Thanks to the role that complex financial instruments played in the global financial crisis of 2008, regulatory agencies are stepping up their game to oversee almost every imaginable kind of derivatives. But should forex derivatives also be regulated?
That’s the exact question that the U.S. Treasury is posing to the public. To make a long story short, it is arguing that not all derivatives are evil and that forex forwards and swaps should be exempted from regulation. But before we discuss its reasons, here’s a quick crash course on forex forwards and swaps.
A Forex forward contract or FX forward is a contract between two parties to exchange currencies at an agreed upon exchange rate at a future date.
For example, Harry thinks he’ll need 10,000 GBP two months from now when he goes shopping for potions in Diagon Alley. Hermione agrees to sell him sterling in exchange for U.S. dollars at the GBP/USD rate of 1.6000 in a couple of months, so they whip out their quills and sign an FX forward contract.
Forex swaps involve an FX forward transaction along with a Forex spot trade. These are often used by companies to hedge their transactions which involve exchange rate risk.
These are different from currency swaps, which also take fluctuating interest rates into account. Now that’s a complex derivative for y’all! And that’s one example of a financial instrument that should be regulated in the OTC market.
Wait a minute. What’s an OTC market?
OTC stands for over-the-counter market, wherein assets don’t have to be traded on an exchange, such as the New York Stock Exchange or Chicago Mercantile Exchange. This means that counterparties (people like you and me) simply agree to execute a trade directly with each other, like uhm, “over the counter”.
What if one of the parties fails to fulfill his side of the contract? Good question, young padawan. Since the agreement is just between the counterparties, OTC transactions are often prone to default risk, and that is one of the reasons why some people feel that it should be regulated.
But why is the U.S. Treasury suggesting that forex forwards and swaps be exempted from regulation?
Although some naysayers think that forex forwards and swaps belong to the same banana of derivatives that caused the crisis of 2008, the U.S. Treasury has acknowledged that foreign exchange is less risky than mortgage-backed securities, collateral debt obligations, and credit default swaps. They say if the currency industry was one of the troublemakers, why was it largely unaffected by the liquidity crises?