Ch. 5 - The Foreign Exchange Market

Functions of the Foreign Exchange Market

• Transfer purchasing power between countries

• Obtain/provide credit for international trade transactions

• Minimize exposure to the risks of exchange rate changes

Global Trading Day

Foreign exchange market spans the globe, with currencies trading somewhere every hour of every business day

Market Participants

1. Liquidity seekers

2. Profit seekers

5 categories of institutional participants

1. Bank and nonbank foreign exchange dealers

2. Individuals and firms conducting commercial/investment transactions

3. Speculators and arbitrageurs

4. Central banks and treasuries

5. Foreign exchange brokers

Bank and nonbank foreign exchange dealers

Profit from buying foreign exchange at a bid price and reselling it at a slightly higher ask price

Individuals and firms conducting commercial or investment transactions

Use the foreign exchange market to facilitate execution of commercial/investment transactions

Speculators and arbitrageurs

Seek to profit from trading within the market itself

Central banks and treasuries

Use the market to acquire or spend their country’s foreign exchange reserves as well as to influence the price at which their own currency is traded

Foreign exchange brokers

Facilitate trading between dealers without themselves becoming principals in the transaction

World’s largest financial market

Foreign exchange market

Evolution of FX Trading

• 1985: Limited price discovery capability, trades conducted over the phone

• 1990’s: Instantaneous access to market data via computer, only accessible by intermarket dealers

• 2010’s: Trades conducted electronically, separation of interdealer and customer markets has broken down

FX Trading in 1985

• Limited price discovery capability

• Trades conducted over the phone

FX Trading in 1990’s

• Instantaneous access to market data via computer

• Market only accessible by intermarket dealers

FX Trading in 2010

• Trades are conducted electronically

• Separation of the interdealer and customer markets has effectively broken down

3 components of FX Trades

• The FX trade transaction agreement - the interaction of dealers, brokers and aggregators

• Electronic communication and notification for payment settlement

• Final settlement of the currency trade

Instructions for foreign exchange trades are exexcuted through the Society for Worldwide Interbank Financial Telecommunication (SWIFT)

Component 1

• Swift networks sends payment orders, but does not facilitate actual settlement

• Settlement of a foreign exchange trade is made by correspondent accounts that banks and institutions have with each other

Continuous Linked Settlement (CLS)

Component 2

Specialist bank provides settlement services to its members for foreign exchange trades

Payment vs Payment

Component 3

Settlement service where both sides’ payment instructions for an FX transaction are settled simultaneously

FX Market manipulation: the London Fix

• Market analysts noted steep spikes in trading just prior to the 4pm fix, spikes that were not sustained in the hours and days that followed

• 4pm is a daily benchmark used by institutions to mark value

• Traders alleged to collaborate on market movements and price quotes at key times

• Computer algorithms were believed to be less likely to pursue fraudulent trading for fixing given the speed & frequency of transactions

Spot Transactions

Purchase of foreign exchange with delivery and payment between banks taking place normally on the second business day

Value Date

Date of the settlement

Clearing House Interbank Payments System (CHIPS)

• Most $ transactions in the world are settled through the computerized CHIPS in New York

• Calculates net balances owed by any one bank to another and which facilitates payment of those balances by 6pm that same day in the Federal Reserve Bank

Forward transactions

• Requires delivery at a future value date for a specified amount of one currency for a specified amount of another currency

• Exchange rate established at the time of agreement, payment and delivery not required until maturity

Swap Transactions

• Spot against Forward: buying at spot and sells a forward

• Forward-Forward Swaps: Swap of 2 forwards

• Nondeliverable Forwards (NDFs): settled in US dollars

FX Market: Geographical Distribution

• London is the biggest one with 37% of the global market, followed by New York with 19%

• Currency trading in Asia is growing due to the growth of Asian economies, markets and currencies

FX Market: Currency Composition

• USD increased its presence in global currency trades

• Japanese yen and Euro showed declines

• Chinese Yen proportion doubled

Exchange Rate Quotes

CUR1/CUR2

The quotation indicates the number of units of CUR2 required in exchange for receiving one unit of CUR1

Market conventions: European Terms

• Quoting of the quantity for a specific currency per 1 USD

• Market practice for most of the past 60 years or more

Market conventions: American Terms

• Quoting the quantity of USD per one unit of a specific currency

  • Exceptions that use American Terms: EUR, GBP, AUD, NZD

Market convention nicknames

Cable: USD/GBP exchange rate

Loonie: CAD

Kiwi: NZD

Aussie: AUD

Swissie: CHF

Sing Dollar: SGD

Market convention: Direct Quote

Price of a foreign currency in domestic (home) currency units

• Ex: in Paris, EUR 0.8214/USD 1

• Ex: in NYC, USD 1.2174/EUR 1

Market convention: Indirect Quote

Price of domestic currency in foreign currency units

• Ex: in NYC, EUR 0.821/USD 1

• Ex: in Paris, USD 1.2174/EUR 1

Bid

Price in one currency at which a dealer will buy another currency

Ask

Price in one currency at which a dealer will sell the other currency

Bid-Ask Spread

Ask price is slightly higher than the bid price

Cross Rates

Many currency pairs are only inactively traded, so their exchange rate is determined through their relationship to a widely traded third currency

Cash Rates

Forward Rates of 1 year or less maturity

Swap Rates

Forward rates for longer than 1 year maturity

Telephone Era of Currency Trading

• Bretton Woods begins to break down

• SWIFT initiated

• Bankhaurs Herstatt closure introduces settlement risk

Computer Era of Currency Trading

• Reuters launches system for bilateral trades between dealers and launches FXFX page

• EBS launches competitive product to Reuters

• StateStreet launches reatil aggregator FXConnect

• Currenex multi-bank trading system

• Continuous Linked Settlement Bank opens (CLS)

• Interdealer and customer FX market tiering ends with introduciton of multitude of electronic systems

• Cyber attacks on central bank currency transaction messages in SWIFT