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.