All About Forex Market in Usa

8/9/2019 All About Forex Market in Usa

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foreword ALL ABOUT...

Each of these publications presents a lucidand informed picture of the foreign exchangemarket and how it operates, filled withrich insights and reflecting a profoundunderstanding of the market and its complexmechanisms. Roger Kubarychs report, writtentwenty years ago, provided a valuable analysisof the foreign exchange market that is still readand widely appreciated by persons interested ingaining a deeper understanding of that market.

But the foreign exchange market is alwayschanging, always adapting to a shifting worldeconomy and financial environment. Themetamorphosis of the 1980s and 90s in bothfinance and technology has changed the structureof the market and its operations in profoundways. It is useful to reexamine the foreignexchange market from todays perspective.

The focus of the present book is once againon the U.S. segment of the global foreignexchange market. Chapters 1-3 describe thestructure of the market and how it haschanged. Chapters 4-6 comment on the mainparticipant groups and the instruments that

are traded. Chapters 7-8 look at foreignexchange trading from a micro, rather thanmacro, point of viewhow an individualbank or other dealing firm sees things.Chapters 9-11 comment on some of thebroader issues facing the internationalmonetary system and how governments,central banks, and market participantsoperate within that system. This is followed byan epilogue, emphasizing that there are manyunanswered questions, and that we can expectmany further changes in the period ahead,changes that we cannot now easily predict.

Markets go back a long timein Englishlaw, the concept was recognized as early as the11th centuryand it is interesting to comparetodays foreign exchange market with historicalconcepts. More than one hundred years ago,Alfred Marshall wrote that a perfect market isa district, small or large, in which there aremany buyers and many sellers, all so keenly onthe alert and so well acquainted in oneanothers affairs that the price of a commodityis always practically the same for the whole of the district.

Over the past forty years, the Federal Reserve Bank of New York has published

monographs about the operation of the foreign exchange market in the United States.

The first of these reports,The New York Foreign Exchange Market , by Alan Holmes, was

published in 1959. The second, also entitledThe New York Foreign Exchange Market ,

was written by Alan Holmes and Francis Schott and published in 1965. The third

publication,Foreign Exchange Markets in the United States, was written by Roger

Kubarych and published in 1978.

1 q The Foreign Exchange Market in the United States

F O R E W O R D


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Todays over-the-counter global market inforeign exchange meets many of the standards

that classical economists expected of asmoothly functioning and effective market.There are many buyers and many sellers.Entry by new participants is generally not toodifficult. The over-the-counter market iscertainly not confined to a single geographicalarea as the classical standards required.However, with the advance of technology,information is dispersed quickly andefficiently around the globe, with vast

amounts of information on political andeconomic developments affecting exchangerates. As in commodity markets, identicalproducts are being traded in financial centersall around the world. Essentially, the samemarks, dollars, francs, and other currenciesare being bought and sold, no matter wherethe purchase takes place. Traders in differentcenters are continuously in touch and buyingand selling from each other. With tradingcenters open at the same time, there is noevidence of substantial price differenceslasting more than momentarily.

Not all features of todays over-the-countermarket fully conform to the classical ideals.There is not perfect transparency, or full andimmediate disclosure of all trading activity.Individual traders know about the orders andthe flow of trading activity in their own firms,but that information may not be known toeveryone else in the market. However,transparency has increased enormously inrecent years. With the growth of electronicdealing systems and electronic brokering

systems, the price discovery process hasbecome less exclusive and pricing information

more broadly disseminatedat least forcertain foreign exchange products andcurrency pairs. Indeed, by most measures, theover-the-counter foreign exchange market isregarded by observers as not only extremelylarge and liquid, but also efficient andsmoothly functioning.

Many persons, both within and outside theFederal Reserve,helped in the preparation of this

book, through advice, criticism, and drafting.In the Federal Reserve, first and foremost,beforehis tragic death, Akbar Akhtar was a closecollaborator on the project over an extendedperiod, contributing to all aspects of the effortand helping to produce much of what is here.Dino Kos and his colleagues in the MarketsGroup were exceedingly helpful. Allan Malzcontributed in many important ways. RobinBensignor, John Kambhu, and Steven Malinalso provided much valuable assistance, and EdSteinbergs contribution as editor was invaluable.At the Federal Reserve Board, Ralph Smithoffered very useful suggestions and comments.

Outside of the Federal Reserve, MichaelPaulus of Bank of America contributedprofoundly and in many ways to the entireproject, both in technical matters and onquestions of broader philosophy. ChristineKwon also assisted generously. Members of thetrading room staff at Morgan Guaranty werealso very helpful. At Fuji Bank, staff officialsprovided valuable assistance. Richard Levichprovided very helpful comments.

The Foreign Exchange Market in the United Statesq 2

foreword ALL ABOUT...


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TWO-Some Basic Concepts:Foreign Exchange, the ForeignExchange Rate, Payment andSettlement Systems p. 9

FOREWORD

ONE-Trading Foreign Exchange:A Changing Market in aChanging World p. 3

The Foreign Exchange Market in the United States

table of contents 1 of 3 ALL ABOUT...

C H A P T E R S

1

1. How the Global Environment Has Changed 32. How Foreign Exchange Turnover Has Grown 4

1. Why We Need Foreign Exchange 92. What Foreign ExchangeMeans 93. Role of the Exchange Rate 9

Bilateral and Trade-Weighted Exchange Rates 104. Payment and Settlement Systems 11

Payments via Fedwire and CHIPS 12

1. It Is the Worlds Largest Market 152. It Is a Twenty-Four Hour Market 163. The Market Is Made Up of an International Network of Dealers 184. The Markets Most Widely Traded Currency Is the Dollar 195. It Is an Over-the-CounterMarket With an Exchange-TradedSegment 21

1. Foreign Exchange Dealers 232. Financial and Nonfinancial Customers 243. Central Banks 25

Classification of Exchange Rate Arrangements, September 1997 264. Brokers 27

In the Over-the-Counter Market 27Voice Brokers 29Automated Order-Matching or Electronic Broking Systems 29In the Exchange-Traded Market 30

1. Spot 31There Is a Buying Price and a Selling Price 32How Spot Rates Are Quoted: Direct and Indirect Quotes,European and American Terms 32

There Is a Base Currency and a Terms Currency 33Bids and Offers Are for the Base Currency 33Quotes Are in Basis Points 34Cross Rate Trading 34Deriving Cross Rates From Dollar Exchange Rates 34

2. Outright Forwards 36Relationship of Forward to SpotCovered Interest Rate Parity 36Role of the Offshore Deposit Markets for Euro-Dollars and Other Currencies 37How Forward Rates Are Quoted by Traders 38Calculating Forward Premium/Discount Points 38Non-Deliverable Forwards (NDFs) 39

THREE-Structure of theForeign Exchange Market p. 15

FOUR-The Main Participantsin the Market p. 23

FIVE-Main Instruments:Over-the-Counter Market p. 31


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C H A P T E R S

3. FX Swaps 40Why FX Swaps Are Used 40Pricing FX Swaps 41Some Uses of FX Swaps 41Calculating FX Swap Points 43

4. Currency Swaps 44Purposes of Currency Swaps 44

5. Over-the-Counter Foreign Currency Options 45The Pricing of Currency Options 48Delta Hedging 51Put-Call Parity 52How Currency Options Are Traded 52

Options Combinations and Strategies 53Foreign Exchange Options Galore 54

1. Exchange-Traded Futures 59Development of Foreign Currency Futures 62Quotes for Foreign Currency Futures 63

2. Exchange-Traded Currency Options 643. Linkages 65

Linkages Between Main Foreign Exchange Instruments in BothOTC and Exchange-Traded Markets 65

1. Trading Room Setup 672. The Different Kinds of Trading Functions of a Dealer Institution 683. Trading Among Major DealersDealing Directly and Through Brokers 69

Mechanics of Direct Dealing 69Mechanics of Trading Through Brokers:Voice Brokers and ElectronicBrokering Systems 71

4. Operations of a Foreign Exchange Department 735. Back Office Payments and Settlements 75

1. Market Risk 77Measuring and Managing Market Risk 78Value at Risk 78

2. Credit Risk 80Settlement RiskA Form of Credit Risk 81Arrangements for Dealing with Settlement Risk 82Sovereign RiskA Form of Credit Risk 83Group of Thirty Views on Credit Risk 83

3. Other Risks 83

SIX-Main Instruments:Exchange-Traded Market p. 59

SEVEN-How Dealers ConductForeign Exchange Operations p. 67

EIGHT-Managing Risk inForeign Exchange Trading p. 77

FIVE-Main Instruments:Over-the-Counter Market(continued from last page)


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1. U.S. Foreign Exchange Operations Under Bretton Woods 86Authorization and Management of Intervention Operations 872. U.S.Foreign Exchange Operations Since the Authorization in 1978

of Floating Exchange Rates 883. Executing Official Foreign Exchange Operations 91

Techniques of Intervention 924. Reaching Decisions on Intervention 935. Financing Foreign Exchange Intervention 94

1. The Gold Standard, 1880-1914 972. The Inter-War Period, 1919-1939 993. The Bretton Woods Par Value Period, 1946-1971 1004. The Floating Rate Period, 1971 to Present 103

1. Some Approaches to Exchange Rate Determination 107The Purchasing Power Parity Approach 107The Balance of Payments and the Internal-External Balance Approach 108The Monetary Approach 109The Portfolio Balance Approach 110Measuring the Dollars Equilibrium Value:A Look at Some Alternatives 111How Good Are the Various Approaches? 112

2. Foreign Exchange Forecasting in Practice 113Assessing Factors That May Influence Exchange Rates 114

3. Official Actions to Influence Exchange Rates 115Continuing Close G7 Cooperation in Exchange Markets 117

1. Global Financial Trends 119Introduction of the Euro 119Increased Trading in Currencies of Emerging Market Countries 120

2. Shifting Structure of the Foreign Exchange Market 121Consolidation and Concentration 121Automated Order-Matching Systems 121

3. New Instruments, New Systems 122

125



C H A P T E R S

TEN-Evolution of theInternational Monetary

System

p. 97

ELEVEN-The Determination ofExchange Rates p. 107

TWELVE-Epilogue:What Lies Ahead? p. 119

NINE-Foreign ExchangeMarket Activities of the U.S.Treasury and the FederalReserve p. 85

FOOTNOTES


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Since the early 1970s, with increasinginternationalization of financial transactions,the foreign exchange market has beenprofoundly transformed, not only in size, butin coverage, architecture, and mode of operation. That transformation is the result of structural shifts in the world economy and inthe international financial system. Amongthe major developments that have occurredin the global financial environment are thefollowing:

A basic change in the international monetarysystem, from the fixed exchange rate parvalue requirements of Bretton Woods thatexisted until the early 1970s to the flexiblelegal structure of today, in which nations canchoose to float their exchange rates or tofollow other exchange rate regimes andpractices of their choice.

A tidal wave of financial deregulationthroughout the world,with massive elimi-nation of government controls and restrictions

in nearly all countries, resulting in greaterfreedom for national and internationalfinancial transactions, and in greatly increasedcompetition among financial institutions, bothwithin and across national borders.

A fundamental move toward institu-tionalization and internationalization of savings and investment , with funds managersand institutions around the globe havingvastly larger sums available, which they areinvesting and diversifying across bordersand currencies in novel ways and in everlarger amounts as they seek to maximizereturns.

A broadening and deepening trend toward international trade liberalization, within aframework of multilateral trade agreements,such as the Tokyo and the Uruguay Rounds of the General Agreement on Tariffs and Trade,the North American Free Trade Agreement,and U.S. bilateral trade initiatives with China,Japan, and the European Union.

In a universe with a single currency, there would be no foreign exchange market, no

foreign exchange rates, no foreign exchange. But in our world of mainly national

currencies, the foreign exchange market plays the indispensable role of providing the

essential machinery for making payments across borders, transferring funds and

purchasing power from one currency to another, and determining that singularly

important price, the exchange rate. Over the past twenty-five years, the way the market

has performed those tasks has changed enormously.


trading foreign exchange: a changing market in a changing world ALL ABOUT...

C H A P T E R 1

1. HOW THEGLOBALENVIRONMENTHASCHANGED


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In 1998, the Federal Reserves most recentlypublished survey of reporting dealers inthe United States estimated that foreignexchange turnover in the U.S. market was$351 billion a day, after adjustments for

double counting. That total is an increase of 43% above the estimated turnover in 1995and more than 60 times the turnover in 1977,the first year for which roughly comparablesurvey data are available.

Major advances in technology, makingpossible instantaneous real-time transmission of

vast amounts of market information worldwide,immediate and sophisticated manipulation of that information to identify and exploit marketopportunities,and rapid and reliable execution of financial transactionsall occurring with a levelof efficiency and reduced costs not dreamedpossible a generation earlier.

Breakthroughs in the theory and practice of finance, resulting not only in the development

of innovative new financial instruments andderivative products, but also in advances inthinking that have changed our understandingof the financial system and our techniques foroperating within it.

The common theme underlying all of thesedevelopments is the role of marketsthe growthand development of markets, enhanced freedomand competition in markets, improvements in theefficiency ofmarkets,increased reliance on marketforces and mechanisms,and the creation of bettermarket techniques and instruments.

The interplay of these forces, feeding off eachother in a dynamic and synergistic way, created aglobal environment of creativity and ferment. Inthe 1970s, exchange rates became more volatileand imbalances in international payments grewmuch larger for well-known reasons: the advent of

a floating exchange rate system, deregulation,and major macroeconomic shifts in the world

economy. That caused financing needs toexpand, whichat a time of rapid technologicaladvanceprovided fertile ground for thedevelopment of new financial products andmechanisms. These innovations helped marketparticipants circumvent existing controls andencouraged further moves toward deregulation,which led to additional new products, facilitatedthe financing of still larger imbalances, andencouraged a trend toward institutionalization

of savings and diversification of investment.Financial markets grew progressively larger andmore sophisticated, integrated,and efficient.

In that environment,foreign exchange tradingincreased rapidly and changed intrinsically.The market has expanded from one of banks toone in which many other kinds of financial andnon-financial institutions also participateincluding nonfinancial corporations, investmentfirms, pension funds, and hedge funds. Itsfocus has broadened from servicing importersand exporters to handling the vast amounts of overseas investment and other capital flows thatcurrently take place. It has evolved from a seriesof loosely connected national financial centers toa single integrated international market thatplays a far more extensive and direct role in oureconomies, affecting all aspects of our lives andour prosperity.



2. HOW FOREIGNEXCHANGETURNOVERHASGROWN


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Note: Merchandise trade is the sum of exports and imports of goods.

U.S. and World Merchandise Trade, 1970-95

0

300

600

900

1,200

1,500

1995199019801970

Billions of dollars

U.S.

0

2,000

4,000

6,000

8,000

10,000

1995199019801970

Billions of dollars

World

F I G U R E 1 - 1

In some ways, this estimate understates thegrowth and the present size of the U.S. foreign

exchange market. The $351 billion estimateddaily turnover covered only the threetraditional instruments in the over-the-counter (OTC)marketspot , outright forwards, and foreignexchange (FX) swaps; it did not includeover-the-counter currency optionsand currency swapstraded in the OTC market, which totaled about$32 billion a day in notional value (or face value)in 1998. Nor did it include the two productstraded, not over-the-counter, but in organized

exchangescurrency futuresandexchange-traded currency options, for which the notional value of the turnover was perhaps $10 billion per day.1

The global foreign exchange market also hasshown phenomenal growth.In 1998, in a surveyunder the auspices of the Bank for InternationalSettlements (BIS), global turnover of reportingdealers was estimated at about $1.49 trillionper day for the traditional products, plus an

additional $97 billion forover-the-counter currency options and currency swaps, and a

further $12 billion for currency instrumentstraded on the organized exchanges. In thetraditional products, global foreign exchangeturnover, measured in current exchange rates,increased by more than 80 percent between1992 and 1998.

The expansion in foreign exchange turnover,in the United States and globally, reflects thecontinuing growth of international trade and

the prodigious expansion in global financeand investment during recent years. Withrespect to trade, the dollar value of UnitedStates international transactions in goods andservicesthe sum of exports and importstripled between 1980 and 1995 to around 15 timesits 1970 level. International trade in the globaleconomy also has expanded at a rapid pace.Worldmerchandise trade is now more than 2 times its1980 level (Figure 1-1).


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But international trade cannot account forthe huge increase in the U.S. foreign exchangeturnover over the past twenty-five years. Theenormous expansion of international capitaltransactions, both here and abroad, has been adominant force. U.S. international capital inflows,including sales of U.S. bonds and equities

to foreigners, acquisition of U.S. factoriesby foreigners, and bank deposit inflows, haveaveraged more than $180 billion per year since themid-80s.

Large and persistent external trade andpayments deficits in the United States and

Note: Merchandise trade balance is the gap between exports and imports of goods.

Billions of U.S. dollars

Merchandise Trade Balance

-200-150-100

-500

50100150

200United StatesGermanyJapan

199519901985198019751970



0

50

100

150

200

250

300

19951986-951976-851970-75

Note: Both inflows and outflows of capital exclude official capital movements.

Billions of dollarsInflows

U.S. International Capital Flows, 1970-95 (Annual Rate)

0

50

100

150

200

250

300

19951986-951976-851970-75

Billions of dollarsOutflows


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0

500

1,000

1,500

2,000

2,500

19951985

*Outstanding amount of international bond issues at end-period.**Gross purchases and sales of securities between residents and non-residents.***U.S. values are for 1994.

Billions of dollarsInternational Bond Issues*

International Securities Markets

0

50

100

150

2001995***1980

GermanyJapanU.S.

Percent of GDP

Cross-Border Securities Transactions**

F I G U R E 1 - 2

corresponding surpluses abroad have contributedto the growth in financing. Through much of theperiod since 1983, the United States has recordedtrade deficits in the range of $100-$200 billion peryear, while Japan and, to a lesser extent,Germanyhave registered substantial trade surpluses. Incontrast, all three countries experienced onlymodest trade deficits or surpluses through the1960s and early 1970s.

The internationalization of financial activityhas increased rapidly.Cross-border bank claimsare now nearly five times the level of 15 yearsago; as a percentage of the combined GDP of the OECD countries, these claims have risenfrom about 25 percent in 1980 to about 42

percent in 1995.During that same period,cross-border securities transactions in the threelargest economiesUnited States, Japan, andGermanyexpanded from less than 10 percentof GDP to around 70 percent of GDP in Japanand to well above 100 percent of GDP inGermany and the United States (Figure 1-2).Annual issuance of international bonds hasmore than quadrupled during the past ten years(Figure 1-2). Between 1988 and 1993, securitiessettlements through Euroclear and Cedelthetwo main Euro market clearing housesincreased six-fold.

All of this provided fertile ground for growthin foreign exchange trading.


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Foreign exchange refers to money denomi-nated in the currency of another nation orgroup of nations. Any person who exchangesmoney denominated in his own nationscurrency for money denominated inanother nations currency acquires foreign exchange.That holds true whether theamount of thetransaction is equal to a few dollars or tobillions of dollars; whether the personinvolved is a tourist cashing a travelers checkin a restaurant abroad or an investorexchanging hundreds of millions of dollars forthe acquisition of a foreign company; andwhether the form of moneybeing acquiredis foreign currency notes, foreign currency-denominated bank deposits, or other short-term claims denominated in foreign currency.A foreign exchange transaction is still a shiftof funds, or short-term financial claims, fromone country and currency to another.

Thus, within the United States, any moneydenominated in any currency other than the

U.S. dollar is, broadly speaking, foreignexchange.

Foreign exchange can be cash, funds availableon credit cards and debit cards, travelers checks,bank deposits, or other short-term claims. It isstill foreign exchange if it is a short-termnegotiable financial claim denominated in acurrency other than the U.S.dollar.

But, in the foreign exchange market describedin this bookthe international network of majorforeign exchange dealers engaged in high-volumetrading around the worldforeign exchangetransactions almost always take the form of anexchange of bank depositsof different nationalcurrency denominations. If one bank agrees tosell dollars for Deutsche marks to another bank,there will be an exchange between the two partiesof a dollar bank deposit for a DEM bank deposit.In this book, foreign exchange means abankbalance denominated in a foreign (non-U.S.dollar) currency.

Almost every nation has its ownnational currencyor monetary unitits dollar, its peso,its rupeeused for making and receivingpayments within its own borders. But foreigncurrencies are usually needed for paymentsacross national borders. Thus, in any nationwhose residents conduct business abroad or

engage in financial transactions with persons inother countries, there must be a mechanism forproviding access to foreign currencies, so thatpayments can be made in a form acceptable toforeigners. In other words, there is need forforeign exchange transactionsexchanges of one currency for another.

The exchange rate is a pricethe number of unitsof one nations currency that must be surrenderedin order to acquire one unit of another nations

currency. There are scores of exchange ratesfor the U.S. dollar. In the spot market, there is anexchange rate for every other national currency


some basic concepts: foreign exchange,the foreign exchange rate, payment and settlement systems

ALL ABOUT...

C H A P T E R 2

1. WHYWENEEDFOREIGNEXCHANGE

3. ROLE OF THEEXCHANGERATE

2. WHATFOREIGNEXCHANGE MEANS


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traded in that market, as well as for variouscomposite currencies or constructed monetary

units such as the International Monetary FundsSDR, the European Monetary Unions ECU,and beginning in 1999, the euro. There arealso various trade-weighted or effective ratesdesigned to show a currencys movements againstan average of various other currencies (seeBox 2-1). Quite apart from the spot rates, thereare additional exchange rates for other deliverydates, in the forward markets. Accordingly,although we talk about the dollar exchange rate in

the market, and it is useful to do so, there is nosingle, or unique dollar exchange rate in the

market, just as there is no unique dollar interestrate in the market.

A market price is determined by the inter-action of buyers and sellers in that market, and amarket exchange rate between two currencies isdetermined by the interaction of the official andprivate participants in the foreign exchange ratemarket.For a currency with an exchange rate thatis fixed, or set by the monetary authorities,

the central bank or another official body is a keyparticipant in the market,standing ready to buy orsell the currency as necessary to maintain theauthorized pegged rate or range.But in the UnitedStates, where the authorities do not intervene inthe foreign exchange market on a continuousbasis to influence the exchange rate, marketparticipation is made up of individuals,nonfinancial firms, banks, official bodies, andother private institutions from all over the worldthat are buying and selling dollars at thatparticular time.

The participants in the foreign exchangemarket are thus a heterogeneous group. Someof the buyers and sellers may be involved inthe goods market, conducting internationaltransactions for the purchase or sale of merchandise. Some may be engaged in directinvestment in plant and equipment, or inportfolio investment, dealing across bordersin stocks and bonds and other financialassets, while others may be in the moneymarket, trading short-term debt instru-ments internationally. The various investors,hedgers, and speculators may be focused onany time period, from a few minutes to severalyears. But, whether official or private, andwhether their motive be investing, hedging,speculating, arbitraging, paying for imports,or seeking to influence the rate, they are all

part of the aggregate demand for and supply



ALL ABOUT...

BILATERAL ANDTRADE-WEIGHTEDEXCHANGERATESMarket trading is bilateral, and spot andforward market exchange rates are quotedin bilateral termsthe dollar versus thepound, franc, or peso. Changes in the

dollars average value on a multilateralbasis(i.e., its value against a group orbasket of currencies) are measured byusing various statistical indexes that havebeen constructed to capture the dollarsmovements on a trade-weighted average,or effective exchange rate basis. Amongothers, the staff of the Federal ReserveBoard of Governors has developed andregularly publishes such indexes, whichmeasure the average value of the dollaragainst the currencies of both a narrowgroup and a broad group of othercountries. Such trade-weighted andother indexes are not traded in the OTCspot or forward markets, where onlythe constituent currencies are traded.However, it is possible to buy and sellcertain dollar index based futures andexchange-traded options in the exchange-traded market.

B O X 2 - 1


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Just as each nation has its own nationalcurrency, so also does each nation haveits own payment and settlement systemthat is, its own set of institutions andlegally acceptable arrangements for makingpayments and executing financial transac-tions within that country, using its nationalcurrency. Payment is the transmission of aninstructionto transfer value that results from atransaction in the economy, and settlementis the final and unconditionaltransfer of the value specified in a payment instruction.Thus, if a customer pays a department storebill by check, payment occurs when thecheck is placed in the hands of the depart-ment store, and settlement occurs when thecheck clears and the department stores bankaccount is credited. If the customer pays thebill with cash, payment and settlement aresimultaneous.

When two traders enter a deal and agree toundertake a foreign exchange transaction, theyare agreeing on thetermsof a currency exchangeand committing the resources of their respectiveinstitutions to that agreement.But theexecutionof that exchangethe settlementdoes nottake place until later.

Executing a foreign exchange transactionrequires two transfers of money value, inopposite directions, since it involves theexchange of one national currency for another.Execution of the transaction engages thepayment and settlement systems of bothnations, and those systems play a key role in theoperations of the foreign exchange market.

Payment systems have evolved and grownmore sophisticated over time. At present, variousforms of payment are legally acceptable in theUnited Statespayments can be made, forexample,by cash,check,automated clearinghouse(a mechanism developed as a substitute for certainforms of paper payments), and electronic fundstransfer (for large value transfers between banks).Each of these accepted forms of payment has itsown settlement techniques and arrangements.

By number of transactions, most paymentsin the United States are still made with cash(currency and coin) or checks. However, theelectronic funds transfer systems, whichaccount for less than 0.1 percent of thenumber of all payments transactions inthe United States, account for more than80 percent of the value of payments. Thus,

of the currencies involved, and they all play arole in determining the market exchange rate

at that instant.

Given the diverse views, interests, andtime frames of the participants, predictingthe future course of exchange rates is aparticularly complex and uncertain business.At the same time, since the exchange rate

influences such a vast array of participantsand business decisions, it is a pervasive

and singularly important price in anopen economy, influencing consumer prices,investment decisions, interest rates, economicgrowth, the locat ion of industry, andmuch else. The role of the foreign exchangemarket in the determination of that price iscritically important.

11q The Foreign Exchange Market in the United States


ALL ABOUT...

4. PAYMENT ANDSETTLEMENTSYSTEMS


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electronic funds transfer systems representa key and indispensable component of the

payment and settlement systems. It is theelectronic funds transfer systems that executethe inter-bank transfers between dealersin the foreign exchange market. The twoelectronic funds transfer systems operating inthe United States are CHIPS (Clearing HouseInterbank Payments System), a privatelyowned system run by the New York ClearingHouse, and Fedwire, a system run by theFederal Reserve (see Box 2-2).

Other countries also have large-valueinterbank funds transfer systems, similar toFedwire and CHIPS in the United States. In theUnited Kingdom, the pound sterling leg of aforeign exchange transaction is likely to besettled through CHAPSthe Clearing HouseAssociation Payments System, an RTGSsystem whose member banks settle with eachother through their accounts at the Bank of England. In Germany, the Deutsche mark leg of a transaction is settled through EAFanelectronic payments system where settlementsare made through accounts at Germanyscentral bank, the Deutsche Bundesbank.A newpayment system, named Target, has beendesigned to link RTGS systems within theEuropean Community, to enable participants tohandle transactions in the euro upon itsintroduction on January 1, 1999.

Globally, more than 80 percent of globalforeign exchange transactions have a dollar leg.Thus, the amount of daily dollar settlements ishuge, one trillion dollars per day or more. Thesettlement of foreign exchange transactionsaccounts for the bulk of total dollar paymentsprocessed through CHIPS each day.

The matter of settlement practices is of particular importance to the foreign exchange



ALL ABOUT...

PAYMENTS VIAFEDWIRE ANDCHIPS

When a payment is executed over Fedwire,a regional Federal Reserve Bank debits onits books the account of the sending bankand credits the account of the receivingbank, so that there is an immediate transferfrom the sending bank and delivery to thereceiving bank of central bank money(i.e.,a deposit claim on that Federal ReserveBank).A Fedwire payment is settledwhenthe receiving bank has its deposit account at

the Fed credited with the funds or isnotified of the payment. Fedwire is a real-time gross settlements (or RTGS) system.To control risk on Fedwire, the FederalReserve imposes charges on participantsfor intra-day (daylight) overdrafts beyond apermissible allowance.

In contrast to Fedwire, paymentsprocessed over CHIPS are finally settled,not individually during the course of the day,

but collectively at the end of the business day,after the net debit or credit position of eachCHIPS participant (against all other CHIPSparticipants) has been determined. Finalsettlement of CHIPS obligations occurs byFedwire transfer (delivery of central bankmoney). Settlement is initiated when thoseCHIPS participants in a net debit positionfor the days CHIPS activity pay their daysobligations. If a commercial bank that isscheduled to receive CHIPS payments makesfunds available to its customers beforeCHIPS settlement occurs at the end of theday, that commercial bank is exposed tosome risk of loss if CHIPS settlement cannotoccur.To ensure that settlement does, in fact,occur, the New York Clearing House has putin place a system of net debit caps and a loss-sharing arrangement backed up by collateralas a risk control mechanism.

B O X 2 - 2


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market because ofsettlement risk, the risk thatone party to a foreign exchange transaction will

pay out the currency it is selling but not receivethe currency it is buying. Because of time zonedifferences and delays caused by the banksowninternal procedures and corresponding banking

arrangements, a substantial amount of timecan pass between a payment and the time the

counter-payment is receivedand a substantialcredit risk can arise. Efforts to reduce oreliminate settlement risk are discussed inChapter 8.



ALL ABOUT...


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structure of the foreign exchange market ALL ABOUT...

C H A P T E R 3

The foreign exchange market is by far the largestand most liquid market in the world. Theestimated worldwide turnover of reportingdealers, at around $1 trillion a day, is severaltimes the level of turnover in the U.S.Government securities market, the worldssecond largest market. Turnover is equivalentto more than $200 in foreign exchange markettransactions, every business day of the year, for

every man,woman, and child on earth!

The breadth, depth, and liquidity of themarket are truly impressive. Individual trades of $200 million to $500 million are not uncommon.Quoted prices change as often as 20 times aminute. It has been estimated that the worldsmost active exchange rates can change up to18,000 times during a single day.2 Large tradescan be made, yet econometric studies indicatethat prices tend to move in relatively smallincrements, a sign of a smoothly functioning andliquid market.

While turnover of around $1 trillion per dayis a good indication of the level of activity andliquidity in the global foreign exchange market, itis not necessarily a useful measure of otherforces in the world economy.Almost two-thirds of the total represents transactions among thereporting dealers themselveswith only one-third accounted for by their transactions withfinancial and non-financial customers. It isimportant to realize that an initial dealertransaction with a customer in the foreignexchange market often leads to multiple furthertransactions, sometimes over an extended period,as the dealer institutions readjust their ownpositions to hedge, manage, or offset the risksinvolved. The result is that the amount of tradingwith customers of a large dealer institution active

in the interbank market often accounts for a verysmall share of that institutions total foreignexchange activity.

Among the various financial centers aroundthe world, the largest amount of foreign exchangetrading takes place in the United Kingdom, eventhough that nations currencythe poundsterlingis less widely traded in the market than

several others.As shown in Figure 3-1, the UnitedKingdom accounts for about 32 percent of theglobal total; the United States ranks a distantsecond with about 18 percent, and Japan is thirdwith 8 percent. Thus, together, the three largestmarketsone each in the European, WesternHemisphere, and Asian time zonesaccount forabout 58 percent of global trading. After thesethree leaders comes Singapore with 7 percent.

1. ITIS THEWORLDS LARGESTMARKET

Source: Bank for International Settlements.Note: Percent of total reporting foreign exchange turnover,adjusted for intra-country double-counting.

Shares of Reported GlobalForeign Exchange Turnover, 1998

United Kingdom

United States

Japan

Singapore

Hong Kong

Germany

Switzerland

France

Others

F I G U R E 3 - 1


18/98


During the past quarter century, the concept of a twenty-four hour market has become a reality.Somewhere on the planet, financial centers areopen for business, and banks and otherinstitutions are trading the dollar and othercurrencies, every hour of the day and night,aside from possible minor gaps on weekends.In financial centers around the world, businesshours overlap; as some centers close, othersopen and begin to trade. The foreign exchangemarket follows the sun around the earth.

The international date line is located in thewestern Pacific, and each business day arrivesfirst in the Asia-Pacific financial centersfirst Wellington, New Zealand, then Sydney,Australia, followed by Tokyo, Hong Kong, andSingapore. A few hours later, while marketsremain active in those Asian centers, tradingbegins in Bahrain and elsewhere in the MiddleEast. Later still, when it is late in the business

day in Tokyo, markets in Europe openfor business. Subsequently, when it is earlyafternoon in Europe, trading in New York andother U.S. centers starts. Finally, completing thecircle, when it is mid- or late-afternoon in theUnited States, the next day has arrived in theAsia-Pacific area, the first markets there haveopened,and the process begins again.

The twenty-four hour market means thatexchange rates andmarket conditionscanchangeat any time in response to developments that cantake place at any time. It also means that tradersandothermarket participantsmustbe alert to thepossibility that a sharp move in an exchange ratecan occur during an off hour, elsewhere in theworld.The large dealing institutions have adaptedto these conditions, and have introduced variousarrangements for monitoring markets andtrading on a twenty-four hour basis. Some keeptheir New York or other trading desks open

The large volume of trading activity inthe United Kingdom reflects Londons strong

position as an international financial centerwhere a large number of financial institutionsare located.In the 1998 foreign exchange marketturnover survey, 213 foreign exchange dealerinstitutions in the United Kingdom reportedtrading activity to the Bank of England,compared with 93 in the United States reportingto the Federal Reserve Bank of New York.

In foreign exchange trading, London

benefits not only from its proximity to majorEurocurrency credit markets and other financialmarkets,but also from its geographical locationand time zone. In addition to being open when

the numerous other financial centers in Europeare open, Londons morning hours overlap with

the late hours in a number of Asian and MiddleEast markets; Londons afternoon sessionscorrespond to the morning periods in the largeNorth American market. Thus, surveys haveindicated that there is more foreign exchangetrading in dollars in London than in the UnitedStates, and more foreign exchange trading inmarks than in Germany. However, the bulkof trading in London, about 85 percent, isaccounted for by foreign-owned (non-U.K.

owned) institutions, with U.K.-based dealersof North American institutions reporting 49percent, or three times the share of U.K.-ownedinstitutions there.


2. ITIS ATWENTY-FOURHOURMARKET


19/98


twenty-four hours a day, others pass the torchfrom one office to the next, and still others followdifferent approaches.

However, foreign exchange activity does notflow evenly. Over the course of a day, there is acycle characterized by periods of very heavyactivity and other periods of relatively lightactivity. Most of the trading takes place when thelargest number of potential counterparties isavailable or accessibleon a global basis. (Figure 3-2 gives a general sense of participation levels inthe global foreign exchange market by trackingelectronic conversations per hour.) Marketliquidity is of great importance to participants.Sellers want to sell when they have access to themaximum number of potential buyers, andbuyers want to buy when they have access to themaximum number of potential sellers.

Business is heavy when both the U.S. marketsand the major European markets are openthatis, when it is morning in New York and afternoon

in London. In the New York market, nearly two-thirds of the days activity typically takes place inthe morning hours. Activity normally becomesvery slow in New York in the mid- to lateafternoon, after European markets have closedand before the Tokyo, Hong Kong, and Singaporemarkets have opened.

Given this uneven flow of business around theclock,market participants often will respond lessaggressively to an exchange rate development thatoccurs at a relatively inactive time of day,and willwait to see whether the development is confirmedwhen the major markets open. Some institutionspay little attention to developments in less activemarkets. Nonetheless, the twenty-four hourmarket does provide a continuous real-timemarket assessment of the ebb and flow of influences and attitudes with respect to the tradedcurrencies, and an opportunity for a quick judgment of unexpected events. With manytraders carrying pocket monitors, it has becomerelatively easy to stay in touch with market


Note: Time (0100-2400 hours, Greenwich Mean Time) Source: Reuters

Electronic conversations per hour (Monday-Friday, 1992-93)

10Amin

Tokyo

Lunchhour

in Tokyo

Lunchhour

in London

Europecoming

in

Americascoming

in

Asiagoing

out

Londongoing

out

Afternoonin

America

New Zealand coming

in

6 Pmin

New York

TokyoComing

in

The Circadian Rhythms of the FX Market

05,000

10,00015,000

20,00025,00030,00035,00040,00045,000

PeakAvg

2300210019001700150013001100900700500300100

F I G U R E 3 - 2


20/98


The market consists of a limited number of majordealer institutions that are particularly active inforeign exchange, trading with customers and(more often) with each other.Most,but not all, arecommercial banks and investment banks. These

dealer institutions are geographically dispersed,located in numerous financial centers around theworld. Wherever located, these institutions arelinked to, and in close communication with, eachother through telephones, computers, and otherelectronic means.

There are around 2,000 dealer institutionswhose foreign exchange activities are coveredby the Bank for International Settlementscentral bank survey, and who,essentially, makeup the global foreign exchange market.A muchsmaller sub-set of those institutions accountfor the bulk of trading and market-makingactivity. It is estimated that there are 100-200 market-making banks worldwide; majorplayers are fewer than that.

At a time when there is much talk about anintegrated world economy and the globalvillage, the foreign exchange market comesclosest to functioning in a truly global fashion,linking the various foreign exchange tradingcenters from around the world into a single,unified, cohesive, worldwide market. Foreignexchange trading takes place among dealersand other market professionals in a largenumber of individual financial centersNew York, Chicago, Los Angeles, London, Tokyo,Singapore, Frankfurt, Paris, Zurich, Milan,and many, many others. But no matter in

which financial center a trade occurs, the samecurrencies,or rather,bank deposits denominatedin the same currencies, are being boughtand sold.

A foreign exchange dealer buying dollarsin one of those markets actually is buying adollar-denominated deposit in a bank locatedin the United States, or a claim of a bankabroad on a dollar deposit in a bank located inthe United States. This holds true regardless of the location of the financial center at whichthe dollar deposit is purchased. Similarly, adealer buying Deutsche marks, no matterwhere the purchase is made,actually is buyinga mark deposit in a bank in Germany or aclaim on a mark deposit in a bank inGermany. And so on for other currencies.

Each nations market has its owninfrastructure. For foreign exchange marketoperations as well as for other matters, eachcountry enforces its own laws, bankingregulations,accounting rules, and tax code,and,as noted above, it operates its own payment andsettlement systems. Thus, even in a globalforeign exchange market with currencies tradedon essentially the same terms simultaneously inmany financial centers, there are differentnational financial systems and infrastructuresthrough which transactions are executed, andwithin which currencies are held.

With access to all of the foreign exchangemarkets generally open to participants from allcountries, and with vast amounts of market


3. THEMARKETIS MADEUP OFAN INTERNATIONALNETWORK OFDEALERS

developments at all timesindeed, too easy,some harassed traders might say. The foreign

exchange market provides a kind of never-ending

beauty contest or horse race, where marketparticipants can continuously adjust their bets to

reflect their changing views.


21/98

The dollar is by far the most widely tradedcurrency. According to the 1998 survey, the dollarwas one of the two currencies involved in anestimated 87 percent of global foreign exchangetransactions, equal to about $1.3 trillion aday. In part, the widespread use of the dollarreflects its substantial international role as:investment currency in many capital markets,reserve currency held by many central banks,transaction currency in many internationalcommodity markets, invoice currency in manycontracts, and intervention currency employedby monetary authorities in market operations toinfluence their own exchange rates.

In addition, the widespread trading of thedollar reflects its use as a vehicle currencyin foreign exchange transactions, a use thatreinforces, and is reinforced by, its internationalrole in trade and finance. For most pairs of currencies, the market practice is to trade eachof the two currencies against a common thirdcurrency as a vehicle, rather than to trade thetwo currencies directly against each other. The

vehicle currency used most often is the dollar,although by the mid-1990s the Deutsche markalso had become an important vehicle, with itsuse, especially in Europe, having increasedsharply during the 1980s and 90s.

Thus, a trader wanting to shift funds fromone currency to another, say, from Swedishkrona to Philippine pesos, will probably sellkrona for U.S. dollars and then sell the U.S.dollars for pesos.Although this approach resultsin two transactions rather than one, it may bethe preferred way, since the dollar/Swedishkrona market, and the dollar/Philippine pesomarket are much more active and liquid andhave much better information than a bilateralmarket for the two currencies directly againsteach other. By using the dollar or some othercurrency as a vehicle, banks and other foreignexchange market participants can limit more of their working balances to the vehicle currency,rather than holding and managing manycurrencies, and can concentrate their researchand information sources on the vehicle.


information transmitted simultaneously andalmost instantly to dealers throughout the

world, there is an enormous amount of cross-border foreign exchange trading among dealersas well as between dealers and their customers.At any moment, the exchange rates of majorcurrencies tend to be virtually identical in all of the financial centers where there is activetrading. Rarely are there such substantial pricedifferences among major centers as to providemajor opportunities for arbitrage.In pricing, thevarious financial centers that are open for

business and active at any one time areeffectively integrated into a single market.

Accordingly, a bank in the United States islikely to trade foreign exchange at least as

frequently with banks in London, Frankfurt,and other open foreign centers as with otherbanks in the United States.Surveys indicate thatwhen major dealing institutions in the UnitedStates trade with other dealers,58 percent of thetransactions are with dealers located outsidethe United States. The United States is notunique in that respect. Dealer institutions inother major countries also report that morethan half of their trades are with dealers that

are across borders; dealers also use brokerslocated both domestically and abroad.


4. THEMARKETS MOSTWIDELYTRADEDCURRENCYIS THEDOLLAR


22/98

Use of a vehicle currency greatly reduces thenumber of exchange rates that must be dealt

with in a multilateral system. In a system of 10currencies, if one currency is selected as vehiclecurrency and used for all transactions, therewould be a total of ninecurrency pairs or exchangerates to be dealt with (i.e., one exchange rate forthe vehicle currency against each of the others),whereas if no vehicle currency were used, therewould be45 exchange rates to be dealt with. Ina system of 100 currencies with no vehiclecurrencies, potentially there would be 4,950

currency pairs or exchange rates [the formula is:n(n-1)/2].Thus,using a vehicle currency can yieldthe advantages of fewer, larger, and more liquidmarkets with fewer currency balances, reducedinformational needs,and simpler operations.

The U.S.dollar took on a major vehicle currencyrole with the introduction of the Bretton Woodspar value system, in which most nations mettheir IMF exchange rate obligations by buyingand selling U.S. dollars to maintain a par valuerelationship for their own currency against the U.S.dollar. The dollar was a convenient vehicle, notonly because of its central role in the exchange ratesystem and its widespread use as a reservecurrency, but also because of the presence of largeand liquid dollar money and other financialmarkets, and, in time, the Euro-dollar marketswhere dollars needed for (or resulting from)foreign exchange transactions could convenientlybe borrowed (or placed).

Changing conditions in the 1980s and 1990saltered this situation. In particular, the Deutschemark began to play a much more significant role asa vehicle currency and,more importantly,in directcross trading.

As the European Community moved towardeconomic integration and monetary unification,the relationship of the European Monetary System

(EMS) currencies to each other became of greaterconcern than the relationship of their currencies to

the dollar. An intra-European currency marketdeveloped,centering on the mark and on Germanyas the strongest currency and largest economy.Direct intervention in memberscurrencies,ratherthan through the dollar, became widely practiced.Events such as the EMS currency crisis of September 1992, when a number of Europeancurrencies came under severe market pressureagainst the mark, confirmed the extent to whichdirect use of the DEM for intervening in the

exchange market could be more effective thangoing through the dollar.

Against this background, there was very rapidgrowth indirect cross rate trading involving theDeutsche mark, much of it against Europeancurrencies, during the 1980s and 90s. (A crossrate is an exchange rate between twonon-dollar currenciese.g., DEM/Swiss franc, DEM/pound,and DEM/yen.) As discussed in Chapter 5, thereare derived cross rates calculated from the dollarrates of each of the two currencies, and there aredirect cross rates that come fromdirect trading between the two currencieswhich can result innarrower spreads where there is a viable market.Ina number of European countries, the volume of trading of the local currency against the Deutschemark grew to exceed local currency tradingagainst the dollar, and the practice developed of using cross rates between the DEM and otherEuropean currencies to determine the dollar ratesfor those currencies.

With its increased use as a vehicle currency andits role in cross trading, the Deutsche mark wasinvolved in 30 percent of global currency turnoverin the 1998 survey. That was still far below thedollar (which was involved in 87 percent of globalturnover),but well above the Japanese yen (rankedthird, at 21 percent), and the pound sterling(ranked fourth,at 11 percent).




23/98


24/98

as regulator, depending on whether securities aretraded on the exchange.

Steps are being taken internationally to helpimprove the risk management practices of dealersin the foreign exchange market, and to encouragegreater transparency and disclosure. With respectto the internationally active banks, there has beena move under the auspices of the Basle Committeeon Banking Supervision of the BIS to introducegreater consistency internationally to risk-basedcapital adequacy requirements. Over the past

decade, the regulators of a number of nationshave accepted common rules proposed by the

Basle Committee with respect to capital adequacyrequirements forcredit risk, covering exposuresof internationally active banks in all activities,including foreign exchange. Further proposalsof the Basle Committee for risk-based capitalrequirements formarket risk have been adoptedmore recently. With respect to investment firmsand other financial institutions, internationaldiscussions have not yet produced agreements oncommon capital adequacy standards.




25/98


C H A P T E R 4

the main participants in the market ALL ABOUT...

Most commercial banks in the United Statescustomarily have bought and sold foreignexchange for their customers as one of theirstandard financial services. But beginning ata very early stage in the development of theover-the-counter market, a small number of large commercial banks operating in NewYork and other U.S. money centers took onforeign exchange trading as a major business

activity. They operated for corporate andother customers, serving as intermediariesand market makers. In this capacity, theytransacted business as correspondents formany other commercial banks throughout thecountry, while also buying and selling foreignexchange for their own accounts. These majordealer banks found it useful to trade witheach other frequently, as they sought to findbuyers and sellers and to manage theirpositions. This group developed into aninterbankmarket for foreign exchange.

While these commercial banks continue toplay a dominant role, being a major dealer in theforeign exchange market has ceased to be theirexclusive domain.During the past 25 years, someinvestment banking firms and other financialinstitutions have become emulators and directcompetitors of the commercial banks as dealers inthe over-the-counter market. They now also serveas major dealers, executing transactions thatpreviously would have been handled only by thelarge commercial banks, and providing foreignexchange services to a variety of customers incompetition with the dealer banks. They are nowpart of the network of foreign exchange dealersthat constitutes the U.S. segment of the foreignexchange market. Although it is still called theinterbankmarket in foreign exchange,it is moreaccurately an interdealermarket.

The 1998 foreign exchange market turnoversurvey by the Federal Reserve Bank of New Yorkcovered the operations of the 93 major foreignexchange dealers in the United States. The totalvolume of transactions of the reporting dealers,corrected for double-counting among themselves,at $351 billion per day in traditional products,plus $32 billion in currency options and currencyswaps, represents the estimated total turnover in

the U.S. over-the-counter market in 1998.

To be included in the reporting dealers groupsurveyed by the Federal Reserve, an institutionmust be located in the United States and play anactive role as a dealer in the market. There are noformal requirements for inclusion, other thanhaving a high enough level of foreign exchangetrading activity.Of course,an institution must havea name that is known and accepted to enable it toobtain from other participants the credit linesessential to active participation.

Of the 93 reporting dealers in 1998, 82 werecommercial banks, and 11 were investmentbanks or insurance firms. All of the large U.S.money center banks are active dealers. Most of the 93 institutions are located in New York, but anumber of them are based in Boston, Chicago,San Francisco, and other U.S. financial centers.Many of the dealer institutions have outlets inother countries as well as in the United States.

Included in the group are a substantialnumber of U.S. branches and subsidiaries of major foreign banksbanks from Japan, theUnited Kingdom,Germany, France, Switzerland,and elsewhere. Many of these branches andagencies specialize in dealing in the homecurrency of their parent bank. A substantialshare of the foreign exchange activity of the

1. FOREIGNEXCHANGEDEALERS


26/98


According to the 1998 survey, as shown inFigure 4-1, 49 percent of the foreign exchangetrading activity in the over-the-counter marketrepresented interdealer transactions, that is,trading by the 93 reporting dealers amongthemselves and with comparable dealers abroad.Of the remaining 51 percent of total foreignexchange transactions, financial (non-dealer)customers accounted for 31 percent, and non-financial customers 20 percent.

The range of financial and nonfinancialcustomers includes such counterparties as:smaller commercial banks and investmentbanks that do not act as major dealers,firms and corporations that are buying orselling foreign exchange because they (or thecustomers for whom they are acting) are in theprocess of buying or selling something else(a product, a service, or a financial asset),managers of money funds,mutual funds,hedge

dealers in the United States is done by these U.S.branches and subsidiaries of foreign banks.

Some,but not all,of the 93 reporting dealersin the United States act as market makers forone or a number of currencies.A market makeris a dealer who regularly quotes both bids andoffers for one or more particular currencies andstands ready to make a two-sided market for itscustomers.Thus,during normal hours a marketmaker will, in principle, be willing to committhe firms capital, within limits, to complete

both buying and selling transactions at theprices he quotes, and to seek to make a profiton the spread, or difference, between thetwo prices. In order to make a profit from this

activity, the market maker must managethe firms own inventory and position very

carefully, and accurately perceive the short-term trends and prospects of the market. Amarket maker is more or less continuously inthe market, trading with customers andbalancing the flow of these activities withoffsetting trades on the firms own account.In foreign exchange, as in other markets,market makers are regarded as helpful tothe functioning of the marketcontributingto liquidity and short-run price stability,

providing useful price information, smoothingimbalances in the flow of business,maintainingthe continuity of trading, and making it easierto trade promptly.


2. FINANCIAL ANDNONFINANCIALCUSTOMERS

F I G U R E 4 - 1


27/98



All central banks participate in their nationsforeign exchange markets to some degree, andtheir operations can be of great importance to

those markets. But central banks differ, not onlyin the extent of their participation,but also in themanner and purposes of their involvement. The

funds, and pension funds; and even high networth individuals. For such intermediaries and

end-users, the foreign exchange transaction ispart of the payments processthat is, a meansof completing some commercial, investment,speculative,or hedging activity.

Over the years, the universe of foreignexchange end-users has changed markedly,reflecting the changing financial environment.By far the most striking change has been thespectacular growth in the activity of those

engaged in international capital movementsfor investment purposes. A generation ago,with relatively modest overseas investmentflows, foreign exchange activity in the UnitedStates was focused on international trade ingoods and services. Importers and exportersaccounted for the bulk of the foreign exchangethat was bought from and sold to finalcustomers in the United States as they financedthe nations overseas trade.

But investment to and from overseasasindicated by the capital flows,cross-border bankclaims, and securities transactions reported inChapter 1has expanded far more rapidly thanhas trade. Institutional investors, insurancecompanies, pension funds, mutual funds, hedgefunds, and other investment funds have, inrecent years, become major participants inthe foreign exchange markets. Many of theseinvestors have begun to take a more globalapproach to portfolio management. Eventhough these institutions in the aggregate stillhold only a relatively small proportion (5 to 10

percent) of their investments in foreigncurrency denominated assets, the amounts

these institutions control are so large that theyhave become key players in the foreign exchangemarket. In the United States, for example,mutual funds have grown to more than $5trillion in total assets,pension funds are close to$3 trillion, and insurance companies about $21/2 trillion.The hedge funds, though far smallerin total assets,also are able to play an importantrole, given their frequent use of high leverageand, in many cases, their investors financial

strength and higher tolerance for risk.

Given the large magnitudes of theseinstitutions assets, even a modest shift inemphasis toward foreign investment can meanlarge increases in foreign exchange transactions.In addition, there has been a tendency amongmany funds managers worldwide to managetheir investments much more actively, and withgreater focus on short-term results. Rapidgrowth in derivatives and the development of new financial instruments also have fosteredinternational investment.

Reflecting these developments, portfolioinvestment has come to play a very prominentrole in the foreign exchange market andaccounts for a large share of foreign exchangemarket activity. The role of portfolio investmentmay continue to grow rapidly, as fund managersand investors increase the level of fundsinvested abroad, which is still quite modest,especially relative to the corresponding levels inmany other advanced economies.

3. CENTRALBANKS


28/98


CLASSIFICATION OFEXCHANGERATEARRANGEMENTS, SEPTEMBER1997*

Regime Number of CountriesIndependently Floating 51Managed Floating 47Limited Flexibility 16

European Monetary System1 12Other 4

Pegged to 67U.S. dollar 21French franc 15Other currency 9Composite2 22Total 181

*The International Monetary Fund classification of exchange rate regimes with independently floating representing the highest degreeof flexibility, followed by managed floating; of the seven largest industrial democracies, four (United States, Japan,Canada, and United Kingdom) belong to the independently floating group, and three (France, Germany, and Italy) participate in the European MonetarySystem arrangement.

1Refers to the arrangement under the European Monetary System covering Austria, Belgium, Denmark, Finland, France, Germany,Ireland, Italy,Luxembourg, Netherlands, Portugal and Spain.

2Refers to countries where exchange rates are pegged to various basketsof currencies, including two countries (Libya and Myanmar) that peg their currencies to the SDR basket.


role of the Federal Reserve in the foreign exchangemarket is discussed more fully in Chapter 9.

Intervention operations designed to influenceforeign exchange market conditions or theexchange rate represent a critically importantaspect of central banks foreign exchangetransactions. However, the intervention practicesof individual central banks differ greatly withrespect to objectives, approaches, amounts,and tactics.

Unlike the days of the Bretton Woods parvalue system (before 1971), nations are nowfree, within broad rules of the IMF, to choosethe exchange rate regime they feel best suitstheir needs. The United States and many otherdeveloped and developing nations have chosen an

independently floating regime, providing for aconsiderable degree of flexibility in their exchange

rates. But a large number of countries continueto peg their currencies, either to the U.S. dollar orsome other currency, or to a currency basket or acurrency composite, or have chosen some otherregime to limit or manage flexibility of the homecurrency (Figure 4-2). The choice of exchangerate regime determines the basic frameworkwithin which each central bank carries out itsintervention activities.

The techniques employed by a central bank tomaintain an exchange rate that is pegged or closelytied to another currency are straightforward andhave limited room for maneuver or change. Butfor the United States and others with more flexibleregimes, the approach to intervention can be

F I G U R E 4 - 2


29/98


varied in many wayswhether and when tointervene, in which currencies and geographic

markets, in what amounts, aggressively or less so,openly or discreetly, and in concert with othercentral banks or not. The resolution of these andother issues depends on an assessment of marketconditions and the objectives of the intervention.As discussed in Chapter 9, the United States,operating under the same broad policy guidelineover a number of years, has experienced bothperiods of relatively heavy intervention andperiods of minimal activity.

Foreign exchange market intervention is notthe only reason central banks buy and sellforeign currencies. Many central banks serve astheir governments principal internationalbanker, and handle most, and in some casesall, foreign exchange transactions for thegovernment as well as for other public sectorenterprises, such as the post office, electricpower utilities, and nationalized airline orrailroad. Consequently, even without its ownintervention operations, a central bank may beoperating in the foreign exchange market in

order to acquire or dispose of foreigncurrencies for some government procurement

or investment purpose. A central bank alsomay seek to accumulate, reallocate amongcurrencies, or reduce its foreign exchangereserve balances. It may be in the market asagent for another central bank, using thatother central banks resources to assist itin influencing that nations exchange rate.Alternatively, it might be assisting anothercentral bank in acquiring foreign currenciesneeded for the other central banks activities or

business expenditures.

Thus,for example, the Foreign Exchange Deskof the Federal Reserve Bank of New York engagesin intervention operations only occasionally. Butit usually is in the market every day, buying andselling foreign currencies, often in modestamounts, for its customers (i.e., other centralbanks, some U.S. agencies, and internationalinstitutions).This customerbusiness provides auseful service to other central banks or agencies,while also enabling the Desk to stay in close touchwith the market for the currencies being traded.


In the Over-the-Counter MarketThe role of a broker in the OTC market is to bringtogether a buyer and a seller in return for a fee orcommission. Whereas a dealer acts as principalin a transaction and may take one side of a tradefor his firms account, thus committing the firmscapital, a brokeris an intermediary who acts asagent for one or both parties in the transactionand, in principle, does not commit capital. Thedealer hopes to find the other side to thetransaction and earn a spread by closing out theposition in a subsequent trade with another party,while the broker relies on the commission

received for the service provided (i.e.,bringing thebuyer and seller together). Brokers do not takepositions or face the risk of holding an inventoryof currency balances subject to exchange ratefluctuations. In over-the-counter trading, theactivity of brokers is confined to the dealersmarket. Brokers,including voicebrokers locatedin the United States and abroad, as well aselectronic brokerage systems, handle about one-quarter of all U.S.foreign exchange transactions inthe OTC market. The remaining three-quarterstakes the form ofdirect dealingbetween dealersand other institutions in the market.The present

4. BROKERS


30/98

24 percent share of brokers is down from about50 percent in 1980 (Figure 4-3). The number of

foreign exchange brokers in the United Stateswas 9 in 1998,including voice brokers and the twomajor automated order-matching, or electronicbrokerage systems. The number of brokerssurveyed is down from 17 in 1995.

The share of business going through brokersvaries in different national markets, because of differences in market structure and tradition.Earlier surveys showed brokers share averages

as low as 10-15 percent in some markets(Switzerland and South Africa) and as high as45-50 percent in others (France, Netherlands,and Ireland).Many U.S. voice broker firms havebranches or affiliations with brokers in othercountries.It is common for a deal to be brokeredbetween a bank in the United States and one inLondon or elsewhere during the period of theday when both markets are active.

In the OTC market, the extent to whichbrokering, rather than direct dealing, is usedvaries, depending on market conditions, thecurrency and type of transaction beingundertaken, and a host of other factors. Size isone factorthe average transaction is larger inthe voice brokers market than in the market as awhole. Using a broker can save time and effort,providing quick access to information and alarge number of institutions quotes, though atthe cost of a fee.Operating through a broker canprovide at least a degree of confidentiality, whena trader wants to pursue a particular strategywithout his name being seen very widely aroundthe market in general (counterparties to eachtransaction arranged by a broker will,of course,be informed, but after the fact). The brokersmarket provides access to a wide selection of banks, which means greater liquidity. Inaddition,a market maker may wish to show onlyone side of the pricethat is,indicate a price at

which the market maker is willing to buy, or aprice at which the market maker is willing to

sell, but not bothwhich can be done in thebrokers market, but generally not in directdealing. Of course, a trader will prefer to avoidpaying a brokers fee if possible, but doesnt wantto miss a deal just to avoid a fee.

Foreign exchange brokerage is a highlycompetitive field and the brokers must provideservice of high quality in order to make a profit.Although some tend to specialize in particular

currencies, they are all rivals for the samebusiness in the inter-dealer market.Not only dobrokers compete among themselves for brokerbusinessvoice brokers against each other,against voice brokers located abroad, andagainst electronic broking systemsbut thebroker community as a whole competes againstbanks and other dealer institutions that have theoption of dealing directly with each other, bothin their local markets and abroad,and avoidingthe brokers and the brokers fees.



0

10

20

30

40

50

199819951992198919861980

Note: Percent of total foreign exchange market turnover,adjusted for double-counting.Source: Federal Reserve Bank of New York.

Percent

Brokers Share of Daily Turnoverin the U.S. Foreign Markets, 1980-98

F I G U R E 4 - 3


31/98


Voice BrokersSkill in carrying out operations for customers

and the degree of customers confidencedetermine a voice brokers success. To performtheir function, brokers must stay in closetouch with a large number of dealers andknow the rates at which market participantsare prepared to buy and sell. With 93 activedealers in New York and a much largernumber in London, that can be a formidabletask, particularly at times of intense activityand volatile rate movements. Information

is the essential ingredient of the foreignexchange market and the player with thelatest, most complete, and most reliableinformation holds the best cards. As onechannel, many voice brokers have opentelephone lines to many trading desks, so thata bank trader dealing in, say, sterling, can hearover squawk boxes continuous oral reports of the activity of brokers in that currency, thecondition of the market, the number of transactions occurring, and the rates atwhich trading is taking place, though tradersdo not hear the names of the two banks inthe transaction or the specific amounts of the trade.

Automated Order-Matching, or ElectronicBroking SystemsUntil 1992, all brokered business in theU.S. OTC market was handled by voicebrokers. But during the past few years,electronic broker systems(or automated order-matching systems) have gained a significantshare of the market for spot transactions.The two electronic broking systems currentlyoperating in the United States are ElectronicBrokerage Systems, or EBS, and Reuters2000-2. In the 1998 survey, electronic brokingaccounted for 13 percent of total marketvolume in the United States,more than doubleits market share three years earlier. In the

brokers market, 57 percent of turnover is nowconducted through order-matching systems,

compared with 18 percent in 1995.

With these electronic systems, traders cansee on their screens the bid and offer rates thatare being quoted by potential counterpartiesacceptable to that traders institution (as wellas quotes available in the market morebroadly), match an order, and make the dealelectronically,with back offices receiving propernotification.

The electronic broking systems areregarded as fast and reliable. Like a voicebroker, they offer a degree of anonymity.The counterparty is not known untilthe deal is struck, and then only to theother counterparty. Also, the systems canautomatically manage credit lines. A traderputs in a credit limit for each counterpartythat he is willing to deal with, and when thelimit is reached, the system automaticallydisallows further trades. The fees chargedfor this computerized service are regardedas competitive. The automated systems arealready widely used for certain standardizedoperations in the spot market, particularly forsmaller-sized transactions in the most widelytraded currency pairs.Many market observersexpect these electronic broking or order-matching systems to expand their activitiesmuch further and to develop systems tocover additional products, to the competitivedisadvantage, in particular, of the voicebrokers. Some observers believe thatautomated systems and other technologicaladvances have substantially slowed thegrowth in market turnover by reducing daisychaining and the recycling of transactionsthrough the markets, as well as by othermeans. (Electronic broking is discussedfurther in Chapter 7.)



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In the Exchange-Traded MarketIn the exchange-traded segment of the market,

which covers currency futures and exchange-traded currency options, the institutionalstructure and the role of brokers are differentfrom those in the OTC market.

In the exchanges, orders from customers aretransmitted to a floor broker .The floor broker thentries to execute the order on the floor of theexchange (by open outcry), either with anotherfloor broker or with one of the floor traders,

also called locals, who are members of theexchange on the trading floor, executing tradesfor themselves.

Each completed deal is channeled through theclearinghouse of that particular exchange by a

clearing member firm. A participant that is not aclearing member firm must have its trades cleared

by a clearing member.

The clearinghouse guarantees the perfor-mance of both parties, assuring that the longside of every short position will be met, andthat the short side of every long position willbe met. This requires (unlike in the OTCmarket) payment of initial and maintenancemargins to the clearinghouse (by buyers andsellers of futures and by writers, but not

holders, of options). In addition, there is dailymarking to market and settlement. Thus,frequent payments to (and receipts from)brokers and clearing members may becalled for by customers to meet these dailysettlements.




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main instruments: over-the-counter market ALL ABOUT ...


C H A P T E R 5

A spot transaction is a straightforward (oroutright) exchange of one currency for another.The spot rate is the current market price, thebenchmark price.

Spot transactions do not requireimmediatesettlement, or payment on the spot. Byconvention, the settlement date, or valuedate, is the second business day after thedeal date (or trade date) on which thetransaction is agreed to by the two traders.The two-day period provides ample time forthe two parties to confirm the agreement andarrange the clearing and necessary debitingand crediting of bank accounts in variousinternational locations.

Exceptionally, spot transactions between theCanadian dollar and U.S.dollar conventionally aresettledonebusiness day after the deal, rather thantwobusiness days later,since Canada is in the sametime zone as the United States and an earlier valuedate is feasible.

It is possible to trade for value datesin advanceof the spot value date two days hence (pre-spotor ante-spot). Traders can trade for valuetomorrow,with settlement one business day afterthe deal date (one day before spot); or even forcash,with settlement on the deal date (two daysbefore spot). Such transactions are a very smallpart of the market, particularly same day cashtransactions for the U.S. dollar against European

Chapter 3 noted that the United States has both anover-the-counter market in foreign

exchange and anexchange-traded segment of the market. TheOTC market is the U.S.

portion of an international OTC network of major dealersmainly but not exclusively

banksoperating in financial centers around the world, trading with each other and

with customers, via computers, telephones, and other means. Theexchange-traded

market covers trade in a limited number of foreign exchange products on the floors of

organized exchanges located in Chicago, Philadelphia, and New York.

This chapter describes the foreign exchangeproducts traded in the OTC market. It covers thethree traditional foreign exchange instrumentsspot , outright forwards, and FX swaps, whichwere theonlyinstruments traded before the 1970s,and which still constitute the overwhelming shareof all foreign exchange market activity. It also

covers two more recent products in which OTCtrading has developed since the 1970scurrencyswapsandOTC currency options.

The next chapter describescurrency futuresand exchange-traded currency options, whichcurrently are traded in U.S. exchanges.

1. SPOT


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or Asian currencies, given the time zonedifferences. Exchange rates for cash or value

tomorrow transactions are based on spot rates,but differ from spot, reflecting in part, the factthat interest rate differences between the twocurrencies affect the cost of earlier payment.Also,pre-spot trades are much less numerous and themarket is less liquid.

A spot transaction represents adirect exchangeof one currency for another, and when executed,leads to transfers through the payment systems of

the two countries whose currencies are involved.Ina typical spot transaction,Bank A in New York willagree on June 1 to sell $10 million for Deutschemarks to Bank B in Frankfurt at the rate of, say,DEM 1.7320 per dollar, for value June 3.On June 3,Bank B will pay DEM 17.320 million for creditto Bank As account at a bank in Germany, andBank A will pay $10 million for credit to BankBs account at a bank in the United States.The execution of the two payments completes thetransaction.

There is a Buying Price and a Selling PriceIn the foreign exchange market there are alwaystwo pricesfor every currencyone price at whichsellers of that currency want to sell, and anotherprice at which buyers want to buy.Amarket maker is expected to quote simultaneously for hiscustomersbotha price at which he is willing to selland a price at which he is willing to buy standardamounts of any currency for which he is makinga market.

How Spot Rates are Quoted: Direct and IndirectQuotes,European and American TermsExchange rate quotes,as the price of one currencyin terms of another, come in two forms: a directquotation is the amount of domestic currency(dollars and cents if you are in the United States)per unit of foreign currency and an indirectquotation is the amount of foreign currency per

unit of domestic currency (per dollar if you are inthe United States).

The phrase American terms means a directquote from the point of view of someone locatedin the United States. For the dollar, that meansthat the rate is quoted invariable amounts of U.S. dollars and cents per one unit of foreigncurrency (e.g., $0.5774 per DEM1). The phrase European termsmeans a direct quote from thepoint of view of someone located in Europe. Forthe dollar, that meansvariable amounts of

foreign curren

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