I guess it's legal cos financial institutions make a lot of money from it and pay the governments a lot of money to ensure nobody looks too closely.

Plus most people in government are lawyers or careerists who don't understand finance who are advised by either civil servants who are generalists (ie don't understand finance) or paid lobbyists with a vested interest in filtering out the bad news. So nobody who knows what they're talking about who isn't on the take ever gets to look at these things dispassionately and get a view on whether it should continue. Or at least, nobody with the power to do anything about it.

Like the ratings agency that mixed trash in with the good stuff cos they knew nobody else knew any better and nobody was watching them, so why not ? More profit and treble bonuses all round.

keep to the Fen Causeway

Suppose I lend you £79  and you lend me €100 and we set each loan to be variable-rate at the respective central bank's base rate (4.5% ad 3.75%) respectively. We agree to pay each other interest each day.

Because the exchange rate today is 0.79 €/£ no money need change hands when setting this up. We can also agree to put some collateral (say, you post €10 and I post £8) in escrow and if exchange rates fluctuate we will top it up by the difference between the nominal values of the two loans. If we can't keep at least the initial amounts in the accounts the contract gets cancelled at nearly zero cost because the notional values nearly match and there's enough money in the escrow to make up the difference.

The notional value of this arrangement is €200 at inception, but in fact only €20 are posted as collateral. The only risk is that exchange rates will fluctuate more that 10% in a day and the party on the wrong side of that movement won't have enough cast lying around. But the other party is covered for the first 10% from the escrow account.

Leaving aside the question of why should we want to enter into such an agreement (called a currency swap) how would you justify makig it illegal, and which amount is more representative of the quantities involved? €200 (notional) or €20 (collateral) or the average daily payment over time?

A vivid image of what should exist acts as a surrogate for reality. Pursuit of the image then prevents pursuit of the reality -- John K. Galbraith