10th Global Conference on Business & Economics
ISBN : 978-0-9830452-1-2
Regulation of FX market
Tamás Isépy
Adjunct Professor
University of Pannonia
Departement of International Economics
Tel.: +36-20-547-5470
Abstract
This study focuses on different deals on FX market and analise whether a regulation
lead to more efficient market. In the last years ther is solid increase of spot deals on FX
market, which can only with estimation splitted into arbitrage, hedging and speculative deals.
Do the rise of speculation lead to a more volatile or a more stable and last vulnerable FX
market and currency? FX swap deals in most cases are used for refinancing long term loans
and applicable eliminating banks interest rate risk. However, in case of liquidity dry up banks
have to face of both foreign exchange- and interest rate risk.
About Tobin tax
In case of analysing the relationship between turnover and volatility we have to
differentiate between markets – foreign exchange market, money market, securities. The
former finding emphasize the relationship between higher turnover higher volatility.
On FX market Galati (2001) analysing datas between 1998-1999 finds „that in most cases
unexpected trading volumes and volatility are positively correlated, suggesting that both are
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driven by the arrival of public information, as predicted by the mixture of distributions
hypothesis.” moreover she finds „that the correlation between trading volumes and volatility
is positive during “normal” periods but turns negative when volatility increases sharply.”
Jorion (1996) finds that FX spotvoulume is positively correlated with volatility from 19851992 figures.
Causal relationship is not pointed out, but there is a fact, that market participants who hold
more risky portfolios have an influence with their attitudes to higher turnover. In spite of the
fact that different markets have special features my research target is to decide whether there
are any relationship on FX market between higher turnover and higher volatility. I assume
that FX market need enough turnover to ensure relative stable foreign exchange price
movement without solid falls and jumps on the market. However the development of spot
deals and particularly FX swap deals can serve some concerns. Spot deals are partly in
connection with forward deals in case of arbitrage deals – covered or uncovered interest rate
parity. On the FX market, however there is a solid increase of spot deals, which mean rising
proportion of speculation. Market need speculation, but overspeculated market can amplify
the volatility of the individual market.
On money market interest tax exist in several countries, while on securities market there is
share price earning tax. On foreign exchange market there was a suggestion of foreign
exchange earning tax’ introduction. Tobin tax was however not accepted by the policy makers
with remarks that it should be introduced in every coutries in order to avoid arbitrage between
markets. Lack of this measurements FX trading will appeared only in those coutries where fx
trading is free of tax.
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My proposal in this area would be the following: Tobin tax can be applicable using different
level of taxniveau for the deals with different maturity. If somebody speculate on the market,
then the earning will be a basic of tax, but with different measure. The lower the duration is,
the higher will be the tax. If the offset spot deal is f.e. in two week, than the market participant
have to pay higher tax than in case of deal with two month maturity.
Certainly nobody wear a T-shirt with title, that „I am speculant” or „I trade an arbitrage deal”,
but analising the FX deals ex-post it can be controlled. My suggestion would be, that
everybody has to pay at the date of spot deal a given level of tax in every cases and in some
cases the national tax authorities should pay back the superflous tax at the end of the year. An
required amount by the market participant depending on the period of time where they
sepeculated on rise or fall of currency.
Krueger (1996) emphasize that distinction between hedging and speculation not easy. Min H.
G.; J.A. McDonald (1999) underlines the damages of too thin foreign exchange market’s role
in Asian crisis. Krueger (1996) mention the definition „lack of speculation” and „too much
speculation”. On the FX market the efficient speculation proportion is not estimated yet.
Maybe policy maker could calculate that ex post from volatility and turnover datas.
Applied Tobin-tax would encourage the effort to separate deals considered as gambling and as
hedge deals, arbitrage deals and normal level of speculation. Or more precisly speculation will
be reduced because of tax.
FX market is one of the most quick market reflecting to new information regarding
underlying deal. From gambling the state has to have in form of tax remarkable income.
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After introduction of Tobin tax there would be some coutries where speculative FX trades
would concentrate. The paid Tobin-tax can be requested to paid back by national tax
authorities if the attitude was arbitrage between markets or hedging. In case of speculation
national or international authorities should declare the accepted proportion of speculation.
This aggregate proportion is applicable for individual market participant. If on an aggregate
level 20-30 percentage of total fx spot deals is considered as maximum level, than until that
speculation level there is not requested to pay Tobin tax. So individual market participants can
get back at year end the tax paid during the year.
FX swap deal is one of the most relevant deal of financnig banks assets. FX swap not for
reducing FX exposure since spot and forward leg together mean closed FX position, however
it is a tool for managing interest rate risk. If bank finance their assets with maturity f.e. 20
years by 3 month FX swaps than the following point of view need to considered. If the
interest period of 20 years assets equals to the FX swap deals than there is not any additional
interest rate risk. But it should be pay also attention on liquidity risk too.
Analysing FX market turnover and volatility
1. Table Global foreign exchange market turnover1
Daily averages in April, in billions of US dollars
1992
Spot transactions
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394
1995
1998
494
4
568
20042
2001
387
631
2007
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10th Global Conference on Business & Economics
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Outright forwards
58
97
128
131
209
362
Up to 7 days
….
50
65
51
92
154
Over 7 days
….
46
62
80
116
208
324
546
734
656
954
1714
Up to 7 days
….
382
528
451
700
1329
Over 7 days
….
162
202
204
252
382
Estimated gaps in reporting
44
53
60
26
106
129
Total „traditional” turnover
820
1190
1490
1200
1900
3210
Foreign exchange swaps
Memo: Turnover at April
2007 exchange rates3
Remarks:
1
Adjusted for local and cross-border double-counting. Due to incomplete maturity breakdown,
components do not always sum to totals. 2Data for 2004 have been revised.
3
Non-US dollar legs of foreign
currency transactions were converted from current US dollar amounts into original currency amounts at average
exchange rates for April of each survey year and then reconvertedinto US dollar amounts at average April 2007
exchange
Source: BIS Triennial Central Bank Survey 2007
Tobin’s suggestion was at time when increasing turnover resulted in increasing
volatility. I have choosen EUR/USD exchange rate movement from euro introduction until
2007. EUR and USD are the most traded currency, namely 27% of total spot transactions
Survey about FX market in BIS Triennal Survey in 2007. Solid increase of FX swap market
is explainable by rising hedging acticity on the market, moreover by rising importance of this
credit financing form.
2. Table Volatility of EUR/USD rates
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1999
Volatility
2000
2001
ISBN : 978-0-9830452-1-2
2002
2003
2004
2005
2006
2007
0,00449
0,006467
0,00575
0,004674
0,005706
0,00501
0,004556
0,003695
0,002942
0,015173
0,021546
0,017548
0,014645
0,019447
0,015519
0,014241
0,011471
0,01041
Daily
Volatility
10 days
Source: National Bank of Hungary FX rate statistics
1. Graph EUR/USD volatility (01.01.1999-31.12.2007)
0,03
0,02
0,01
0
-0,01
-0,02
-0,03
Author’s calculation
Sources: National Bank of Hungary FX Statistics
I choosed EUR/USD rate, since it has the highest proportion of total average daily turnover
with 27%. BIS (2007)
Table 1. and Table 2. 1. Graph underlines the fact that higher spot transaction volume in the
analised period of time were with lower volatility.
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Robert J. Engle received Nobel prize in 2003 for autoregressive conditional heteroscedasticity
(ARCH) model, which methodology is useful for estimate the futures volatility. This method
is applicable when the variance is not constant. My calculation reflects to the average
EUR/USD exchange rate fluctuation in the past and not the estimation for the futures
volatility.
Since the most traded FX deal is EUR/USD, and these are the two main reserve currency on
the world I have choosen this exchange rates. BIS Central Bank Survey about FX deals is on
3 years basis, therefore it can be only estimated that higher turnover on FX market lead to
lower volatility of EUR/USD exchange rate both on 1 day and 10 days basis. Most of the
banks’ risk management system is prefer to estimated 10 days price movements and
maximum loss of 10 days, therefore I have used 1 and 10 days volatility time series of
EUR/USD prices. Internal Value at Risk analysis basically use 10 days estimated maximum
loss with 99% probability.
Higher average turnover do not lead higher volatility of prices on FX market, but lower
volatility. There is trade off between lower volatility – lower price of hedging deal and Tobintax – as direct state income after FX trade. Introduction of Tobin tax would only lead to
higher administration cost, only partly splitted FX deals into arbitrage, hedge, speculation
deals. These result would suggest to policy makers not having concerns about higher turnover
on the market and increasing number of speculation on FX market, since these market
participants’ activity contribute to lower volatility and cheaper hedging of open FX positions
exposures.
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10th Global Conference on Business & Economics
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Results is encourage increasing volume on the FX spot markets which lead to lower volatility
and higher stability of currency. Higher turnover on spot market also mean, that spot rates can
less influenced by speculation on FX forward market.
3. Table Financial System of TRIAD
Financial System of TRIAD
USD
FX Market
Equity
Bond
EUR
FX Market
Money
Market
Equity
Bond
JPY
FX Market
Money
Market
Equity
Bond
Money
Market
3. Table emphasize the fact, parts of the financial systems in a given currency are available
through FX market. Lower volatility of FX market with increasing turnover encourage policy
makers to pay attention even to the part of financial system in a given currency.
Banking regulation with regards to foreign exchange deals
Basel II concentrate preliminarily on new calculation of credit risk. Basel I. was
launched in 1988 considered credit risk only by differentiating clients but there was
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assumpted that market participants in one client category have the same creditworthiness.
Basel II. however paid attention on different client ratings so the worser is the rating the
higher is the minimum necessary capital wich should be ordered to the individual deals. Basel
I. amendment in 1996 started to focus on market risk among them on foreign exchange risk.
Standard models have standard factors which changing by different maturity of fx deals.
Banks could develope intern model, which in most cases allow reducing the minimum equty
capital for a given fx exposure. Otherwise banks would use the standard model.
In case of FX swap we can not speak about deal which is applicable to hedge fx risk but
interest rate risk. Banks have the possibility to lend money in another currency with FX swap
in spite of loan in national currency. Two type of interest arbitrage exist: covered when both
spot and forward deals exist next to the two money market deals (borrowing in one currency
and lending in another currency) and uncovered interest arbitrage deal, when forward leg is
not traded.
In a current crisis there is a phenomenon, that the money market and fx market together are
not in line because of the fact that the deals are trade on different price, than arbitrage free
deals
Banks do maturity transformation, they finance loans with long maturity by funds with short
term maturity. It means in case of loans int he same currency only interest rate risk, to be
more precise if funding’s interest period equals long term loan, than there is not any interest
rate risk. If there is liquidity dry up on the money market, fx market, than banks run foreign
exchange- and interest rate risk, since they have to finance their long term loan by national
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currency funding. They can obviously forward their additional cost to their clients. Moreover
this phenomenon can reflect in bank’s level liquidity crisis, which lead to higher FX rates.
It happened in the hungarian banking system where most of the banks funded their long term
loans in fireign currency by 3 month funding/FX swaps. This refinancing structure is
applicable for that, when thereis a liquidity ont he market. Liquidity dry up, however
underlines that banks need to measure their liquidity risk more accurately. Funding’s
substitution can be short term source in national currency, but it is not hedge deal, since it has
both foreign exchange- and interst rate risk. Liquidity draought on FX swap market can exists
only for short period of time, beacuse it can occure systemic banking crisis. In Hungary
Hungarian National Bank negotiated with ECB a EUR/HUF FX swap line in amount of 5
billions EUR.
It might be considered to prescribe a minimum currency supply for banks on the interbank
market as prudential requirements. There is a maximum limit per client ont he interbank
market., but it has wealth to analyse introduction of this minimum on bank system level for
ensuring currency liquidity on a market.
Reason of liquidity draught situations on bank level are only partly known. National or
Supranational Banking Supervision’s aim to avoid these situations. Prescribing of minimu
liquidity requirements would reduce systemic risk. The world has learnt in 1998, that failure
of LTCM which hedge fund focuced on arbitrage deals, led to further banks’ failure. Shocks
beacuse of liquidity dry up can be resulted in remarkably loss on banking system so enforcing
these minimu by taxes and punishments will mean lower cost of banking systems than that of
consolidation by central bank.
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10th Global Conference on Business & Economics
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Regulation’s possibility of foreign exchange market
On FX market i focos on two issues. Firstly the daily spot turnover are much higher
than voulumes explained by trading in goods. See 2. graph. It has to be considered that not
only commerce (import and export) are using this transaction with T+2 value dates, but
moreover banks can roll their position mainly by FX swaps and spot legs of arbitrage deals
can also increase the proportion of non speculative spot’ volume.
Analysing forward deals volume there is possible only an estimation. First of all there is a
milestone that enough volume of spot and forward transactions ensure the arbitrage free
environment, however there is a rough estimation ordering the total forward deals to spot
deals. The target can be to define and seggregate speculative spot deals and non specukative
spots. This is much lower than datas from 2 graph. (88% in 2007)
2. Graph Trades in goods /spot deals ratio
Yearly merchandise deals/ yearly estimated spot deals
0,14
0,12
0,10
0,08
ratio
0,06
0,04
0,02
0,00
1992
1995
1998
2001
2004
Authors calculations
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10th Global Conference on Business & Economics
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Sources: WTO Statistics, BIS Triennal Central Bank Survey
If there is an estimated speculative volume of FX spot transactions than it has a value to
analyse an eventual introduction a tax suggested by Nobel laurate James Tobin. Tobin’s aim
was hindering of „hot money” – capital movements with short term maturity – since these
were coupled with high volume spot transactions. Tobin tax was not applied, because that of
lack of all coutries introduction FX tarnsaction would traded in tax free country. Practically
considered it is hardly imaginable, that if stock exchanges in Tokio, New York and London
agreed about tax, than market participant would vote for a trading in a tax free developing
country. However it can be not underestimate that overspeculated currency mean an
overvalued and undervalued currency, very fluctuated exchange rate and deterred prices,
unstable situation in a country or region.
I think those market participant who use spot deals above estimated optimum volume are
gambler, who need to pay tax for the staate. National or Supranational Authority can prescribe
that above a given volume request tax at purchasing and selling currency. This tax can be
cancelled if the spot volume is not higher than a optimum. Market participant would pay tax
but they could get some money back depending the maturity of holding the currency. The
longer is the maturity the lower is the paid tax. Commerce related transaction, hedging and
arbitrage deals would not in charge. It could be documented at the end of year. Effects of this
measurement, that many of speculative traders would trade in tax free countries and the split
into spot volume into arbitraging, hedging and speculation would possible
.
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As a mentioned before Supervisory Authorities woul tolerate speculation until a given level.
Moreover I would like to declare that this thought is only applicable when higher volume of
spot deals are in relationship to higher volatility.
If higher volume leads to lower volatility on the market than Tobin tax introduction has not
got value, since lower volatility has lower hedging cost in FX market.
Conlusions
Foreign exchange market particular spot market has extended until 2007. Main result
of this study that increasing EUR/USD turnover led to lower volatility of spot market.
Beacause of higher turnover spot market are less vulnerable against speculation from futures
market. Therefore lower volatility means lower cost of hedging the foreign exhange risk
exposure. FX market has not to be regulated.
In current crisis FX swap market liquidity dried up so commercial banks needed FX swap line
from FED and ECB. Without this banks had to face FX- and interest rate risk, which
threatened higher bank systemic risk.
References
Amatatsu, Y; Baba, N. (2008): Price discovery from cross-currency and FX swaps: a
structural analysis BIS Working Papers No 264
Baba, N.; Packer, F. (2009): From turmoil to crisis: dislocations int he FX swaps market
before and after the failure of Lehman Brothers BIS Working Papers No 285
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10th Global Conference on Business & Economics
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BIS (2007): Foreign exchange and derivatives market activity in 2007, Triennial Central Bank
Survey
Galati, G. (2000): Trading Volumes, Volatility and Spreads in Foreign Exchange MArkets:
Evidence From Emerging Market Coutries, BIS Working Papers No 93
Jorion, Ph (1996): Risk and Turnover int he Foreign Exchange Market in Frenkel, J.A.; Galli
G.; Giovannini A. : The Microstructure of Foreign Exchange Markets
Krueger, M. (1996): Speculation, Hedging and Intermediation int he Foreign Exchange
Market, Banco de Espana
L.P.Hansen, R.J. Hodrick (1983): Risk Averse Speculation int he Forward Foreign
Exchange Market: An Econometris Analysis of Linear Models in J.A. Frenkel: Exchange
Rates and International Macroeconomics
Min H. G.; J.A. McDonald (1999): Does a Thin Foreign Exchange Market Lead to
Destabilizing Capital-Market Speculation in the Asian Crisis Coutries? The World Bank
Development
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