EU in 2021, European authorities have been working to bring euro-denominated derivatives clearing into the EU – shifting it both from London and from Chicago to Amsterdam, Frankfurt, and Paris. If the UK can convince the EU of that they are trustworthy and cooperative, then it should be possible to collaborate and bring more business to London.

Stephen G. Cecchetti is Rosen Family Chair in International Finance at Brandeis University, Research Associate at the NBER, Research Fellow at the CEPR, and Vice Chair of the Advisory Scientific Committee of the European Systemic Risk Board. From 2008 to 2013, Cecchetti served as Economic Adviser and Head of the Monetary and Economic Department at the Bank for International Settlements in Basel, Switzerland. From 1997 to 1999 he was Director of Research at the Federal Reserve Bank of New York. In addition, he has been on the faculty of The Ohio State University and the New York University Leonard N. Stern School of Business. In 2016, he received an Honorary Doctorate in Economics from the University of Basel.