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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?

Treasury Secretary Timothy Geithner and his gang also commended the foreign exchange community in its bold move of launching Continuously Linked Settlement (CLS) in 2002, a system which provides transparency and negates settlement risk in transactions.

Lastly, subjecting forwards and swaps to third-party institutions that would regulate and report trading information also has its disadvantages. Tougher scrutiny could discourage swaps businesses, cause systemic risk and possibly even financial instability.

You might be thinking, “Forwards? Swaps? C’mon, Forex Ninja, I like to keep things nice and simple – I trade the spot market! What the heck does this have to do with me?”

Well you should know that these recent developments can (and most likely will) effect the spot market. As I said, regulation is the new fad in the financial markets. Regulatory agencies are doing their best to implement changes so that in the future, we can avoid another crash of the system. Therefore, it is important to know these changes, as any new developments can have significant effects on retail traders down the road.

If we do see an exemption across the board, we could see more trading of FX forwards and swaps, which in turn could lead to an increase in the average daily volume in the Forex market. This would mean more liquidity in the markets. Of course, this may just be a marginal effect, since this isn’t the spot market.

In addition, an exemption would signal to traders that the Forex market would remain free from the rigid regulations of the CFTC (Commodity Futures Trading Commission). This would give U.S. traders more incentive to keep their accounts with U.S.-based brokers. Take note, some U.S. traders have taken to moving their accounts to offshore brokers in attempt to bypass certain limits (i.e. the 50:1 leverage) that the CFTC wants to impose on U.S. brokers.

In any case, this is an issue that I’ll be keeping an eye on. I am sure that many players in the financial markets will make sure their opinions are heard and we shall see how the Treasury and CFTC go about this. If in fact more regulation is imposed on forwards and swaps, is it only a matter of time before the spot market becomes the CFTC’s next target?

What do you think of these new regulations? Post your comments below!