Foreign exchange market activities of the U.S. Treasury and the Federal Reserve

During the first decade and half after World War II,United States monetary authorities did not actively intervene or directly operate in foreign exchange market for purpose of influencing the dollar exchange rate orexchange market conditions. Under the Bretton Woods par value exchange rate system,obligation of United States was to assure the gold convertibility of the dollar at $35 per ounce to central banks and monetary authorities of IMF members.The actions a other governments,intervening in dollars as appropriate to keep their own currencies within one percent of dollar par value IMF rules required, maintained the day-to-day market level of the dollar within those narrow margins. Under that arrangement, the United States played only a passive role in the determination of exchange rates in the market: In a system of “n” currencies, not every one of the “n” countries can independently set its own exchange rate against the others. Such a system would be over-determined. At least one currency must be passive, and the dollar served as that “nth” currency.

In the early 1960s , United States became more active in exchange market operations. By then,the United States had begun to experience its own serious and prolonged balance payments problems. Increasingly, the United States became concerned about protecting its gold stock and maintaining the credibility of the dollar’s link to gold and the official gold price of $35 per ounce on which the world par value system of exchange rates was based.

The Bretton Woods fixed exchange rate system became unsustainable over time broke down in 1971 and finally collapsed in 1973. In 1978, after much of the world had moved de facto to a floating exchange rate system, the IMF Articles were amended to change the basic obligation of IMF members.No longer were members obliged to maintain par values; instead, they were “to collaborate with Fund and other members to assure orderly exchange arrangements and to promote stable system of exchange rates.” Each a authorized to adopt exchange arrangement of its choice—fixed floating, tied to another currency or to a basket of currencies—subject, in all cases, to general obligations of the IMF: to avoid exchange rate manipulation; to promote orderly economic, financial, and monetary conditions and foster order economic growth with reasonable price stability. U.S.law was amended to authorize the United States to accept obligation introduced in the 1978 IMF amendment.

Currently, the exchange rate regime of the United States is recorded by the IMF under the classification of “Independent Floating,” with the notation that exchange rate of the dollar is determined freely in the foreign exchange market. Of course, the United States does on occasion intervene in the foreign exchange market, as described below. However, in recent periods such occasions have been rare; the United States has intervened only when there was clear and convincing case that intervention was called for.

1. U.S. FOREIGN EXCHANGE OPERATIONS UNDER BRETTONWOODS

During Bretton Woods years,although there were number of changes in various nations’ a values, exchange rate fluctuations were relatively modest most of the time. However, exchange market pressures showed in other ways. Much attention was paid to the size of U.S. gold reserves in relation to the size of U.S. official dollar liabilities—the dollar balances held by official institutions in other countries. Various measures were taken to protect the U.S. gold stock acredibility dollar convertibility for foreign official holders. Many actions were taken by U.S. authorities to hold down the growth of what foreign central banks might regard as their “excess” dollar balances, with view to reducing the pressure for conversion of official dollar holdings into gold. Specific U.S. actions taken during the Bretton Woods par value period included:

borrowing foreign currencies from foreign monetary authorities through reciprocal credit lines (swap lines) for the purpose of selectively buying dollars from certain foreign central banks that might otherwise have sought to convert those dollars into gold;

selling foreigncurrency-denominated bonds (called Roosa bonds after the then Under- Secretary of the Treasury) to mop up excess dollars that might otherwise be converted by foreign central banks into gold;

acquiring foreign currencies by drawing down the U.S. reserve position at the IMF, again using those currencies to buy excess dollars from other central banks and also to pay off swap debts;

cooperate with monetary authorities of other major countries to buy and sell gold in the free market to maintain the free market dollar price of gold close to the official price of $35 per ounce; and

intervening, on occasion, directly in th foreign exchange market during the 1960s and early 1970s in order to reduce the pressures to convert dollars into gold, and to maintain or restore orderly conditions in volatile currency markets.

2. U.S. FOREIGN EXCHANGE OPERATIONS SINCE THE AUTHORIZATION IN 1978 OF FLOATING EXCHANGE RATES

with the interpretation.During some periods, “countering disorderly market conditions” has been interpreted very narrowly, and intervention has been limited to rare and extreme situations; during other periods, it has been interpreted broadly and operations have been extensive.

During the first dozen years after exchange rate floating was sanctioned by 1978 IMF amendment, the United States changed its approach and its goals several times. There were a number of key turning points, and the U.S. experience from 1978 to 1990 breaks down into five distinct periods.

All U.S. intervention operations in the foreign exchange market are publicly reported on a quarterly basis, few weeks after the close of the period. These reports, entitled “Treasury and Federal Reserve Foreign Exchange Operations,” are presented by the Manager of the System Open Market Account and are published by the Federal Reserve Bank of New York and in the Federal Reserve Bulletin.Each report documents any U.S. intervention activities of the previous quarter, describing the market environment in which they were conducted. This series provides a record of U.S. actions in the foreign exchange market for the period since 1961.

3. EXECUTING OFFICIAL FOREIGN EXCHANGE OPERATIONS

In some countries the central bank serves as government’s principal banker, or only banker, for international payments. In such cases, the central bank may buy and sell foreign exchange, not only for foreign exchange intervention purposes, but for such purposes as paying government bills, servicing foreign currency debts, and executing transactions for the national post office, railroads, and power company.

The Federal Reserve Bank of New York conducts all U.S. intervention operations in the foreign exchange market on behalf of U.S. monetary authorities.It also conducts certain nonintervention business transactions on behalf of various U.S. Government agencies. Given the vast array of international activities in which U.S. Government departments agencies are involved, it is left to individual agencies to acquire the foreign currencies needed for their operations in the most economical way they can find. Today, only fraction of the U.S. Government’s total foreign exchange transactions are funneled through the Federal Reserve Bank of New York; the bulk of such transactions go directly through commercial or other channels.

At the New York Fed, the Foreign Exchange Desk monitors the foreign exchange market on a continuing basis, watching the market and keeping up-to-date with significant developments that may be affecting the dollar and other major currencies. The Desk staff tracks market conditions around the clock during periods of stress. Federal Reserve staff, like others in the market, sit in trading room surrounded by screens, telephones, and computers, watching the rates, reading the continuous outpouring of data, analyses, and news developments, listening over the brokers’ boxes to the flow of transactions, and talking on telephone with other market players to try to get full understanding of different market views on what is happening and likely to happen and why.Quite importantly,Desk personnel also stay in close touch with their counterparts in the central banks of the other major countries—both in direct one-toone calls and through regularly scheduled conference calls—to keep informed on developments in those other markets, to hear how the other central banks assess developments and their own aims, and to discuss with them emerging trends and possible actions. The staff on the Foreign Exchange Desk of the New York Fed confers regularly, several times a day,with staff both at Treasury and at the Federal Reserve Board of Governors in Washington, reporting the latest developments and assessments about market trends and conditions.

4. FINANCING FOREIGN EXCHANGE INTERVENTION

All foreign exchange operations by the monetary authorities must,of course,be financed.In the case of a foreign central bank operating in dollars to influence the exchange rate for its currency,that simply may mean transfers into or out of its dollar accounts (held at the Federal Reserve Bank of New York or at commercial banks) as it buys and sells dollars in market. For the United States, it currently means adding to or reducing the foreign currency balances held by the Treasury and the Federal Reserve.However,U.S. techniques for acquiring resources for xchange market operation have gone through several phases

During the late 1940s and the1950s, under the Bretton Woods system,the United States kept its reserves almost entirely in the form of gold, and did not hold significant foreign currency balances. Since the U.S. role in the foreign exchange markets was entirely passive, market intervention and financing market intervention were not an issue.

In the early 1960s, when the United States began to operate more actively in foreign exchange market and was reluctant to draw down its gold stock, U.S. authorities began practice of establishing reciprocal currency arrangement—or swap line central banks and monetary authorities abroad,as means of gaining rapid access to foreign currencies for market intervention and other purposes.

The foreign currency balances owned by the Treasury’s Exchange Stabilization Fund and by the Federal Reserve System are regularly invested in a variety of instruments that have a high degree of liquidity, good credit quality, and market-related rates of return.A significant portion of the balances consists of German and Japanese government securities, held either directly or under repurchase agreement. As of June 1998, outright holdings of foreign government securities by U.S. monetary authorities totaled $7.1 bn, and government securities held under repurchase agreements by U.S. monetary authorities totaled $10.9 billion. The Federal Reserve Bank of New York makes these various investments for both the Treasury and the Federal Reserve, and the Desk stays in close contact with German and Japanese money market and capital market sources in arranging these transactions.

structure of the foreign exchange market

1.IT IS THE WORLD’S LARGEST MARKET

The foreign exchange market is by far the largest and most liquid market in the world. The estimated worldwide turnover of reporting dealers, at around $1½ trillion a day, is several times the level of turnover in the U.S. Government securities market, the world’s second largest market. Turnover is equivalent to more than $200 in foreign exchange market transactions, every business day of the year, for every man,woman, and child on earth!

The breadth, depth, and liquidity of the market are truly impressive. Individual trades of $200 million to $500 million are not uncommon. Quoted prices change as often as 20 times a minute. It has been estimated that the world’s most active exchange rates can change up to 18,000 times during a single day.2 Large trades can be made, yet econometric studies indicate that prices tend to move in relatively small increments, a sign of a smoothly functioning and liquid market.

While turnover of $1½ trillion per day is a good indication of the level of activity and liquidity in the global foreign exchange market, it is not necessarily a useful measure of other forces in the world economy.Almost two-thirds of the total represents transactions among the reporting dealers themselves—with only onethird accounted for by their transactions with financial and non-financial customers.It is important to realize that an initial dealer transaction with a customer in the foreign exchange market often leads to multiple further transactions, sometimes over an extended period,as the dealer institutions readjust their own positions to hedge, manage, or offset the risks involved.The result is amount of trading with customers of large dealer institution active in the interbank market often accounts for a very small share of that institution’s total foreign exchange activity.

Among the various financial centers around the world, the largest amount of foreign exchange trading takes place in the United Kingdom, even though that nation’s currency—the pound sterling—is less widely traded in the market than several others.As shown in , the United Kingdom accounts for about 32 percent of the global total; the United States ranks a distant second with about 18 percent, and Japan is third with 8 percent. Thus, together, the three largest markets—one each in the European, Western Hemisphere, and Asian time zones—account for about 58 percent of global trading. After these three leaders comes Singapore with 7 percent.

The large volume trading activity United Kingdom reflect London’s strong position as an international financial center where large number financial institutions are located. In the foreign exchange market turnover survey, 213 foreign exchange dealer institutions in the United Kingdom reported trading activity to the Bank of England, compared with 93 in the United States reporting to the Federal Reserve Bank of New York. In foreign exchange trading, London benefits not only from its proximity to major Euro currency credit markets and other financial markets, but also from its geographical location and time zone. In addition to being open when the numerous other financial centers in Europe are open, London’s morning hours overlap with the late hours in a number of Asian and Middle East markets; London’s afternoon sessions correspond to the morning periods in the large North American market. Thus,surveys have indicated that there is more foreign exchange trading in dollars in London than in the United States, and more foreign exchange trading in marks than in Germany. However, the bulk of trading in London, about 85 percent, is accounted for by foreign-owned (non-U.K. owned) institutions,with U.K.-based dealers of North American institutions reporting 49 percent, or three times the share of U.K.-owned institutions there.

2. IT IS A TWENTY-FOUR HOUR MARKET

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

The international date line is located in the western Pacific, and each business day arrives first in the Asia-Pacific financial centers — first Wellington, New Zealand, then Sydney, Australia, followed by Tokyo, Hong Kong, and Singapore. A few hours later, while markets remain active in those Asian centers, trading begins in Bahrain and elsewhere in the Middle East. Later still, when it is late in business day in Tokyo, markets in Europe open for business. Subsequently, when it is early afternoon in Europe, trading in New York and other U.S. centers starts. Finally, completing the circle, when it is mid- or late-afternoon in the United States, the next day has arrived in the Asia-Pacific area, the first markets there have opened, and the process begins again.

The twenty-four hour market means that exchange rates and market conditions can change at any time in response to developments that can take place at any time. It also means that traders and other market participants must be alert to the possibility that a sharp move in an exchange rate can occur during an off hour, elsewhere in the world.The large dealing institutions have adapted to these conditions, and have introduced various arrangements for monitoring markets and trading on a twenty-four hour basis. Some keep their New York or other trading desks open twenty-four hours a day, others pass the torch from one office to the next, and still others follow different approaches.

3. THE MARKET IS MADE UP OF AN INTERNATIONAL NETWORK OF DEALERS

The market consists of a limited number of major dealer institutions that are particularly active in foreig exchange, trading with customers and with each other.Most,but not all,are commercial banks and investment banks. These dealer institutions are geographically dispersed, located in numerous financial centers around the world. Wherever located, these institutions are linked to,and close communication with,each other through telephones, computers, and other electronic means.

There are 2,000 dealer institutions whose foreign exchange activities are covered by Bank for International Settlements’ central bank survey, and essentially, make up global foreign exchange market. A much smaller sub-set of those institutions account for the bulk of trading and market-making activity. It is estimated that there are 100- 200 market-making banks worldwide; major players are fewer than that.

Accordingly, a bank in the United States is likely to trade foreign exchange at least as frequently with banks in London, Frankfurt, and other open foreign centers as with other banks in the United States. Surveys indicate that when major dealing institutions in the United States trade with other dealers, 58 percent of the transactions are with dealers located outside the United States.The United States is not unique in that respect. Dealer institutions in other major countries also report that more than half of their trades with dealers that are across borders; dealers also use brokers located both domestically and abroad.

4. THE MARKET’S MOSTWIDELY TRADED CURRENCY IS THE DOLLAR

The dollar by far the most widely traded currency.According to the 1998 survey,the dollar was one of the two currencies involved in an estimated 87 percent of global foreign exchange transactions, equal to about $1.3 trillion a day. In part, the widespread use of the dollar reflects its substantial international role as: “investment” currency in many capital markets, “reserve” currency held by many central banks, “transaction” currency in many international commodity markets,“invoice” currency in many contracts, “intervention” currency employed by monetary authorities in market operations to influence their own exchange rates.

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

1. WHY WE NEED FOREIGN EXCHANGE

Almost every nation has its own national currency or monetary unit—its dollar, its peso, its rupee—used for making and receiving payments within its own borders. But foreign currencies are usually needed for payments across national borders. Thus, in any nation whose residents conduct business abroad or engage in financial transactions with persons in other countries, there must be a mechanism for providing access to foreign currencies, so that payments can be made in a form acceptable to foreigners. In other words, there is need for“foreign exchange” transactions—exchanges of one currency for another.

2. WHAT “FOREIGN EXCHANGE” MEANS

“Foreign exchange” refers to money denominated in the currency of another nation or group of nations. Any person who exchanges money denominated in his own nation’s currency for money denominated in another nation’s currency acquires foreign exchange.That holds true whether.the amount of the transaction is equal to a few dollars or to billions of dollars; whether the person involved is a tourist cashing a traveler’s check in a restaurant abroad or an investor exchanging hundreds of millions of dollars for the acquisition of a foreign company; and whether the form of money being acquired is foreign currency notes, foreign currencydenominated bank deposits, or other shortterm claims denominated in foreign currency. A foreign exchange transaction is still a shift of funds,or short-term financial claims, from one country and currency to another. Thus,within the United States, any money denominated in any currency other than the U.S. dollar is, broadly speaking, “foreign exchange.” Foreign exchange can be cash, funds available on credit cards and debit cards, traveler’s checks, bank deposits, or other short-term claims. It is still “foreign exchange” if it is a short-term negotiable financial claim denominated in a currency other than the U.S. dollar.

But,in the foreign exchange market described in this book—the international network of major foreign exchange dealers engaged in high-volume trading around the world—foreign exchange transactions almost always take the form of an exchange of bank deposits of different national currency denominations.If bank agrees to sell dollars for Deutsche marks to another bank, there will be an exchange between the two parties of a dollar bank deposit for a DEM bank deposit.In this book, “foreign exchange” means a bank balance denominated in a foreign (non-U.S.dollar) currency.

3. ROLE OF THE EXCHANGE RATE

The exchange rate is a price—the number of units of one nation’s currency that must be surrendered in order to acquire one unit of another nation’s currency. There are scores of “exchange rates” for the U.S. dollar. In the spot market, there is an exchange rate for every other national currency traded in that market, as well as for various composite currencies or constructed monetary units such as the International Monetary Fund’s“SDR,”the European Monetary Union’s “ECU,” and beginning in 1999, the “euro.” There are also various “trade-weighted” or “effective” rates designed to show currency’s movements against an average of various other currencies. Quite apart from the spot rates, there are additional exchange rates for other delivery dates, 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 no single, or unique dollar exchange rate in the market, just as there is no unique dollar interest rate in the market.

A market price is determined by the interaction of buyers and sellers that market, and a market exchange rate between two currencies is determined by the interaction of the official and private participants in the foreign exchange rate market.For a currency with an exchange rate that is fixed, or set by the monetary authorities, the central bank or another official body is a key participant in the market, standing ready to buy or sell the currency as necessary to maintain the authorized pegged rate or range.But in the United States, where the authorities do not intervene in the foreign exchange market on a continuous basis to influence the exchange rate, market participation is made up of individuals, nonfinancial firms, banks, official bodies, and other private institutions from all over the world that are buying and selling dollars at that particular time.

The participants in the foreign exchange market are thus a heterogeneous group. Some of the buyers and sellers may be involved in the “goods” market, conducting international transactions for the purchase or sale of merchandise. Some may be engaged in “direct investment” in plant and equipment, or in “portfolio investment,” dealing across borders in stocks and bonds and other financial assets, while others may be in the “money market,” trading short-term debt instruments internationally.The various investors, hedgers, and speculators may be focused on any time period, from a few minutes to several years. But, whether official or private,and whether 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 of the currencies involved, and they all play a role in determining the market exchange rate at that instant. Given the diverse views, interests, and time frames of the participants, predicting the future course of exchange rates is a particularly complex and uncertain business. At the same time, since the exchange rate influences such a vast array of participants and business decisions, it is a pervasive and singularly important price in an open economy,influencing consumer prices, investment decisions, interest rates, economic growth, the location of industry, and much else. The role of the foreign exchange market in the determination of that price is critically important.

4. PAYMENT AND SETTLEMENT SYSTEMS

Just as each nation has its own national currency, so also does each nation have its own payment and settlement system— that is, its own set of institutions and legally acceptable arrangements for making payments and executing financial transactions within that country, using its national currency. “Payment” is the transmission of an instruction to transfer value that results from a transaction in the economy, and “settlement” is the final and unconditional transfer of the value specified in a payment instruction. Thus, if a customer pays a department store bill by check, “payment” occurs when the check is placed in the hands of the department store, and “settlement” occurs when the check clears and the department store’s bank account is credited. If the customer pays the bill with cash, payment and settlement are simultaneous.

When two traders enter a deal and agree to undertake a foreign exchange transaction, they are agreeing on the terms of a currency exchange and committing the resources of their respective institutions to that agreement.But the execution of that exchange—the settlement—does not take place until later. Executing a foreign exchange transaction requires two transfers of money value, in opposite directions, since it involves the exchange of one national currency for another. Execution of the transaction engages the payment and settlement systems of both nations, and those systems play a key role in the operations of the foreign exchange market.

Payment systems have evolved and grown more sophisticated over time. At present, various forms of payment are legally acceptable in the United States—payments can be made, for example, by cash, check, automated clearinghouse (a mechanism developed as a substitute for certain forms of paper payments), and electronic funds transfer (for large value transfers between banks). Each of these accepted forms of payment has its own settlement techniques and arrangements. By number of transactions,most payments in the United States are still made with cash (currency and coin) or checks. However, the electronic funds transfer systems, which account for less than 0.1 percent of the number of all payments transactions in the United States, account for more than 80 percent of the value of payments.Thus, electronic funds transfer systems represent a key and indispensable component of the payment and settlement systems. It is the electronic funds transfer systems that execute the inter-bank transfers between dealers in the foreign exchange market. The two electronic funds transfer systems operating in the United States are CHIPS (Clearing House Interbank Payments System), a privately owned system run by the New York Clearing House,and Fedwire, a system run by the Federal Reserve.

Other countries also have large-value interbank funds transfer systems, similar to Fedwire and CHIPS in the United States. In the United Kingdom, the pound sterling leg of a foreign exchange transaction is likely to be settled through CHAPS—the Clearing House Association Payments System, an RTGS system whose member banks settle with each other through their accounts at the Bank of England. In Germany, the Deutsche mark leg of a transaction is settled through EAF—an electronic payments system where settlements are made through accounts at Germany’s central bank, the Deutsche Bundesbank. A new payment system, named Target, has been designed to link RTGS systems within the European Community, to enable participants to handle transactions in the euro upon its introduction on January 1, 1999.

Globally, more than 80 percent of global foreign exchange transactions have a dollar leg. Thus, the amount of daily dollar settlements is huge, one trillion dollars per day or more. The settlement of foreign exchange transactions accounts for the bulk of total dollar payments processed through CHIPS each day. The matter of settlement practices is of particular importance to the foreign exchange market because of “settlement risk,” the risk that one party to a foreign exchange transaction will pay out the currency it is selling but not receive the currency it is buying. Because of time zone differences and delays caused by the banks’ own internal procedures and corresponding banking arrangements, a substantial amount of time can pass between a payment and the time the counter-payment is received—and a substantial credit risk can arise.

trading foreign exchange: a changing market in a changing world

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.

1. HOW THE GLOBAL ENVIRONMENT HAS CHANGED

Since the early 1970s, with increasing internationalization of financial transactions, the foreign exchange market has been profoundly transformed, not only in size, but in coverage, architecture, and mode of operation. That transformation is the result of structural shifts in the world economy and in the international financial system. Among the major developments that have occurred in the global financial environment are the following:

A basic change in the international monetary system, from the fixed exchange rate “par value” requirements of Bretton Woods that existed until the early 1970s to the flexible legal structure of today, in which nations can choose to float their exchange rates or to follow other exchange rate regimes and practices of their choice.

A tidal wave of financial deregulation throughout the world, with massive elimination of government controls and restrictions in nearly all countries, resulting in greater freedom for national and international financial transactions, and in greatly increased competition among financial institutions, both within and across national borders.

A fundamental move toward institutionalization and internationalization of savings and investment, with funds managers and institutions around the globe having vastly larger sums available, which they are investing and diversifying across borders and currencies in novel ways and in ever larger amounts as they seek to maximize returns.

A broadening and deepening trend toward international trade liberalization, within a framework 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.

Major advances in technology, making possible instantaneous real-time transmission of vast amounts of market information worldwide, immediate and sophisticated manipulation of that information to identify and exploit market opportunities,and rapid and reliable execution of financial transactions—all occurring with a level of efficiency and reduced costs not dreamed possible a generation earlier.

Breakthroughs in the theory and practice of finance, resulting not only in the development of innovative new financial instruments and derivative products, but also in advances in thinking that have changed our understanding of the financial system and our techniques for operating within it.

The common theme underlying all of these developments is the role of markets—the growth and development of markets, enhanced freedom and competition in markets, improvements in th efficiency of markets,increased reliance on market forces and mechanisms, and the creation of better market techniques and instruments.

The interplay of these forces, feeding off each other in a dynamic and synergistic way, created a global environment of creativity and ferment. In the 1970s, exchange rates became more volatile and imbalances in international payments grew much 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 to expand, which—at a time of rapid technological advance—provided fertile ground for the development of new financial products and mechanisms. These innovations helped market participants circumvent existing controls and encouraged further moves toward deregulation, which led to additional new products, facilitated the financing of still larger imbalances, and encouraged a trend toward institutionalization of savings and diversification of investment. Financial markets grew progressively larger and more sophisticated, integrated, and efficient.

In that environment, foreign exchange trading increased rapidly and changed intrinsically. The market has expanded from one of banks to one in which many other kinds of financial and non-financial institutions also participate— including nonfinancial corporations, investment firms, pension funds, and hedge funds. Its focus has broadened from servicing importers and exporters to handling the vast amounts of overseas investment and other capital flows that currently take place. It has evolved from a series of loosely connected national financial centers to a single integrated international market that plays a far more extensive and direct role in our economies, affecting all aspects of our lives and our prosperity.

2. HOW FOREIGN EXCHANGE TURNOVER HAS GROWN

In 1998, the Federal Reserve’s most recently published survey of reporting dealers in the United States estimated that foreign exchange 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 1995 and more than 60 times the turnover in 1977, the first year for which roughly comparable survey data are available.

In some ways, this estimate understates the growth and the present size of the U.S. foreign exchange market. The $351 billion estimated daily turnover covered only the three traditional instruments in the “over-the -counter” (OTC) market—spot, outright forwards, and foreign exchange (FX) swaps; it did not include over-thecounter currency options and currency swaps traded 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 products traded, not “over-the -counter,” but in organized exchanges— currency futures and exchange-traded currency options, for which the notional value of the turnover was perhaps $10billion per day!

The global foreign exchange market also has shown phenomenal growth. In 1998, in a survey under the auspices of the Bank for International Settlements (BIS), global turnover of reporting dealers was estimated at about $1.49 trillion per day for the traditional products, plus an additional $97 billion for over-the-counter currency options and currency swaps, and a further $12 billion for currency instruments traded on the organized exchanges. In the traditional products, global foreign exchange turnover, measured in current exchange rates, increased by more than 80 percent between 1992 and 1998.

The expansion in foreign exchange turnover, in the United States and globally, reflects the continuing growth of international trade and the prodigious expansion in global finance and investment during recent years. With respect to trade, the dollar value of United States international transactions in goods and services—the sum of exports and imports— tripled between 1980 and 1995 to around 15 times its 1970 level. International trade in the global economy also has expanded at a rapid pace.World merchandise trade is now more than 2½ times its 1980 level

But international trade cannot account for the huge increase in the U.S. foreign exchange turnover over the past twenty-five years. The enormous expansion of international capital transactions, both here and abroad, has been a dominant force. U.S. international capital inflows, including sales of U.S. bonds and equities to foreigners, acquisition of U.S. factories by foreigners, and bank deposit inflows, have averaged more than $180 billion per year since the mid-80s.

Large and persistent external trade and payments deficits in the United States and corresponding surpluses abroad have contributed to the growth in financing. Through much of the period since 1983, the United States has recorded trade deficits in the range of $100-$200 billion per year, while Japan and, to a lesser extent, Germany have registered substantial trade surpluses. In contrast, all three countries experienced only modest trade deficits or surpluses through the 1960s and early 1970s.

The internationalization of financial activity has increased rapidly.Cross-border bank claims are now nearly five times the level of 15 years ago; as a percentage of the combined GDP of the OECD countries, these claims have risen from about 25 percent in 1980 to about 42 percent in 1995.During that same period, crossborder securities transactions in the three largest economies—United States, Japan, and Germany—expanded from less than 10 percent of GDP to around 70 percent of GDP in Japan and to well above 100 percent of GDP in Germany and the United States . Annual issuance of international bonds has more than quadrupled during the past ten years . Between 1988 and 1993, securities settlements through Euroclear and Cedel—the two main Euro market clearing houses— increased six-fold.

All of this provided fertile ground for growth in foreign exchange trading.