LONDON &S212; As governments seek to root out and smother what they see as excessively risky and questionable financial market activity, the world of currency &S220;carry trades&S221; has found its way onto their radar.

Speaking in Davos, Switzerland, last month, Britain&S217;s top financial regulator, Adair Turner, branded carry trades &S212; borrowing in currencies with the lowest interest rates to invest in higher-yielding ones &S212; as &S220;economically valueless.&S221;

&S220;If I could wave a magic wand here, and greatly reduce the carry trade, I&S217;m pretty certain the world would be a better place,&S221; the Financial Services Authority chairman said.

Strong stuff &S212; and he is far from alone.

Haruhiko Kuroda, the Asian Development Bank president and the former top Japanese financial diplomat, described such transactions as a &S220;naked trade&S221; that required the utmost caution.

And for all its speculative lure, there is some logic to the authorities&S217; wishing this financial game away. 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 in London alone turn over more than $1.5 trillion every day, according to the latest figures. Some estimates have carry trade-related deals making up as much as 15 to 20 percent of total market activity, but the overall size of outstanding carry trades at any one time is almost impossible to calculate.

Although it is classic hedge fund territory, proprietary traders at banks &S212; currently under notice from President Barack Obama in his attempt to limit banks&S217; risk-taking activities &S212; have been major proponents. And using &S220;cheap&S221; currencies like the Japanese yen and the Swiss franc to play higher-yielders &S212; often in emerging markets and developing countries &S212; has been a speculative strategy for decades.

But near-zero U.S. interest rates last year saw the dollar become the financing currency for these trades. And the latest wave, which prompted the U.S. economist Nouriel Roubini to warn of the &S220;mother of all carry trades,&S221; has been met with some fierce resistance both from emerging economies fearful of overvalued currencies and local market bubbles and from chastened developed country regulators.

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 short term personal loans.

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 workable only as long as you duck out before the inevitable currency move wipes out your interest gain, which can create violent herding.

The initial buying of the high yielder has the perverse effect of pushing the risky currency higher &S212; giving the impression of a one-way bet and complicating policy for any developing country, as the overvalued exchange rate hammers the country&S217;s export competitiveness.

The situation can persist for several months and even years, but the unwind is then all the more sudden and vicious as the leveraged positions all head for the exit at the same time.

And this is what Mr. Turner at the Financial Services Authority was railing against.

&S220;It&S217;s a form of speculative activity where you can&S217;t work out what the value is to the real economy,&S221; he said, adding that speculators relied on being able to get out of the trade before the &S220;train wreck.&S221;

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 impossible to nail down exposure at any given point in time, and estimates vary. Mr. Kuroda of the Asian Development Bank 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 that the recent dollar carry trade was as high as $1.5 trillion.

But if the size of the overall trade is not easy to gauge, some say they can estimate &S220;crowdedness&S221; of these trades from monitoring hedge fund and speculative positioning data.

A paper last month by a New York University professor, Richard M. Levich, and a hedge fund manager, Momtchil Pojarliev, said their use of this data could at least provide regulators of pre-bubble warnings to allow them to &S220;counsel&S221; banks and funds on the risk.

Reuters

Inside the Markets: Regulators Tackle 'Carry Trades'