/ investors to make higher - risk loans / investments to cover the higher cost of hedging. let me finish by coming back to the title of my talk and explain why i have learned not to worry and love the basis. in the current world of low returns on reserve assets, for conservative asset managers like ourselves at the rba, the return enhancement offered by the basis is highly beneficial. 3 we can still confine ourselves to our conservative investable universe of sovereign assets, but earn the ( often quite substantial ) return by swapping from the various reserve currencies that we hold into yen ( where the basis tends to be the widest ). in addition to that, we can also swap australian dollars, our natural funding currency, into yen for domestic liquidity management purposes. we can manage the risks around these transactions with a well - articulated and conservative counterparty framework, reinforced by isda agreements with daily margining. in doing so, we can also take comfort that we are playing a useful role in providing a counterbalancing flow in the market, thereby limiting the rise in the basis and facilitating hedging of cross - border flows. of course, we don ’ t want everyone to love the basis as much as we do, otherwise our return enhancement would soon disappear. 3 / 4 bis central bankers'speeches so i hope we can all learn not to worry, most of the time, about the basis. but while we are not worrying, we should still spend time understanding the various cross - border flows that underpin the basis. but please can we make sure we look at all the different participants in the market and the different factors that affect them, as the papers presented at this conference generally do. then, on the hopefully rare occasions when we do need to worry about the basis, we are better placed to respond appropriately. 1 for those who don ’ t share my cultural heritage, i am referring to stanley kubrick ’ s dr strangelove or : how i learned to stop worrying and love the bomb. 2 the basis is shorthand for the extent of the deviation from covered interest parity ( cip ). it is the difference between the cost of borrowing directly in us dollars ( say ) and the synthetic cost from borrowing in a foreign currency and swapping the foreign currency into us dollars. apositive ( negative ) basis means that the us dollar interest rate is higher ( lower ) than the foreign interest rate adjusted for the cost of the swap.

the combination of maturity and currency mismatch ; in particular, a bank funding a portfolio of foreign currency assets, by swapping its local currency ( for which it has a natural funding base ) into the foreign currency with short - dated swaps. the assets are generally long - dated and not particularly liquid. so we have a dangerous cocktail of maturity and currency transformation. if the basis gets too wide, then this can quickly become unprofitable. even more worryingly, if a quantitative constraint hits the swap market, rather than just experiencing just an increase in the cost of the swap, a bank funding itself with short - dated swaps is quickly going to find itself in the equivalent of a sudden stop. ( note this is quite a different scenario from funding domestic assets with foreign currency swapped back into domestic currency, for which there is ultimately a domestic backstop in the event of liquidity stresses. ) a positive basis is often described as indicative of a us dollar shortage. i don ’ t find that term very helpful at all. ‘ shortage ’ very much implies a quantitative constraint, rather than a pricing constraint. but in most circumstances, we are talking about the latter. that is, the supply of dollars might go down, so the price goes up. there is no shortage, there is just more demand than supply, and, as with other markets, the price adjusts to equilibrate the market. the market is functioning effectively and efficiently. the focus of analysis should be on the various factors that affect demand and supply. the papers at this conference highlight the range of factors that need to be taken into account. there are exceptions, most obviously 2008, where there clearly was a dollar shortage. at that time, there was effectively no market - clearing price and rationing was in effect. but that period was the exception, rather than the rule. 2 / 4 bis central bankers'speeches over the past few years, that has not been the state of the world. the basis has gone up and down in response to the shifts in demand and supply. as it has moved around, it has in turn generated behavioural responses from market participants. for example, when the basis got particularly wide a year or so ago, a number of banks which had previously found it uneconomical to arbitrage the market, re - entered as it was profitable to do so, even given the balance sheet costs to them of the trade. in the past, we might have expected wide