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Forward and Swap Contracts in a Speculative Attack on a Pegged Rate (7/28/00)
Dear Dr. Risk
I am not sure this
question is of interest for many people. I would like to know how foreign
exchange swaps are used in speculative attacks against pegged exchange rate
Dear Ilja Thanks for your thoughtful message and relevant context and references.
The short version
This is essentially a problem with everyday currency market jargon that seems arcane to outsiders. What you call a swap paired and offsetting spot and forward outright transactions is what currency dealers in the inter bank market call a forward FX swap or simply a forward, for short. That is what they typically trade among themselves. What you call a forward the exchange of known amounts of two currencies at a specific future date is what currency dealers in the inter bank market call a forward outright or outright forward, and banks do them almost exclusively with customers.
Consequently, a hedge fund speculator might do an forward outright with a currency dealer at a commercial bank, and the dealer might lay off the risk via a forward FX swap in the inter bank market. That swap might involve a bank in the home country of the doomed currency.
More on speculation
Warren Buffet and many before him have said, "There's a sucker in every poker game. After 30 minutes in the game, if you haven't figured out who it is ... you're it!" In the case of pegged currency regimes, often, the sucker has been the central bank that tried to support a pegged exchange rate. George Soros and others made billions of dollars off this sort of place in the nineties, and speculators will get richer off different governments in the future.
That isn't to say that nobody can maintain fixed exchange rates. The Hong Kong Monetary Authority (http://www.info.gov.hk/hkma/) with its currency board system (http://www.info.gov.hk/hkma/eng/currency/index.htm) has done an outstanding job of maintaining the ratio of HK$7.80 to US$1 since 1983.
If you own some of the weak, doomed currency that the central bank is trying to support, you can make a profit by selling it and buying the currency against which the weak currency will depreciate. That works fine, up to a point. However, the big money comes from selling the doomed currency short, and that's what the big speculators do. As with shares, one way to do this is to borrow it and sell it, then later buy it back for less than you paid and repay your loan:
That's a bit awkward. Alternatively, a hedge fund might just do a forward outright transaction, where it agrees now to pay in one year F pesos for 1 dollar. Then it waits and reverses that trade in the spot market for a profit of X1 F, which is positive if F < X1.
However, a common practice in the inter bank currency market is to do the forward FX swap, which consists of doing an offsetting spot transaction at the same time as the forward outright transaction. Some traders in the inter bank market call this a forward transaction, and others call it a swap. Naturally, the speculator doing this swap then eliminates the currency exposure to the currencies, either dealing it away in the spot market or borrowing and lending it away. So this approach is a little awkward, too.
Does that make sense? Dr. Risk
How safe are dollar deposits in various banks around the world? (9/28/99)
Dear Dr. Risk I would like to know wich are the risk of the dollar deposits in:
A International Banking Facilty in the US
Dear Tommaso While I'm asking some experts on this topic, please answer me this: Why do you care? Idle curiosity? Dr. Risk
Dear Dr. Risk I work for the Central Bank of my country, which have recently been upgraded in his credit rating and is seeking markets to invest. Also is a good subject to give in my class of International Banking and a good example for my students in the usage of the internet as a research tool. Tommaso
Dear Tommaso I spoke with a Wall Street professional and a source close to Alan Greenspan ("Close" is a relative term. The source is closer to Greenspan than I am, but so is Andrea Mitchell, and I wouldn't ask her.)
Advice from Wall Street
Mr. Wall Street is a Mexican national. He rated the credit quality, as follows:
1. (best) US bank in US
As you can see, I didn't ask him your question, precisely.
His argument is that US banks follow US practices and have US regulation. The foreign banks may have some freedom from US regulations and personnel certainly have bad habits from their hometown banking practices. Any money in Mexico is up for grabs! The US bank in Mexico has to fear some US regulation and scrutiny, which keeps it in line, and it has some protection, because the Mexican bandits don't want to anger the US without good reason. The Mexican bank in Mexico has no real laws or rules to obey, because the powerful can change them on a moment's notice, to confiscate some or all of deposits, capital, and equity.
As he put it, "Mexico is a kleptocracy. Hoodlums run the government. Law is whatever they want at the moment. Private property is whatever they don't take. The ruling class craps all over the constitution, whenever it gives them an advantage they want. The government can take anything, anytime. By the way, crime is currently out of control, and individual criminals run rampant, too.
"In Mexico, in 1982 they nationalized banks, froze the accounts, and converted the dollar accounts into pesos at a confiscatory exchange rate. They didn't touch CitiBank, which was then mainly in the private banking business and had only accounts of prominent Mexicans. Carlos Salinas was President of Mexico. His brother, Raul, got 10% of every nationalization, hence his nickname, "Mr. Ten Percent".
"The largest Mexican banks these days are Bancomer, Banamex, and Serfin. Spanish and Canadian banks are moving in, and may be more secure than the local banks. CitiCorp has acquired local banks and is now a retail bank there."
Advice from Washington
I ran your question by a U.S. government employee, who spoke with me on the condition that I would not identify him or her. I'll just call this source "Sheehy". Sheehy says, "As it turns out, the question of supervisory control of foreign banking entities is a very sensitive issue. Historically (10+ years ago), branches and agencies of foreign banks were subject to significantly fewer restrictions that US banks, e.g. branching across state lines was not prohibited. It is my understanding that US bankers were behind much of the most recent legislation regarding acceptable/unacceptable behavior by foreign bank branches and agencies.
"Let me now answer the questions addressed to Dr. Risk ... These are quite simple. I believe the questions are asking about the riskiness of deposits in particular institutions. This is a function of where the capital backing the deposits is located. If the institution is a US bank, regardless of its location, at a minimum, it is subject to US regulations (Fed, OCC, FDIC, OTS, and/or state regulators); in particular, capital requirements. Additionally, if the branch of the US bank is located outside of the US, it will be subject to local regs as well. I cannot speak to the efficacy of these regs. In some countries, they may be essentially nonexistent; in others, they may be onerous. An International Banking Facility is not a legal entity; it has to do with off-shore banking. I am not very familiar with these. Deposits in US banks have US risk, regardless of where the deposits are located. That is, the capital backing the deposits is in the US and is subject to US regulations. If the deposits are in a Mexican bank, regardless of where the deposits are (Mexico or the US), these deposits are backed by capital in Mexico. That capital is not subject to US regulatory authority. US regulatory authorities only have authority over branches and agencies located in the US.
"Does all of that make sense? In short, authorities in a country only have control over capital located in that country. Foreign entities may be allowed to do business in that country, but there is no authority over the capital (its measurement, adequacy, etc.) that is located in the home country. For that reason, if you deposit money in a branch of a foreign bank located in the US, you still bear the risk that the bank may be inadequately regulated in its home country. It may go bankrupt and the US will have no control or authority over that resolution process.
"As to your additional questions ... General Information ... The specific answers to all these queries are in the Federal Reserve's Regulation K, which details the treatment of US branches of foreign banks and foreign branches of US banks.
"Before 1978, there was basically no federal oversight of US branches of foreign banks. Each state established its own controls. There was not coordinated oversight. The International Banking Act of 1978 established federal oversight. In 1991, the Foreign Bank Supervisory Enhancement Act was also passed.
"As it stands, a foreign bank must apply to the Federal Reserve. We oversee supervision in the US. The foreign bank may still be chartered as either a state or federal branch, which will affect which regulator oversees specific functions.
"Historically, the foreign bank could choose to be either insured or uninsured (that is the deposits). Since 1991, all new insured branches must be capitalized here.
"Who regulates...It depends on how the foreign branch is chartered and what services they provide. It could be as many as five different regulators.
"Deposit structure...It depends on the type of license that the branch has as I indicated above. Some branches may be restricted to a single type of deposit. Others may be able to accept numerous types. Again, Reg K.
"London and H.K...Host countries have jurisdiction. You would have to get information from them about any specific rules and regs that apply to foreign branches in their countries.
"BIS requirements apply to countries that have adopted them. In many instances though, specific requirements are left to the discretion of each country. Additionally, many countries have different definitions of capital, i.e. is preferred stock Tier 1 or Tier 2 capital. I don't want to get off on capital arbitrage, but I would imagine that certain forms of arbitrage are restricted in some countries and are all but encouraged in other countries. This is a topic for another discussion.
"Mexico is an OECD country. Interestingly, just before the crash in 1994, they were admitted to the OECD. Instantaneously, loans to government entities in Mexico had no capital requirements (per the Basle Accord) as they were deemed riskless. We all know what happened. This exemplifies one of the many problems with the Accord's statutory limits; they are arbitrary.
"Hong Kong...I don't believe it is OECD, especially now that it is back with China.
"Deposits risk in specific institutions...and you want a simple answer...It depends on credit risk and transfer risk specific to that institution.
"Additional Information ...
"Recommended readings/follow-up if you're really interested...
"Regulation K (I have been told that it is actually very well-written; i.e., not your typical fed speak. ["Well-written" is a relative term and highly subjective, as a comparison of Reg K with the writings of P.J. O'Rourke shows.]
"The Fed recently (April 12, 1999) approved the establishment of a US branch of Banco de Credito e Inversiones S.A. (from Chile). You might check the Fed's website (www.federalreserve.gov) to see if the Press Release is there. I believe it will be. It briefly explains the process that the Fed went through in approving the branch license. Further, it defines the scope of the bank's allowed activities in the US. In addition, it states that 'The Board [of Governors] generally also must determine that the foreign bank is subject to comprehensive supervision or regulation on a consolidated basis by its home country supervisor.' Also, 'Chile's risk-based capital standards conform to those established by the Basle Capital Accord.'
"Economist article in Jan. 30th issue
"Contact Public Affairs at any Fed as they will have some officially prepared responses to many of the above questions. I have been told that this is a particularly sensitive area. We (the Fed) must be very careful what we say with respect to foreign bank supervision.
"Well, just image what the response would have been if I had truly researched the topic. Actually, I found the questions were very interesting. In fact, they were more interesting that what ever it was I was working on last week, so they got priority.
"If I can be of further assistance, let me know. I am always glad to help."
Thanks, "Sheehy". Dr. Risk
Derivatives DictionaryTM Terms and definitions relating to currency. The main Derivatives DictionaryTM is here.
8/28/01 "Web Currency Trading Vexes Regulators." Wall Street Journal (2000 August 14) By Tom Barkley.
Currency trading on the Internet is booming. Regulation is floundering.
Regulators cannot establish who has jurisdiction, because the trading companies are offshore and/or move the money customer's money offshore as soon as they get it. "You can't spend six months and $1 million working with investigators all over the world and then have someone file a motion of 'I know it's fraud, it's just not your fraud,'" said Philip Feigin, former head of he North American Securities Administrators Association and the Colorado Division of Securities. The CFTC has an additional problem: namely, laws regulating futures markets deliberately exempt currency transactions from the CFTC's jurisdiction.
Feigin helped bring to Colorado a "model commodity code" that prohibits currency futures not trading on an exchange. About 20 states use that law to shut down retail trading operations that resemble futures, because they don't settle.
Why the scammers are able to make such inroads? Obviously, the existing currency market isn't supplying the retail customer with a competitive combination of price and quality. Did you ever notice that you can't get an Euro or yen account at your local U.S. bank? Wonder why? Me too! I'll let you know when I find out.
How can reduce fraud in the retail currency market?
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