Tony Latter: Derivatives from a Central Bank perspective Speech by Mr Tony Latter, Deputy Chief Executive of the Hong Kong Monetary Authority, at the Seminar Programme of the FOW Derivatives Expo, Hong Kong, 5 November 2001 *  *  *  Introduction Why may central banks be interested in derivatives? Although it is dangerous to generalise, and no two central banks may see them in precisely the same light, there are certain aspects of derivatives in which central banks, including the Hong Kong Monetary Authority, probably have a common interest. I should like to review some of these today. For present purposes one does not need to be too precise as to what is meant by derivatives, save to note that the focus here is only on financial derivatives, although these do of course share many of the same basic characteristics as commodity or other derivatives. The textbooks give various definitions of a financial derivative: for instance, that it is a contract the value of which depends on or derives from the value of some underlying financial asset or index; or that it is an instrument which does not constitute ownership but only a promise or option to convey ownership. At its widest, the definition could embrace all futures, forwards, swaps, options, warrants, convertibles, asset-backed securities and so on, and all combinations or variations of those.
If, indeed, the bilateral exchange rate arrangement does not of itself matter much in the long-term determination of price competitiveness, why not anyway tie your currency in some way to that of your closest neighbour or major trading partner, as a matter of convenience, in the expectation of savings in transaction costs and of other synergies which would benefit both sides, independently of any arguments about price competitiveness? There are some fairly compelling arguments in favour of such an arrangement. The elimination of currency exposure and transaction costs would doubtless be welcomed. Prima facie one would expect resultant gains in the generation of mutually beneficial trade. One may recall that this was one of the principal factors justifying the introduction of the euro. For Hong Kong, however, both the United States and Mainland China are major trading partners, so there would, in this context, be offsetting effects from merely switching the peg from one currency to the other. On the other hand, there are some significant examples of economies which retain a currency independent of that of their main trading partner without obvious disadvantage. Take Canada and Mexico for example. The United States is a considerably more important trading partner to both Canada and Mexico than is China to Hong Kong, and the financial linkages are probably stronger too, but the Canadian dollar and Mexican peso remain separate from the US dollar, and the Canadian and Mexican economies do not appear to be disadvantaged.