Taxing Excessive Currency Speculation
To Prevent Social Crisis and Finance Global Challenges
A CIDSE-Caritas Internationalis-Justice and Peace Europe
Background Paper - January 1999
Technical Appendices
TECHNICAL APPENDIX 1
A basic taxonomy of currency transactions
Spot transactions are conversions done at the price of today and settlement is usually within two days. However, this is not the only way currencies change hands. Apart from these spot operations, a number of 'derivative currency transactions' are made, such as forwards, repos, swaps, futures and options.
In essence, derivatives can be traded in two different ways, over-the-counter (OTC) or at an exchange. Over-the-counter derivatives are freely negotiated between two parties, with the terms of the contract - in terms of maturity date, contract price, notional – being customised to the specific needs of the users ('tailor made'). Since the contract is tailor-made, it is difficult to have a secondary market for it, so the contract cannot be settled before maturity. As such, the holder of the contract is exposed to 'counterparty risk', i.e. the risk that the other party will be unable to meet its obligations at maturity. For non-financial end-users, this counterparty is typically a bank.
In exchange-traded derivatives, the counterparty in the contract is the clearing house of an exchange, matching supply and demand for a given contract. As such, in order to provide liquidity, the terms of the contract need to be standardised. This enables the creation of a liquid secondary market, where the value of a specific derivative contract is determined daily, and positions can be unwound on a daily basis before maturity. The fact that the counterparty is the clearing house, rather than an individual market participant, reduces counterparty risk considerably.
A forward is the most basic type of derivative, whereby users of it promise to buy or sell a specified asset at a specified price for delivery at some future maturity. As it is an OTC-instrument, terms are freely negotiated, but there is no secondary market, and settlement is at maturity. Until that point, no cash changes hand.
Often, a spot and a forward operation are combined into one transaction, enabling the purchase or sale of a specific currency now at the current market price, while at the same time reselling it or buying it back at some predetermined future time (say, after 7 days) at the predetermined forward rate. This is called a repo (currency repos; often the term 'foreign exchange swaps' is used, which is a bit confusing). In non-technical terms, this operation is generally labelled as a 'round-trip'.
The exchange-traded alternative to a forward is a futures contract. It is simply a standardised forward with an active secondary market; trading is anonymously with the clearing house as a counterparty; the value of the contract is determined daily and contracts are 'marked to market'. For example, cash (a 'margin payment') is paid in by the user to cover any value losses on the contract, and is also paid out (on an account of the user at the clearing house) to the user when the value of the contract increases, on a daily basis. This last specific feature of futures contracts greatly reduces counterparty risk.
A swap is generally defined as an exchange operation by which two parties, within a specified time period, on regular intervals, exchange payments. These exchanged payments can be of a dual nature: or they are exchanges in different currencies (labelled as currency swaps, e.g. exchanging a payment in dollars with one in deutschmarks), in different interest rates (labelled interest rate swaps, e.g. exchanging a fixed interest rate payment for a variable interest rate payment), or a combination of the two (cross-currency swap). As such, a swap is nothing other than a bundle of forwards, and shares all the basic features.
Options are another type of financial derivative products, having a number of different characteristics from swaps. An option is a contract between parties giving the buyer the right, but not the obligation, to buy (call-option) or sell (put-option) a specified amount of a financial asset at a predetermined price (the strike price), and this during a specified future period (American option), or at a specific moment in the future (European option). For that right, the buyer pays a (non-refundable) up-front fee (the premium) to its counterparty, the seller (or writer). As such, the writer cashes in the premium, and has an obligation to honour the contract when the buyer decides to execute the option.
Unlike forwards and swaps, the pay-off profile of an option is non-linear. The maximum amount the buyer of an option contact can lose is the premium; however, he can gain a lot. The counter-party in the option, i.e. the seller (or 'writer') cashes in the premium. He must honour the obligation whenever the buyer decides to execute. His gain is limited to the premium; his losses can be considerable.
Due to no or a very limited investment upfront, derivatives enable investors (or speculators) to take very large underlying demand or supply positions in a currency (the so-called 'notional amount') with little cash involved. This is the so-called 'leverage' effect of derivatives, which also increases the potential rate of return, relative to the small cash investment.
In a detailed market survey done by the Bank of International Settlements (BIS) in 1995, the global daily volume of currency transactions was estimated at about US$ 1.3 trillion. Of this amount, about US$ 530 million were spot operations, about US$ 100 billion referred to outright forward operations and about US$ 600 billion to foreign exchange repos. Other derivatives, like currency swaps and options, made up the total.
TECHNICAL APPENDIX 2
An example of currency speculation
This appendix provides a more detailed presentation of how currency speculation works in a fixed exchange rate system, and how speculators can gain from it. Market participants include individuals and companies that need foreign exchange for international transaction purposes (and are active on the market usually through brokers, usually banks), banks that are active on the market, for their clients or for their own purpose (e.g. to trade currencies for profit), all kinds of investors (institutional investors such as pension funds, mutual funds and hedge funds, but also individuals) and central banks of countries.
In a fixed system, the value of the currency is completely fixed at a certain value (the 'parity'), against another currency (say the US dollar) or can move only within a limited range (around that parity). The parity does not change until it can no longer be held, and then, moves to a different parity currency (by a 'devaluation' or 'revaluation'), or the country moves to another currency system, such as a floating exchange rate system. Even in a fixed exchange system, the value of a currency is constantly determined on the basis of demand and supply; when there is a disequilibrium between supply and demand at the current parity, it is the function of the central bank, by doing foreign exchange operations using basically its foreign exchange reserves, to supplement demand or supply in order to restore equilibrium at the given parity. More demand than supply for the local currency increases the foreign reserves of the central bank; the reverse decreases foreign exchange reserves and can only be sustained until reserves are depleted.
A forced downward change in parity is usually the result of a consensus among market participants in the international financial market that the current parity cannot be held, and, as a result, that supply of the currency (e.g. by sell orders) becomes much greater than the demand for it. It is usually triggered by massive speculation that this indeed will happen.
Monetary authorities can react by central bank foreign exchange intervention, by increasing local currency interest rates in order to make the local currency more attractive for investors, or to take measures such as capital controls to limit dealings in foreign exchange transactions, or some combination. Usually, it is accompanied by a government statement committing to a firm stance on the parity. Crucial in the defence is the view of the market on the quality of commitment and the credibility and sustainability of the defence mechanisms. If not, the pressure on the local currency parity intensifies, convincing everyone who is able to get out of an asset position in the local currency to sell, leading to an unmatchable excess supply of local currency.
Speculators can gain from their behaviour, essentially by creating some sort of liability position in the local currency maturing somewhere in the future, i.e. after the anticipated devaluation has taken place. Simple strategies of this kind are for example:
The specific characteristic of fixed parity exchange rate systems is that an attack starts as soon as speculators think the attack has some chance of succeeding, because they will reap gain when indeed the speculative attack succeeds, but will not suffer a loss when it does not because then the value of the currency remains unchanged (Krugman [1998]).