Financial Regulatory Forum

ANALYSIS-Carry trades fly onto regulators’ radar screens

By Reuters Staff
February 11, 2010

By Mike Dolan
   LONDON, Feb 11 (Reuters) – As governments seek to root out and smother what they see as excessively risky and questionable financial market activity, the world of so-called currency “carry trades” has found its way onto their radar.
   Speaking in Davos last month, Britain’s top financial regulator Adair Turner branded carry trades — borrowing in currencies with the lowest interest rates to punt the proceeds on higher-yielding ones — as “economically valueless”.
   “If I could wave a magic wand here, and greatly reduce the carry trade, I’m pretty certain the world would be a better place,” the Financial Services Authority chairman was quoted as saying.
   Strong stuff and he is far from alone.
   Asian Development Bank President and Japan’s former top financial diplomat Haruhiko Kuroda described carry as a “naked trade” that required the utmost caution. “It’s speculative and it’s risky by definition,” he told Reuters.
   And for all its speculative lure, there is some logic to the authorities wishing this financial game away and already some considerable effort is being put into frustrating it worldwide.
   For decades, the carry trade has been a lifeblood of global foreign exchange markets — which latest figures show in London alone turn over more than $1.5 trillion every day.
   Some guesstimates reckon as much as 15-20 percent of that activity may be in some way related to carry trades but the overall size of outstanding carry trades at any one given time are almost impossible to calculate.
   Although it is classic hedge fund territory, proprietary traders at banks — currently under notice from U.S. President Barack Obama in his attempt to limit banks’ risk taking activities — have been major proponents.
   And shorting “cheap” currencies such as Japan’s yen and Switzerland’s franc to play higher-yielders — often in emerging markets and developing countries — has been a speculative strategy for decades.
   But near-zero U.S. interest rates last year saw the dollar assume the mantle of funding currency for these trades. 
   And that latest wave, which prompted U.S. economist Nouriel Roubini to warn of the “mother of all carry trades” — has been met with some fierce resistance from both emerging economies fearful of overvalued currencies and local market bubbles, as well as chastened developed country regulators.
   With everyone still picking up the pieces from one of the largest bubble bursts in history, there is deep mistrust of efficient market theories and also a growing assertiveness among emerging giants such as Brazil that they can tax disruptive “hot money” inflows they see as more trouble than they are worth.
   Lou Jiwei, head of sovereign wealth fund China Investment Corp, said last month that fueling of these trades was changing thinking: “Short-term and frequent capital flows into emerging markets brought big pressure on governments to manage capital.”
   
   INHERENTLY UNSTABLE
   The big problem with currency carry trades is that they are inherently unstable. Although they can prove lucrative for short-term players able to get in and out of positions quickly, they fly in the face of basic interest rate theory.
   In a global market, the main reason one currency offers a higher interest rate than another is that it is compensating the holder for exchange rate risk. The interest rate premium on a currency merely reflects its implied depreciation over time.
   So leveraged trades exploiting higher rates are only workable so long as you duck out before the inevitable currency move wipes out your interest gain.
   And this can create violent herding. The initial buying of the high yielder has the perverse effect of pushing the risky currency higher — giving the impression of a one-way bet and complicating policy for any developing country who watches on as the overvalued exchange rate hammers its export competitiveness.
   The situation can persist for several months and even years, but the unwind is then all the more sudden and vicious and the leveraged positions all head for the exit at the same time.
   And this is what Turner at the FSA was railing against.
   “It’s a form of speculative activity where you can’t work out what the value is to the real economy,” he said, adding that speculators relied on being able to get out from the trade before the “train wreck”.
   The problem for regulators is the difficulty in locating and estimating the outstanding size of these trades.
   Studies by the Bank for International Settlements and others say it is nigh-on impossible to nail down exposure at any given point in time.
   Kuroda, for example, said the size of the yen carry trade at its peak before the credit crisis was in the region of $1 trillion. Chinese officials have reportedly claimed the recent dollar carry trade was as high as $1.5 trillion.
   Both those estimates almost certainly inflate the size with straight foreign currency purchases, such as Japanese households buying bonds in South African rand or New Zealand dollars. Even though these investments are sometimes considered carry trades, they are not leveraged per se and hence less inherently twitchy.
   But if the size of the overall trade is not easy to gauge, some reckon they can estimate “crowdedness” of these trades from monitoring hedge fund and speculative positioning data.
   A paper last month by New York University Professor Richard Levich and hedge fund manager Momtchil Pojarliev said their use of this data could at least provide regulators of pre-bubble warnings to allow them to “counsel” banks and funds on the risk.
   “Beyond counselling, regulators of course have the option to raise capital requirements for operations deemed to carry greater risks.” (Editing by Andy Bruce) ((London newsroom +44 207 542 8488. Email:mike.dolan@thomsonreuters.com))
 Keywords: MARKETS CARRY 
  
Thursday, 11 February 2010 06:50:05RTRS [nLDE6182B3] {C}ENDS

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