Active Stocks
Thu Mar 28 2024 15:59:33
  1. Tata Steel share price
  2. 155.90 2.00%
  1. ICICI Bank share price
  2. 1,095.75 1.08%
  1. HDFC Bank share price
  2. 1,448.20 0.52%
  1. ITC share price
  2. 428.55 0.13%
  1. Power Grid Corporation Of India share price
  2. 277.05 2.21%
Business News/ Opinion / Online-views/  Are forex derivatives different from a regulation perspective?
BackBack

Are forex derivatives different from a regulation perspective?

Are forex derivatives different from a regulation perspective?

Premium

In the coming weeks, the US treasury secretary Timothy Geithner will decide if foreign exchange derivatives should also be subject to increased regulations, just as other derivatives markets. The Dodd-Frank Act, which proposes increased regulation of the over-the-counter (OTC) derivatives markets, gave the treasury secretary a year to decide if and why forex derivatives are different from others, and if and why they should be exempted from the Act. The decision on this will soon be due.

It’s not very surprising that in the run-up to this decision, there is a chorus of protest against a move to include forex derivatives in the Dodd-Frank Act. Banks and organizations that represent them are understandably resisting the move to increase regulation. Responding to the treasury’s call for comments on the issue, officials from the Financial Services Roundtable and Institute of International Bankers wrote that the foreign exchange markets already operate with a high level of transparency and that they performed smoothly during the financial markets crisis. Another response, echoed by Alan Greenspan in a recent Financial Times (FT) op-ed, is that increased regulations will export the forex derivatives market out of the US. But as FT’s Lex column puts it, “Greenspan’s warning against ill-considered regulation is distorted by the pro-market ideology that blinded him to the pre-crash excesses in financial markets."

Also Read Mobis Philipose’s earlier columns

The pertinent question here is if there is a case for differential treatment for forex derivatives. Viral Acharya, professor of finance at New York University’s Stern School of Business, says, “With foreign exchange derivatives, the feeling is that there are enough players on both sides, who offset each other, and hence are unlikely to cause systemic risk. However, in an extreme situation, such as when a large country undertakes a devaluation of its currency, it could result in huge losses for some important players in the market. While the devaluation by a large country or a zone itself will cause a global shock, the large forex losses will make things worse. It may not be entirely accurate to say that forex derivatives won’t ever cause systemic risk."

Also there are varying degrees of transparency in the OTC forex derivatives market. Forwards and swaps, for instance, are in a relatively better position, with a large proportion of them being settled through a central counterparty such as CLS Bank. But when it comes to options, the degree of transparency is far lower. Acharya points that when a large dealer or a bank takes large positions using barrier options, essentially betting against a devaluation of a currency, it would be akin to American International Group’s prior practice of writing insurance against corporate defaults in the credit default swaps market. If a large currency devaluation does occur, it could cause a huge shock to the system. In fact, there’s a lot of scope for improvement in the settlement of forwards and swaps as well. CLS Bank essentially mitigates the time-zone risk that arises when banks from different countries deal with each other. But it doesn’t protect its members against the risk of price movement if one of the parties to the deal defaults. Thus, it doesn’t really play the role of a traditional central counterparty.

Needless to say, these factors should be kept in mind while taking the decision about forex derivatives. Acharya adds, “It would have been good if the treasury secretary’s decision was backed by some specific investigation into the OTC forex derivatives market. There should have been an examination of which products are already cleared well and which ones need improvement. There should have been an attempt to get to books of large dealers internationally and understand the risks that are involved. Currently, we’re operating under a veil and there is a lack of transparency in the market."

In this backdrop, the warnings being given by some US regulators such as the Commodity Futures Trading Commission are not overdone. If forex derivatives are excluded from the Dodd-Frank Act, it could well turn out that more traders flock to this market because of relatively lower regulation. This would make the market even more risky.

The OTC forex derivatives market in India has had its fair share of problems in the past because of a lack of transparency. But things are improving thanks to some great work by Clearing Corp. of India Ltd (CCIL). It already acts as a central counterparty for forex forwards and short duration swaps. Importantly, in the options segment, CCIL will soon start a trade repository which will gather details of transactions in the segment. As and when volumes pick up, it will start settling these trades on a non-guaranteed basis.

In sum, the importance of a central counterparty and a trade repository in any derivatives market cannot be overemphasized. Regulators world-over should be cognizant of this while framing regulations in the post-Lehman era.

Your comments are welcome at inthemoney@livemint.com

Unlock a world of Benefits! From insightful newsletters to real-time stock tracking, breaking news and a personalized newsfeed – it's all here, just a click away! Login Now!

Catch all the Business News, Market News, Breaking News Events and Latest News Updates on Live Mint. Download The Mint News App to get Daily Market Updates.
More Less
Published: 04 Apr 2011, 10:23 PM IST
Next Story footLogo
Recommended For You
Switch to the Mint app for fast and personalized news - Get App