Financial and FX Regulation:From Capital Flows to Derivatives

Nelson BarbosaAugust 23, 2011

The Role of Capital Controls

Macroeconomic management• Technical and political limits to monetary and

fiscal policy• Permanent effects of temporary price

deviations on economic developmentPrudential regulation• Reduce FX vulnerability• Reduce pro-cyclicality of capital flows

Evaluation of Capital Controls

Entry controls: • Price controls (taxes) are more efficient than

quantitative controls for macro managementExit controls• Not efficient in crises, reserve accumulation is

the 2nd best policy Prudential controls• Best suited to deal with systemic risk

The Recent Brazilian ExperienceWhy?• Recent increase in commodity prices and

international liquidity created excessive pressures on the exchange rate and domestic credit

What?• Transaction tax (IOF) on new capital flows• Disincentive to high bank exposure in FX markets• Higher reserve and capital requirements for financial

institutions• Quantitative Tightening vs Quantitative Easing

Beyond Capital Flows

• Derivatives’ operations can simulate the impact of capital flows with little effective flows – synthetic positions

• Future and forward rates tend to define the spot rate in the Brazilian FX market

• OTC operations increase financial and FX vulnerability without proper supervision– Example from the 2008 crisis: some Brazilian net

exporters almost went broke

Regulating Derivatives

How do we measure systemic risk?• Consolidation, registration and standardizationHow much is too much?• Hedging vs speculationHow to regulate?• Prudential limits to leverage• Taxes on margin deposits and on high net-

exposure

The Recent Brazilian Initiative

• All FX derivatives must be registered in clearing houses

• All FX must be priced according to the same method (measuring the delta)

• The FX exposure of all agents must be consolidated

• Excessive long positions on BRL pay a financial tax (1%).

First Reactions

• Positive response to registration• Resistance to common pricing of derivatives– Complexity of some contracts– Difficulty to consolidate across many markets

• Negative response to taxation– Extra cost to hedging– Risk of financial disintermediation– Circumvention through foreign markets