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Workings and Players of the FX Market

For our last financial markets primer, or review as the case may be among readers, a good place to start is with the enormous size of the FX market. Without question, the buying and selling of currencies is the largest sector of the financial markets, as measured by the value of daily transactions. In its latest triennial survey published in September 2013, the BIS estimated the volume of currency trades to be $5.3 trillion on average per day.[1] [2] By contrast, in 2013, the global equity market saw $55 trillion of shares traded, but that was over a year.4 Dividing that number by 250, roughly the number of trading days in a year, one arrives at a figure of $220 billion share volume per day, which is a mere 1/25th of currency transactions. The reader perhaps might remember larger values in the area of $600 trillion being cited for derivatives. But those numbers referred to the worth of the assets underlying those contracts rather than actual amounts transferred between traders. While trading volume for derivatives is difficult to estimate, it is definitely less than what is transacted in FX markets.

Volume has grown prodigiously since the current floating rate regime started budding in the early 1970s. Back then, daily turnover was miniscule by today’s standards at a dozen or so billion dollars a day it seems. By 1989, the earliest year for which the BIS has data, FX turnover had increased to $500 billion per day. Except in the early 2000s, owing to the euro’s introduction reducing the number of currencies available for trading, activity has risen uninterruptedly at a rate of 10.3 % per year from 1989 to 2013. Over the same time frame, world trade grew by 5.7 % per year. Clearly, more is transpiring in the FX market than the facilitation of exports and imports. A more telling sign of this is that, by 2013, currency markets were transacting a significantly greater multiple in single day relative to 1989 than what was being traded around the world in goods and services in a whole year. If we look at both figures on a daily basis, the ratio of volume of currency trading to that of real goods and services has steadily risen (Fig. 7.1)[3].

Similar to bonds, most currency trading takes place over the counter in what is called the interbank market. As the term suggests, this is a network made up of major banks connected to each other by telephones, computers, and electronic trading systems. As one might expect from the massive transactional volumes, the interbank FX market is open 24 hours a day during the trading week. In North American and European time zones, this means that Saturday is the only day of the week that the FX market is closed. Activities commence in Auckland and Sydney when it is late Sunday afternoon in North America and evening in Europe. Several hours

Ratio of FX trading volume to global trade, 1989-2013. Source

Fig. 7.1 Ratio of FX trading volume to global trade, 1989-2013. Source: BIS and World Bank

later, the trading action moves to Tokyo, Hong Kong, and Singapore. From there, the action heads to Zurich, Frankfurt, Paris, and London before finishing up for the day in Toronto, New York, and San Francisco. The large banks who participate in FX trading will typically hand their book—that is, the record of their trading positions—from one of their branches to another as the market travels westward from Australasia to North America. Amid this journey, the three main FX trading centers include Tokyo, London, and New York. London is the largest of these three, where 40.9 % of the world’s currency transactions takes place.[4] Currencies are also traded on exchanges, the dominant venue being the Chicago Mercantile Exchange, where market participants have several active US dollar priced futures to choose from, including contracts on the euro, Japanese yen, Swiss franc, British pound, and Australian dollar. At

$128 billion turnover in 2013, however, exchange trading only made up 2.4 % of total FX market volume.[5]

Aside from futures, currencies are transacted through a wide assortment of derivative instruments, including swaps and options. Anchoring all this derivative activity, though, is the spot market. Representing 38 % of activity, the spot market is where currencies are traded for immediate delivery, within one or two days. It is the spot market that features most prominently at the many online FX brokerage services that now allow ordinary investors to play the currency market. Visiting the websites of one of those services, one can readily infer the most actively traded currency pairs. On the top of every quote screen is the Euro/US dollar rate, which represented 24 % of FX volume in 2013. Expressed as what a euro costs in terms of US dollars, this rate has taken the place formerly occupied by the US dollar/German deutschemark pair. Until the introduction of the continental currency in 1999, that pair used to serve as the barometer of the American-European relationship in the currency markets. Constituting 18 % of turnover, the second most actively traded pair is US dollar/Japanese yen, expressed as American dollars in terms of yen. Stated more intuitively, that rate indicates the number of yen that must be exchanged for each US dollar—the second currency listed is always the one in which the pair is priced. This is the more common way that US dollar-based pairs are quoted in the FX market. The third highest volume pair is British pound/US dollar making up 9 % of trading activity, followed by Australian dollar/US dollar, US dollar/Canadian dollar, and US dol- lar/Swiss franc. Emerging market economies have yet to make themselves as actively felt in the currency markets, though in China’s case, this is due to the country’s enforcement of capital controls. Nonetheless, the increasing weight of the developing nations in the world economy has drawn more attention to what currency traders refer to as exotic pairs. Of these, the US dollar/Brazilian real, US dollar/Indian rupee, and US dollar/ Chinese yuan rates experience notable volume. Politically, the most salient of the exotic pairs is the US dollar/Chinese yuan. Partly, this is owing to the prodigious growth of China’s economy over the past three decades. Measured in nominal GDP at least, China has become the world’s second- largest economy. A more burning reason for the political significance of

Table 7.1 Key

currency pairs

Rate

% of Total FX Trading Activity, 2013

Euro/US dollar

24

US dollar/Yen

18

British Pound/US dollar

9

Euro/Japanese Yen

3

US dollar/Chinese Yuan

2

US dollar/Brazilian Real

<1

Source: BIS

the US dollar/Chinese yuan rate is repeated accusations by American public officials and companies that China deliberately keeps its currency undervalued to promote exports (Table 7.1).

There are important pairs not involving the US dollar, the Euro/ Japanese Yen rate chief among them. Nonetheless, the greenback is still the most widely traded component in FX market pairings. In 2013, the US dollar was an element in 87 % of transactions. Meanwhile, the euro factored in 33.4 % of trades, while the yen partook of 23 %. By the way, these percentage figures add up to more than 100 because FX trades involve two currencies—hence, for example, US dollar volume is actually 87 % of 200 %.[1] Helping account for this dominant position is the prevalent practice of invoicing export and import transactions in US dollars. Also explaining the greenback’s role is that the world’s central banks, major players in the FX markets, hold most of their FX reserves in US dollars. As of mid-2015, the percentage of total reserves in US dollars was 64 %. Despite much talk a decade ago about the euro possibly overtaking the US dollar as the world’s reserve currency, the continental unit was still well behind the greenback in second place at 21 %.[7]

Apart from the major banks acting as market makers, the chief participants in FX include hedge funds. Not only do these funds, which pools money from investors, hedge against currency movements, they will actively bet upon them. Mutual funds, which also pools money from investors, trade in FX as well. Being more regulated than hedge funds, mutual funds do not make any speculative bets on the direction of currencies.

Mutual funds enter the FX market to enable the purchase of international securities or to insure their portfolios against adverse swings in the currency market. Insurance companies, brokerage firms, investment banks, and pension funds are involved for similar reasons. Multinational firms take part as well to facilitate foreign direct investments and remit foreign revenues into their home currency. Multinationals, too, hedge against the risks entailed in having revenues and expenses, as well as assets and liabilities, denominated in separate currencies.

Interestingly enough, only 9 % of the market’s volume is attributable to non-financial organizations like corporations and government agencies. We may take this as an additional sign that there is more to FX trading than meets the needs of international commerce in goods and services. The biggest players, at 43 % of turnover, emanate from the financial sector among the just mentioned coterie of insurance companies, mutual funds, investment banks, securities brokers, pension funds, and hedge funds.11 In this financial grouping, too, are central banks, who participate in the currency market to manage their FX reserves. This treasure chest functions as a means for the central bank to diversify its asset base out of domestic securities, finance the country’s imports, and defend their currency against speculative assaults. Periodically, central banks will make dramatic entrances into the FX arena by intervening. Sometimes, they will do this in concert with the central banks of other nations to correct perceived market overshooting of exchange rates.

  • [1] BIS, “Triennial Central Bank Survey: Report on Global Foreign Exchange Market Activity”(September 2013), http://www.bis.org/publ/rpfx13fx.pdf
  • [2] World Federation of Exchanges, “2013 WFE Market Highlights”, (January 28, 2014),http://www.world-exchanges.org/home/index.php/files/18/Studies%20-%20Reports/6/2013%20WFE%20Market%20Highlights.pdf
  • [3] BIS, “Activity in the Foreign Exchange Market”, http://www.bis.org/publ/rpfxf10t.htmand World Bank, “World DataBank: World Development Indicators”, http://databank.worldbank.org/data/Views/VariableSelection/SelectVariables.aspx?source=World%20Development%20Indicators%20and%20Global%20Development%20Finance. Note thatglobal trade in this graph is equal to world exports in 2005 US dollars, as opposed to exportsplus imports, to avoid double counting.
  • [4] BIS, “Triennial Central Bank Survey: Report on Global Foreign Exchange Market Activity"(September 2013), http://www.bis.org/publ/rpfx13fx.pdf
  • [5] Exchange-traded figures obtained from, BIS, “Exchange Traded Derivatives Statistics”,(September 13, 2015), http://www.bis.org/statistics/d1.pdf
  • [6] BIS, “Triennial Central Bank Survey: Report on Global Foreign Exchange Market Activity”(September 2013), http://www.bis.org/publ/rpfx13fx.pdf
  • [7] IMF, “Currency Composition of Official Foreign Exchange Reserves”, (September 2015),http://www.imf.org/external/np/sta/cofer/eng/index.htm
 
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