Forex for a trader
Forex and derivatives

Forex and derivativesThanks to the unmatched liquidity and competition in the forex market, trading currencies also allows a trader to take advantage of a number of other instruments which use currencies as the underlying asset. Active trading in many of these derivatives has further enhanced the status of currencies as one of the world’s most actively traded assets. Most of the more unusual derivatives, especially the exotic options and interest rate products, currently trade primarily in the Over-the-Counter or OTC forex market between major banks and their corporate and institutional clients. Types of Forex Derivatives. Some of the financial instruments which have their values derived from forex rates include the following derivatives: Currency Futures Currency Options, both Vanilla and Exotics Currency Exchange Traded Funds or ETFs Forex Contracts for Difference or CFDs Forwards Currency Interest Rate Swaps Spot trades. These derivative instruments can be used to take forex related positions on their own or in combinations. Often, a strategic combination employing one or more of the above derivative instruments along with spot forex positions can be used by forex traders to maximize profits, minimize risks and generally adjust their overall risk profile. Two of the forex derivatives that are often traded on exchanges, and hence are also available to many individual forex traders, include currency futures and options. They will be covered in greater detail in the sections below. Currency Futures Trading. Currency futures used to be the main way that individual currency traders took positions before retail forex brokers became widely available.

They trade on the floor of exchanges like the Chicago International Monetary Market or IMM. Each currency futures contract trades for a standardized forward delivery date, often maturing on a quarterly basis, and so have similar pricing to a forward outright contract delivering on those same value dates. Currency futures can be actively traded by being either bought or sold via the exchange they trade on. Their values are directly related to the corresponding prices prevailing in the larger OTC spot and forward forex market. Watching currency futures trade on the floor of an exchange can be a confusing endeavor. The first thing that comes to mind is a pack of wild animals howling and making gestures at each other. Nevertheless, the chaos is superficial at best, since almost everything happening in the trading pit is carefully orchestrated to provide instantaneous executions and fair prices for both the local traders and for off the floor traders. American style currency options commonly trade on futures exchanges like the Chicago IMM, where they are options on futures. Other currency options trade on stock exchanges like the Philadelphia Stock Exchange where they are similar to the options traded in the OTC Interbank market which primarily tend to be European style options. Vanilla Currency Option Variations. The OTC vanilla currency option market has provided some creative solutions for the needs of speculators and hedgers. Some of the more common choices are described further below. Currency Warrant – a currency option contract traded in the OTC market and often for longer maturity dates of more than one year. Currency Collar – A popular option combination involving the simultaneous purchase of a call and the sale of a put, or vice versa. The strike prices are usually set out of the money and at a similar distance from the forward rate in order for the strategy to have no net cost. Also sometimes called a risk reversal.

Furthermore, the OTC currency options market has recently expanded to include a wide range of exotic options like: Average Rate Options – Have their underlying rate determined by a process that involves averaging some observed exchange rate sampled at periodic intervals. Average Strike Option – Have their strike prices determined by a process that involves averaging some observed exchange rate sampled at periodic intervals. Binary Options – Also sometimes called digital options, they provide a holder with a fixed payoff if their strike price is better than the prevailing market at expiration, for European style binaries, or at any point during their lifetime, for American style binaries. Knockout Options – Ceases to exist when a pre-determined trigger level trades during their lifetime. Knockin Options – Starts to exist when a pre-determined trigger level trades during their lifetime. Basket Options – Are similar to vanilla European style options, except that their strike price and their underlying rate are determined by reference to a basket of currencies for which the weighted value of the option’s several component counter currencies will be computed in its base currency. Currency Interest rate swap: Agreement to exchange periodic payments related to interest rates between currencies. Can be fixed for floating, or floating for floating based on different indices. This group includes those swaps whose notional principal is amortized according to a fixed schedule independent of interest rates. Currency Swaption – an OTC option granting the buyer the right but not the obligation to enter into a currency interest rate swap. Such a swap involves a commitment between counterparties to exchange interest payment streams in different currencies for a set time frame and also to exchange the principal amounts in different currencies at a set exchange rate on the maturity date.

Forex Contracts for Difference or CFDs. CFDs are foreign exchange agreements that are cash settled on their maturity date. This means that just the net value of the contract, and not the principal currency amounts, will be delivered to the counterparty showing the profit at maturity. CFDs can be traded for value spot or for value on some other selected business day in the future. Currency Interest Rate Swaps. These products generally involve taking on some form of interest rate exposure, in addition to currency risk. Risk Statement: Trading Foreign Exchange on margin carries a high level of risk and may not be suitable for all investors. The possibility exists that you could lose more than your initial deposit. The high degree of leverage can work against you as well as for you. Getting Started In Foreign Exchange Futures. The spot foreign exchange (forex or FX) market is the world's largest market, with over US$1 trillion traded per day. One derivative of this market is the forex futures market, which is only one one-hundredth the size.

This article examines the key differences between forex futures and traditional futures and looks at some strategies for speculating and hedging with this useful derivative. Forex Futures Vs. Traditional Futures Both forex and traditional futures operate in the same basic manner: a contract is purchased to buy or sell a specific amount of an asset at a particular price on a predetermined date. There is, however, one key difference between the two: forex futures are not traded on a centralized exchange; rather, the deal flow is available through several different exchanges in the United States and abroad. The vast majority of forex futures are traded through the Chicago Mercantile Exchange (CME) and its partners (introducing brokers). However, this is not to say that forex futures contracts are over-the-counter per se; the futures are still bound to a designated 'size per contract' and are offered only in whole numbers (unlike forward contracts). It is important to remember that all currency futures quotes are made against the U. S. dollar, unlike the spot forex market. SEE: Futures Fundamentals Here is an example of what a forex futures quote looks like: Euro FX Futures on the CME For any given futures contract, your broker should provide you with its specifications, such as the contract sizes, time increments, trading hours, pricing limits and other relevant information. Here is an example of what a specification sheet might look like: Hedging Vs. Speculating Hedging and speculating are the two primary ways in which forex derivatives are used. Hedgers use forex futures to reduce or eliminate risk by insulating themselves against any future price movements. Speculators, on the other hand, want to incur risk in order to make a profit. Now, let's take a more in-depth look at these two strategies.

Hedging There are many reasons to use a hedging strategy in the forex futures market. One main purpose is to neutralize the effect of currency fluctuations on sales revenue. For example, if a business operating overseas wanted to know exactly how much revenue it will obtain (in U. S. dollars) from its European stores, it could purchase a futures contract in the amount of its projected net sales to eliminate currency fluctuations. SEE: Spotting A Forex Scam When hedging, traders must often choose between futures and another derivative known as a forward. There are several differences between these two instruments, the most notable of which are these: • Forwards allow the trader more flexibility in choosing contract sizes and setting dates. This allows you to tailor the contracts to your needs instead of using a set contract size (futures). • The cash that's backing a forward is not due until the expiration of the contract, whereas the cash behind futures is calculated daily, and the buyer and seller are held liable for daily cash settlements. By using futures, you have the ability to re-evaluate your position as often as you like. With forwards, you must wait until the contract expires. Speculating Speculating is by nature profit-driven.

In the forex market, futures and spot forex are not all that different. So why exactly would you want to participate in the futures market instead of the spot market? Well, there are several arguments for and against trading in the futures market: Advantages • Lower spreads (two to three). • Lower transaction costs (as low as $5 per contract). • More leverage (often $500+ per contract). Disadvantages • Often requires a higher amount of capital ($100,000 lots). • Limited to the exchange's session times. • National Futures Association fees may apply. The strategies employed for speculating are similar to those used in spot markets. The most widely used strategies are based on common forms of technical chart analysis since these markets tend to trend well. These include Fibonacci studies, Gann studies, pivot points and other similar techniques.

Alternately, some speculators use more advanced strategies, such as arbitrage. The Bottom Line As we can see, forex futures operate similarly to traditional stock and commodity futures. There are many advantages to using forex futures for hedging as well as speculating. The distinguishing feature is that the futures are not traded on a centralized exchange. Forex futures can be used to hedge against currency fluctuations, but some traders use these instruments in pursuit of profit, just as they would use futures on the spot market. Forex and Derivatives. Forex and Derivatives. Overview of Forex and Derivative Operations in a Bank. Banks transact in various treasury instruments with an objective of hedging their risks and also to generate trading profits. Apart from regular proprietary business, the treasury operations of a bank aim to continue to focus on enhancing returns from customer relationships that have been built, and successfully capitalise on this to rapidly increase income from foreign exchange and derivative transactions from customers, as also to assist them in covering and hedging their foreign currency and derivative positions. The foreign exchange market encompasses transactions in which funds of one currency are sold for funds in another currency. These transactions take the form of contracts calling for the parties in the contract to deliver to each other on a fixed date a specified sum in a given currency. The exchange, the delivery of one currency on receipt of another, can take place at the time the contract is negotiated or at some future date, as stated in the contract. Foreign exchange transactions, to be distinguished from transactions in foreign currencies, consist of contracts in which each party is committed to deliver one currency while, at the same time, receive another.

Until the time of delivery, when settlement is to be made on the contract, the contract represents a future commitment of the Bank’s resources. Thus, the maturity of a contract culminates in the realisation of the transaction envisaged in the contract, at which time the counterparties are given value for the currencies the contract says they are to receive. In foreign exchange contracts, the value date is the date on which the contract matures, that is the date on which settlement is to be made. For loans and borrowings, including those in the money markets, on the other hand, the value date is that date on which the borrower receives constructive use of the funds loaned, while the maturity date is that future date on which it will repay the funds it has borrowed. Derivatives. In India, different derivatives instruments are permitted and regulated by various regulators, like Reserve Bank of India (RBI), Securities and Exchange Board of India (SEBI). Broadly, RBI is empowered to regulate the interest rate derivatives, foreign currency derivatives and credit derivatives. For regulatory purposes, derivatives have been defined in the Reserve Bank of India Act, vide circular No. DBOD. No. BP. BC. 8621.04.1572006-07 dated 20 April 2007 as follows.

“Derivative” means an instrument, to be settled at a future date, whose value is derived from change in interest rate, foreign exchange rate, credit rating or credit index, price of securities (also called “underlying”), or a combination of more than one of them and includes interest rate swaps, forward rate agreements, foreign currency swaps, foreign currency-rupee swaps, foreign currency options, foreign currency-rupee options or such other instruments as may be specified by the RBI from time to time. MetaTrader 4 Desktop. Our subscription benefits consists of all the prospects accessible to the forex commerce & gives you the easy access to a diversity of financial instruments, commodities, spot metals and Derivatives. Trade the markets with the industry’s prominent & most constant trading platform, the MetaTrader 4. Our clients can perform numerous trading approaches on all of our accounts. Copy trading services & Expert Advisors (EAs) are obtainable in all over our account subscription. MetaTrader 4 Requirements. Operating system: Windows XP or more recent. Screen resolution: Minimum of 1024x768. Internet: Connection speed of 36.6 Kbps or faster. MetaTrader 4 Features. Multiple chart setups Market Watch window Pre-installed indicators Large collection of analysis tools Negative balance protection Customize EA for automated trades Develop technician indicators Importexport historic data in real time. 250+ available instruments to trade Flexible leverage up to 1:400 Trade Forex, Commodities and Derivatives Extensive list of shares from all world markets Optimum execution without rejections Expert Advisors(EA) capabilities 1+CLICK trading enabled Multi-language support. OPEN A TRADING ACCOUNT TODAY. With a simple account registration with HQBroker, you get access to our FREE educational programs, amazing trading bonuses and superb trading conditions we make available to our clients.

High risk trading warning. Foreign Exchange (Forex) and Derivatives trading is highly speculative and carries a high level of risk which may not be suitable for all investors. A possibility of losing capital investments may arise; the Company therefore advises to not invest funds you cannot afford to be depleted to a great extent. For more information regarding the risks involved, click here. Restricted jurisdiction: HQBroker does not offer its services to residents of certain jurisdictions such as USA , France and Hong Kong. For more information, please see the Terms & Conditions. Is Forex a Derivative? Currencies can be traded in spot, futures, options (vanilla), binary options, and CFD (contracts for difference) market. While currency futures and options (vanilla) are offered only by regulated exchanges, binary options are offered by both regulated exchange and OTC binary brokers. The other two kinds of currency trading (CFDs and spot Forex) are only offered on an OTC basis. Due to this complex structure, there is a considerable degree of doubt among beginner traders regarding the instruments, i. e., which of them are derivatives and which of them are not? A derivative is a financial contract whose value changes with the changes in the value of an underlying asset.

By purchasing a derivative contract, a buyer agrees to purchase the underlying asset on a specific date and at a specific price. However, it is quite difficult to categorize all forms of currency trading purely by this definition. Therefore, let us examine various aspects pertaining to different kinds of Forex trading and determine which of them can be categorized as derivatives. The settlement process varies widely between different kinds of Forex trading. Let us review the process in each case to sort out derivatives from non-derivatives. If the settlement is based on the exchange rate of a currency traded in a different market, then the market being studied can be categorized as a derivative. In case of spot Forex trading, a T+2 settlement is followed. This means, all transactions are settled (exchange of underlying currencies) within two business days from the date of execution. Notable exceptions to this rule are currency pairs such as USDCAD, USDTRY, USDPHP, USDRUB, USDKZT and USDPKR, which settle at T+1. Therefore, short-term settlement period and actual exchange of underlying assets (even though a Forex broker uses rollover mechanism to avoid delivery of assets) indicates that spot Forex is not a derivative. Currency trades executed in a futures market are settled after a period of 30 days. Contracts with even longer settlement periods are also sometimes available. The currencies also derive their exchange rate from the prices quoted in the spot market. Generally, there would be a slight difference in the exchange rate of a currency in the futures market, compared with the prices quoted in the spot Forex market, as interest rate differentials are factored into the price.

Therefore, longer settlement period and the price identification mechanism indicate that currency futures is a derivative market. Currency options usually have longer settlement cycles. For example, NASDAQ FX options expire on the third Friday of the expiration month. There is no compulsory delivery. Furthermore, the settlement of currency option contracts in all the exchanges are based on the price traded in the spot market. In case of NASDAQ FX options, the last traded price at 12:00 EST (noon) is used for settlement of the currency options contract. Therefore, longer settlement cycle and price identification mechanism indicate that traditional Forex option contracts are derivative products. Binary brokers offer a range of binary options contracts. Some of them expire in a matter of few minutes. However, none of them leads to the delivery of assets. Furthermore, the settlement is based on the price traded in the spot Forex market.

Therefore, lack of delivery of assets and price identification (and settlement) mechanism indicate that binary options are derivative products. There are many similarities between currency CFDs and spot Forex trading. A trader could use the same charting platform, receive same quotes, etc. However, CFDs are mere contracts that allow a trader to bet on the price change in an asset. It does not result in delivery as in the case of a spot Forex market. The price of a currency in a CFD market follows the price in a spot market. Therefore, lack of delivery of assets and price identification (and settlement) mechanism indicate that currency CFDs are pure derivative products. If the price of a trading instrument in a particular market is dependent on the traded price in another market, then the market being studied can be categorized as a derivative. The exchange rate of a currency in a spot market is influenced by several factors such as unemployment rate, inflation, GDP, PMI, and others. However, the exchange rate is not derived from any of these data. The data only has a strengthening or weakening effect on the exchange rate. For example, an increase in unemployment beyond a central bank’s target level will have a negative effect on a currency’s exchange rate. Instead, an increase in inflation will strengthen the currency if the central bank is expected to raise the interest rates to curb the rising prices. Since the exchange rate of a currency is not derived from any particular data, spot Forex does not fit into derivatives category. The exchange rate of a currency in the futures market is derived from the price traded in the spot market.

Usually, for the same currency, prices traded in the futures market will be a little higher than prices traded in the futures market. As we get closer to the settlement date, the price gap between the futures market and spot market will narrow. The price gap seen at the beginning of a new contract is due to the risk premium, which is added by the market participants to protect themselves. Therefore, the exchange rate calculation indicates that currency futures are derivatives. The premium changes in a traditional options market are reflecting changes in the currency’s exchange rate in the spot FX market. The time left for expiry and the overall sentiment towards a currency also influences the premium. Theoretically, the value of a call or put option is calculated using the Black-Scholes pricing model, which uses six variables, namely volatility, type of option, underlying price of currency or any other asset, time, strike price, and risk-free rate. As the premium is calculated from the underlying price of the currency in the spot market, options are obviously derivatives. Similar to traditional options, binary options also use spot currency exchange rates to settle a contract at expiry.

The value of a currency binary options contract would be theoretically equal to zero or 100 based on the corresponding price of the currency traded in the spot market. Therefore, based on the exchange rate identification mechanism, binary options should be categorized as derivatives. Similar to futures and options, CFDs use spot market prices for trade execution and settlement. Since the price of a currency CFD is directly derived from the spot Forex market prices, we can categorize Forex CFDs as derivatives. Trading time, order size, and volume. Derivative markets generally use standardized contracts or lay down restrictions on order size and volume. We shall categorize the different kinds of currency markets based on this fundamental difference. Currencies can be traded on a 245 basis in a spot market. There are no trade time restrictions. Furthermore, Forex brokers do not specify any standard order size in spot Forex trading. Some online brokers allow traders to trade positions as small as 1 currency unit. Furthermore, Forex brokers do not restrain traders from placing huge orders. If at all there is any restriction, it may be only due to the size of a given broker and its liquidity providers.

Therefore, lack of restrictions on trade timings, lot size, and order volume indicates that spot Forex trading is not a derivative. Currency futures are traded in set hours. Although, the all-night derivative market does exist, it is largely illiquid and cannot be accessed easily by retail traders. There is also a standard lot size in currency futures trading. Furthermore, the exchange specifies a maximum position size for small and large (institutional) traders. In the USA, the Commodity Futures Trading Commission determines the position limit in futures and options contracts. A penalty is also slapped for position limit violation. Based on these restrictions, we can classify currency futures as derivatives. Similarly to currency futures, traditional currency option contracts are traded only during set hours. There is also a standard lot size, and position limits for small and large traders mandated by the market regulators.

Therefore, currency options are derivatives too. Binary options can be traded at any time (some brokers allow even weekend orders). Binary brokers usually set some minimum and maximum order volume levels. However, these restrictions are not set in stone unless the given binary option contract is traded on a regulated exchange. Therefore, it is impossible to classify binary options as a derivative purely by looking at the market’s restrictions on trading time, order size, and volume. Most currency CFDs are traded during the same hours as spot Forex. Also, similarly to spot FX, there will rarely be a meaningful order size and number restriction. Many CFD brokers allow fractional position sizing and flexible high limit on the number of trades when it comes to currency pairs. Therefore, we cannot say that CFDs are derivative contracts just by looking at this parameter. The margin money required to open a position is usually standardized in a derivative market. We shall categorize different kinds of Forex trading based on that rule.

In spot Forex trading, the average leverage offered by online brokers is higher than 1:100. Furthermore, there is no definite rule regarding the minimum capital that needs to be maintained to open a trade. As long as a trader maintains the minimum margin amount specified by a Forex broker, the position will remain open. Spot Forex brokers generally decrease the leverage on weekends. This is done based on particular broker’s judgment and for their own protection – no standard market-wide rule exists to regulate the necessary margin size. Such a lack of definite rules indicates that spot Forex is not a derivative. In the currency futures market, all traders have to maintain a standard minimum margin stipulated by the exchange. An additional amount, as dictated by the exchange, needs to be set aside to carry forward the position overnight. There are no variations in the rules. Therefore, margin rules indicate that currency futures are derivative products. Traditional currency option trades involve buying or selling a call or put option. To buy a call or put option, a trader should have an amount equal to the lot size multiplied by the premium for a strike price. Likewise, to sell a call or put option (writing an option) a trader should have an amount equal to the lot size multiplied by the premium for a strike price, plus the risk margin (writing an option involves unlimited risk). All margin details are standardized by the exchange, indicating that traditional currency options are derivatives. A binary broker determines the minimum investment that can be made in a currency options contract. Some binary brokers allow additional investments (double up) after a contract turns active.

The minimum and maximum additional investment that can be added is also determined by the binary broker and is not left to the trader. Therefore, currency binary options are derivatives. Similarly to currency futures, the broker determines the margin money required to open a CFD contract. The margin terms are standardized and determined by the broker. Therefore, based on capital requirements, we can categorize CFDs as derivatives. A swap rate (overnight interest or rollover fee) is applied for holding a position in a currency pair to compensate each party (a trader and a market maker) for the lack of physical delivery of cash. If there is no exchange of assets, there will be no rollover interest (earned or paid) and that kind of trading would fall under derivatives. We shall apply the rule to categorize different kinds of trading. When a long or short position in a currency pair is left open overnight by a trader, a Forex broker will apply a rollover or swap fee to the trading account. Depending on the interest rate differentials between the currencies, a trader may receive or pay a swap fee. For example, when a short position is opened in the EURUSD pair, a trader will receive the overnight interest for purchasing the greenback, while paying an overnight interest for selling the euro.

Ultimately, the interest rate differential (and the broker’s commission) will decide whether the swap is positive or negative. Unless a trader opens a special swap-free account, this fee is applied by all foreign exchange brokers. Thus, we cannot categorize spot Forex as derivative trading. There is no swap or rollover fee involved in currency futures trading. Therefore, we can categorize currency futures as derivatives. Similar to currency futures, traditional currency options do not carry an overnight rollover fee. Therefore, traditional options can be called derivative trading. Binary options are nothing but bets on the direction of price movement of an asset. As there is no real exchange of assets involved, binary options traders do not incur a swap fee when trading currencies. Therefore, we can categorize them as derivatives. Currency CFDs do not involve any swap fee as there is no settlement or exchange of assets. There are brokers who charge an overnight interest rate. However, it is not standardized. Furthermore, a currency CFD trader may always have to pay an overnight interest fee, but will not earn any kind of interest for keeping a position open, as in the case of spot Forex market.

The broker will hedge its risk using a variety of strategies while acting as the counter party to the trade. Therefore, CFDs can be categorized as derivatives. Based on settlement mechanism, exchange rate identification process, trading time, order size, volume, trading costs, and swaps, it is clear that spot Forex trading is not a derivative. All other forms of currency trading such as futures, vanilla options, binary options, and CFDs can be categorized as derivatives. According to the report by the Bank for International Settlements, in April 2016, the total Forex market turnover was $5.1 trillion per day, of which spot Forex trading accounted for 33% or $1.7 trillion. Options and other products contributed only 5% of the total turnover. Therefore, it can be understood that Forex derivatives (futures, options, binaries, and CFDs) market is small if compared to the spot Forex market. If you want to get news of the most recent updates to our guides or anything else related to Forex trading, you can subscribe to our monthly newsletter. 600+ Assets Available to Trade. Our trading platform is designed to fully match orders across the most reputable global financial markets. Trade all forex majors and minors on over 70 FX pairs with direct access to competitive spreads with no extra commissions. Trade with high leverage up to 1:400 and stops guaranteed. Trade and invest in precious metals like Gold, Silver and Platinum with FSM Smart. Invest in metals trading to diversify your portfolio and limit your risk exposure. Buy, sell, trade precious metal bullion.

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High leverage up to 1:400 Spreads from as low as 0.4 pips Free personal training provided Dedicated account support 245 Secure flexible transactions Learn More. Any Questions? Get in touch with us. Our multi-lingual help desk is 245 dedicated to support your requests and answer any inquiries. Risk: Derivative Trading is a complex financial product traded on margin. Trading Derivatives carries a high level of risk since leverage can work both to your advantage and disadvantage. As a result, Derivative Trading may not be suitable for all investors because you may lose all your invested capital. You should not risk more than you are prepared to lose. Before deciding to trade, you need to ensure that you understand the risks involved taking into account your investment objectives and level of experience. Past performance of Derivative Trading is not a reliable indicator of future results. Most Derivative Trades have no set maturity date.

Hence, a Derivative position matures on the date you choose to close an existing open position. Seek independent advice, if necessary. Please read FSM Smart’s full ‘Risk Disclosure Policy’. MetaTrader 4 Desktop. advanced trading platform MetaTrader 4. Metatrader 4 Desktop. FSMSmart also offers one of the top online forex trading platforms used worlwide: the FSMSmart MetaTrader 4 Platform. The FSMSmart MT4 platform gives our Clients access to trade hundreds of the major currencies, currency pairs, commodities, and other financial products. Maximize your trading capabilities and easily apply trading strategies executions with the platform’s simple but complete interface that’s tuned to our network and servers so that clients can gain a full experience on our MetaTrader 4 Platform which includes automatic order sending, placement of trailing stops, order modification, full trade automation and other trading operations. Risk: Derivative Trading is a complex financial product traded on margin. Trading Derivatives carries a high level of risk since leverage can work both to your advantage and disadvantage.

As a result, Derivative Trading may not be suitable for all investors because you may lose all your invested capital. You should not risk more than you are prepared to lose. Before deciding to trade, you need to ensure that you understand the risks involved taking into account your investment objectives and level of experience. Past performance of Derivative Trading is not a reliable indicator of future results. Most Derivative Trades have no set maturity date. Hence, a Derivative position matures on the date you choose to close an existing open position. Seek independent advice, if necessary. Please read FSM Smart’s full ‘Risk Disclosure Policy’. Dealers slam ‘nonsensical’ treatment of forex derivatives. Proposal on US swap dealer threshold rekindles debate on definition of NDFs and window forwards. Commodity Futures Trading Commission (CFTC) A legal exception from regulation provided to foreign exchange forwards does not extend to NDF s and window swaps. Users, however, say these derivatives are functionally identical. Firms that use these instruments to hedge currency risk fear tipping over into swap dealer status. Regulators are addressing concerns about NDF s in the current de minimis proposal, suggesting an exemption of NDF s from counting towards the swap dealer threshold. The road to hell is paved with good intentions, Samuel Johnson famously said.

He probably wasn’t thinking of the Dodd-Frank Act when he said it, but the well-intentioned statute is driving dealers to despair over its treatment of certain foreign exchange derivatives. Of particular concern are definitions that threaten to force firms into dealer status when they could hardly be considered systemic. “We think this issue was an accident, we don’t think it was intentional. We have spoken with people who were there at the creation of Dodd-Frank who said they never intended to create this distinction. It’s a nonsensical result,” says Bruce Bennett, a partner at law firm Covington in New York. At issue is what legal experts say is the different treatment of essentially identical forex instruments. In 2012, then-Treasury secretary Timothy Geithner exempted physically settled forex forwards from Dodd-Frank’s definition of swaps. However, non-deliverable forwards (NDFs) and a lesser-traded instrument called a window forward were not included in the exemption, meaning they must still be collateralised and count towards a firm’s de minimis threshold for swap dealer registration. The Commodity Futures Trading Commission published a consultation paper on potential changes to the de minimis threshold in June. Bowing to lobbying on the issue, the CFTC included a question on whether NDFs should be exempt from the calculation of aggregate gross notional for the purposes of the threshold. The consultation closes on August 13. “There are market participants that would be a swap dealer solely by virtue of NDF volumes they engage in and otherwise would not be a swap dealer for any other product,” says Bennett.

We think this issue was an accident, we don’t think it was intentional. We have spoken with people who were there at the creation of Dodd-Frank who said they never intended to create this distinction. It’s a nonsensical result. The CFTC requires all firms trading more than $8 billion in notional swaps over a 12-month period to register as a swap dealer. Officially designated swap dealers are subject to heightened requirements around risk management, reporting and record-keeping – duties that would be onerous for smaller trading firms. Although the consultation paper does not include window forwards among its terms of reference, some users believe the instrument should be granted an exemption from the swap definition. Julian Hammar, a lawyer at Morrison & Foerster in Washington, DC, says: “Window forwards if treated as swaps … represent a part of what my clients count toward the de minimis threshold. Their argument essentially is that because window forwards are similar to FX forwards that have been exempted by the Treasury secretary, they should be treated the same way and not have to be counted. That would give them a little more breathing room before having to register.” Hammar is a former assistant general counsel at the CFTC.

During his time at the regulator, he led the teams that drafted some of Dodd-Frank’s key definitions, including that of “swap”. He now represents firms that provide window forwards, as well as other forex instruments such as NDFs, to small and medium-sized enterprises in the US. Exceptions to the rule. The issue stems from Section 721 of Dodd-Frank, which amends the definitions of instruments and dealers under the Commodity Exchange Act. In writing this section, Congress considered that foreign exchange derivatives were already transacted in liquid, efficient and electronified markets. The risks of these instruments were lower than those of, say, interest rate swaps. And so with a nod to future exigencies, Congress included a provision that gave the Treasury secretary the authority to exclude forex swaps and forwards from derivatives requirements such as mandatory clearing and from the calculation of the threshold for swap dealer registration. When Geithner decided to exercise this authority for forex swaps and forwards, NDFs remained outside the exclusion because they failed to meet Dodd-Frank’s definition of a forward: namely, a contract that requires the exchange of two different currencies on a future date at a rate agreed upon at the beginning of the transaction. NDFs are used by counterparties wishing to hedge currency risk in restricted, mostly emerging markets, currencies or for speculation on these currencies. They are cash-settled in the major currency, unlike forex forwards which are physically settled. Window forwards are, like any other forward, characterised by a precise amount to be paid in the foreign currency at a fixed exchange rate. However, rather than an exact settlement date, they provide the option of settling at any point in a given time period, or window.

Bennett says that in response to Geithner’s determination in 2012, Covington submitted a comment letter advocating that both deliverables and non-deliverables should be excluded “because they are the same product with the same economic function. It’s just the accident of whether one currency is deliverable or not.” Geithner responded that he lacked the authority to exclude NDFs because of the limitations of statutory language, says Bennett; a forward necessitates exchange of currencies. “However, in his determination, Geithner said that the CFTC has the authority to exclude NDFs and we are in front of the CFTC right now, still advocating for that position,” Bennett says. Unlike a normal forex forward, NDFs don’t physically settle, they net settle. And so, all you are doing is moving your net gain or loss. Hammar assisted in drafting a comment letter on behalf of two firms, Afex and GPS Capital Markets, which was submitted in response to the CFTC’s 2017 initiative to cut back unnecessary regulation. The letter states that the prejudicial treatment of window forwards raises costs for market participants. The two firms currently operate under the de minimis threshold. In the absence of a formal determination from the CFTC over whether window forwards fall into the swaps classification or not, these companies are forced to continue to employ two distinct formulas to assess aggregate gross notional amounts of swap dealing activity, one calculation with window forwards and another without. “In addition to the operational burden of the redundant calculations, the companies incur significant staffing and information technology expenses to carry out this daily task,” says the letter. Including window forwards in the de minimis calculation also means the companies are pushed closer to the threshold. This may require them to stop offering window forwards to clients at all. And as market participants treat these instruments as swaps “from an abundance of caution”, margin costs add yet more burden, the letter states. “When the majority of regulators globally decided to treat NDFs differently from standard deliverable forwards, it surprised me because these are such a small component of the market,” says Joseph Hoffman, CEO of the currency management business at Mesirow Financial in Chicago. According to data from the Bank for International Settlements, NDF turnover accounted for about 19% of forwards trading and only 2.6% of overall forex trading. Within emerging market currency products, NDFs accounted for 17% of activity (see figure 1). As Treasury and Congress recognised, NDFs do not constitute significant systemic risk either, says Hoffman.

“Unlike a normal forex forward, NDFs don’t physically settle, they net settle. And so, all you are doing is moving your net gain or loss. If you buy euro versus dollars, a lot of times in a deliverable case you are delivering out both sides of the trade. In the NDF space, that risk is much less because you are moving the P&L, the net amount, on settlement day.” Lawyers say that while treatment of NDFs could only be changed by an act of Congress, the CFTC could sidestep that by excluding NDFs from the de minimis counting exercise, as it suggests doing in the consultation paper. Bennett believes this is within the CFTC’s power to do. NDFs would still, however, be subject to non-cleared margin rules. Carl Kennedy, a lawyer at Gibson Dunn & Crutcher, represents a group of derivatives users who have also commented on window forwards. He says the rules governing window forwards are more easily addressed. “I think we would not need an act of Congress. The commissions could take regulatory action. Unlike forex NDFs, the issue here is not the form of settlement. Forex window forwards are physically settled like forex forwards. The issue is really about not knowing just when that settlement will occur. So this is something the CFTC can address,” Kennedy says.

Legally, the commission would first have to consult the Securities and Exchange Commission to determine whether it had the authority to issue an interpretation on its own, he adds. Unlike forex NDFs, the issue here is not the form of settlement… The issue is really about not knowing just when that settlement will occur. “Clearly, these products are within the CFTC’s jurisdiction. But Dodd-Frank requires the CFTC to co-ordinate and jointly take action with the SEC in further defining the term ‘swap’. It might be likely that the commissions would have to work together in issuing an official interpretation.” Hammar says he has asked the CFTC to issue an interpretation that would treat window forwards in the same way as forex forwards. “This could be done by interpreting the statutory definition of forex forwards as covering window forwards. Likely, this would require the Treasury secretary to amend his determination to exempt forex forwards, since the Treasury determination basically states which types of foreign exchange derivatives are covered by the exemption and which are not.” Window forwards would then only be subject to reporting, record-keeping, business conduct standards for swap dealers, and anti-fraud and anti-manipulation rules, just as forex forwards are. Window forwards would not have to count towards the de minimis total or be subject to non-cleared margin rules.

The CFTC could also extend the same relief it suggests for NDFs to windows, says Hammar. “Again, that would provide some breathing room before having to register. It would not relieve window forwards from the non-cleared margin rules, however.” That the CFTC has not acted on window forwards before could be testament to some uncertainty about the window timeframe, says Eric Juzenas, a director in the global regulatory solutions business at Chatham Financial. The flexibility of the window has historically presented the commission with a challenge in terms of where the line falls between forwards and options. “The commission has recognised that in some instances, forward contracts with some optionality on the amount of a commodity to be delivered are still forwards,” he says. “The question for the commission is likely to be: how long a window is acceptable for the contract still to be considered a forward? Thirty days? Six months?

One year? And whether delivery is binding at the end of the window period if delivery does not occur while the window is open.” Technical questions aside, Bennett is generally optimistic that the CFTC will listen to the industry’s concerns that well-intentioned regulation has increased the cost of a fairly simple hedging tool such as NDFs. “It is hard to see justifications for the rule and it’s easy to see costs that it imposes. The commission does seem to get that and has been encouraging,” he says. Why trade with FSMSmart. BENEFITS OF TRADING WITH FSMSmart. More than 600 trading instruments. Trade a wide array of forex currencies, pairs, minors, commodities, futures, shares, indices, and Derivatives. Tight Spreads Without Extra Charges.

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  • Forex and derivatives