The foreign exchange market is actually an electronic network that connects the world’s major financial centers. In turn, each of these centers is a network of foreign exchange traders, currency trading banks, and investment firms. On any given day, the volume of trading on the foreign exchange market (comprising currency swaps and spot and forward contracts) has grown to an unprecedented $3.2 trillion—an amount greater than the yearly gross domestic product of many small nations.6 Several major trading centers and several currencies dominate the foreign exchange market.
Most of the world’s major cities participate in trading on the foreign exchange market. But in recent years, just three countries have come to account for more than half of all global currency trading: the United Kingdom, the United States, and Japan. Accordingly, most of this trading takes place in the financial capitals of London, New York, and Tokyo.
London dominates the foreign exchange market for historic and geographic reasons. The United Kingdom was once the world’s largest trading nation. British merchants needed to exchange currencies of different nations, and London naturally assumed the role of financial trading center. London quickly came to dominate the market and still does so because of its location halfway between North America and Asia. A key factor is its time zone. Because of differences in time zones, London is opening for business as markets in Asia close trading for the day. When New York opens for trading in the morning, trading is beginning to wind down in London.
Figure 9.1 shows why it is possible to trade foreign exchange 24 hours a day (except weekends and major holidays). Exchanges in at least one of the three major centers (London, New York, and Tokyo) keep the market open for 22 hours a day. Trading does not stop during the two hours these exchanges are closed because other trading centers (including San Francisco and Sydney, Australia) remain open. Also, most large banks active in foreign exchange employ overnight traders to ensure continuous trading.
Although the United Kingdom is the major location of foreign exchange trading, the U.S. dollar is the currency that dominates the foreign exchange market. Because the U.S. dollar is so widely used in world trade, it is considered a vehicle currency—a currency used as an intermediary to convert funds between two other currencies. The currencies most often involved in currency transactions are the U.S. dollar, European Union euro, Japanese yen, and British pound.
Currency used as an intermediary to convert funds between two other currencies.
One reason the U.S. dollar is a vehicle currency is because the United States is the world’s largest trading nation. The United States is so heavily involved in international trade that many companies and banks maintain dollar deposits, making it easy to exchange other currencies with dollars. Another reason is that following the Second World War, all of the world’s major currencies were tied indirectly to the dollar because it was the most stable currency. In turn, the dollar’s value was tied to a specific value of gold—a policy that held wild currency swings in check. Although world currencies are no longer linked to the value of gold (see Chapter 10), the stability of the dollar, along with its resistance to inflation, helps people and organizations maintain their purchasing power better than their own national currencies. Even today, people in many countries convert extra cash from national currencies into dollars.
FIGURE 9.1 Financial Trading Centers by Time Zone
Institutions of the Foreign Exchange Market
So far, we have discussed the foreign exchange market only in general terms. We now look at the three main components of the foreign exchange market: the interbank market, securities exchanges, and the over-the-counter market.
It is in the interbank market that the world’s largest banks exchange currencies at spot and forward rates. Companies tend to obtain foreign exchange services from the bank where they do most of their business. Banks satisfy client requests for exchange quotes by obtaining quotes from other banks in the interbank market. For transactions that involve commonly exchanged currencies, the largest banks often have sufficient currency on hand. Yet rarely exchanged currencies are not typically kept on hand and may not even be easily obtainable from another bank. In such cases, banks turn to foreign exchange brokers, who maintain vast networks of banks through which they obtain seldom traded currencies.
Market in which the world’s largest banks exchange currencies at spot and forward rates.
In the interbank market, then, banks act as agents for client companies. In addition to locating and exchanging currencies, banks commonly offer advice on trading strategy, supply a variety of currency instruments, and provide other risk-management services. They also help clients manage exchange rate risk by supplying information on rules and regulations around the world.
But large banks in the interbank market use their influence in currency markets to get better rates for large clients. Small and medium-sized businesses often cannot get the best exchange rates because they deal only in small volumes of currencies and do so rather infrequently. A small company might get better exchange rate quotes from a discount international payment service.
Clearing mechanisms are an important element of the interbank market. Foreign exchange transactions among banks and foreign exchange brokers happen continuously. The accounts are not settled after each individual trade, but are settled following a number of completed transactions. The process of aggregating the currencies that one bank owes another and then carrying out that transaction is called clearing. Years ago banks performed clearing every day or every two days, and physically exchanged currencies with other banks. Nowadays, clearing is performed more frequently and occurs digitally, which eliminates the need to physically trade currencies.
Process of aggregating the currencies that one bank owes another and then carrying out the transaction.
Securities exchanges specialize in currency futures and options transactions. Buying and selling currencies on these exchanges entails the use of securities brokers, who facilitate transactions by transmitting and executing clients’ orders. Transactions on securities exchanges are much smaller than those in the interbank market and vary with each currency. The leading exchange that deals in most major asset classes of futures and options is the CME Group, Inc. (www.cmegroup.com). The CME Group merged the futures and options operations of the Chicago Board of Trade (www.cbt.com), the Chicago Mercantile Exchange (www.cme.com), and the New York Mercantile Exchange (www.nymex.com). The CME Group’s foreign exchange marketplace is the world’s second largest electronic foreign exchange marketplace with more than $80 billion in daily liquidity.7
Exchange specializing in currency futures and options transactions.
Another exchange is the London International Financial Futures Exchange (www.euronext.com), which trades futures and options for major currencies. In the United States, trading in currency options occurs only on the Philadelphia Stock Exchange (www.phlx.com). It deals in both standardized options and customized options, allowing investors flexibility in designing currency option contracts.8
The over-the-counter (OTC) market is a decentralized exchange encompassing a global computer network of foreign exchange traders and other market participants. All foreign exchange transactions can be performed in the OTC market where the major players are large financial institutions such as Goldman Sachs (www.gs.com).
over-the-counter (OTC) market
Decentralized exchange encompassing a global computer network of foreign exchange traders and other market participants.
GLOBAL MANAGER’S BRIEFCASE Managing Foreign Exchange
■ Match Needs to Providers. Analyze your foreign exchange needs and the range of service providers available. Find a provider that offers the transactions you undertake in the currencies you need and consolidate repetitive transfers. Many businesspeople naturally look to local bankers when they need to transfer funds abroad, but this may not be the cheapest or best choice. A mix of service providers sometimes offers the best solution.
■ Work with the Majors. Money-center banks (those located in financial centers) that participate directly in the foreign exchange market can have cost and service advantages over local banks. Dealing directly with a large trading institution is often more cost effective than dealing with a local bank because it avoids the additional markup that the local bank charges for its services.
■ Consolidate to Save. Save money by timing your international payments to consolidate multiple transfers into one large transaction. Open a local currency account abroad against which you can write drafts if your company makes multiple smaller payments in the same currency. Consider allowing foreign receivables to accumulate in an interest-bearing account locally until you repatriate them in a lump sum to reduce service fees.
■ Get the Best Deal Possible. If your foreign exchange activity is substantial, develop relationships with two or more money-center banks to get the best rates. Also, monitor the rates your company gets over time, as some banks raise rates if you’re not shopping around. Obtain real-time market rates provided by firms like Reuters and Bloomberg.
■ Embrace Information Technology. Every time an employee phones, e-mails, or faxes in a transaction, human error could delay getting funds where and when your company needs them. Embrace information technology in your business’s international wire transfers and drafts. Automated software programs available from specialized service providers reduce the potential for errors while speeding the execution of transfers.
The over-the-counter market has grown rapidly because it offers distinct benefits for business. It allows businesspeople to search freely for the institution that provides the best (lowest) price for conducting a transaction. It also offers opportunities for designing customized transactions. For additional ways companies can become more adept in their foreign exchange activities, see this chapter’s Global Manager’s Briefcase titled, “Managing Foreign Exchange.”
Our discussion of the foreign exchange market so far assumes that all currencies can be readily converted to another in the foreign exchange market. A convertible (hard) currency is traded freely in the foreign exchange market, with its price determined by the forces of supply and demand. Countries that allow full convertibility are those that are in strong financial positions and have adequate reserves of foreign currencies. Such countries have no reason to fear that people will sell their own currency for that of another. Still, many newly industrialized and developing countries do not permit the free convertibility of their currencies. Let’s now take a look at why governments place restrictions on the convertibility of currencies and how they do it.
convertible (hard) currency
Currency that trades freely in the foreign exchange market, with its price determined by the forces of supply and demand.
Goals of Currency Restriction
Governments impose currency restrictions to achieve several goals. One goal is to preserve a country’s reserve of hard currencies with which to repay debts owed to other nations. Developed nations, emerging markets, and some countries that export natural resources tend to have the greatest amounts of foreign exchange. Without sufficient reserves (liquidity), a country could default on its loans and thereby discourage future investment flows. This is precisely what happened to Argentina several years ago when the country defaulted on its international public debt.
A second goal of currency restriction is to preserve hard currencies to pay for imports and to finance trade deficits. Recall from Chapter 5 that a country runs a trade deficit when the value of its imports exceeds the value of its exports. Currency restrictions help governments maintain inventories of foreign currencies with which to pay for such trade imbalances. They also make importing more difficult because local companies cannot obtain foreign currency to pay for imports. The resulting reduction in imports directly improves the country’s trade balance.
A third goal is to protect a currency from speculators. For example, in the wake of the Asian financial crisis years ago, some Southeast Asian nations considered controlling their currencies to limit the damage done by economic downturns. Malaysia stemmed the outflow of foreign money by preventing local investors from converting their Malaysian holdings into other currencies. Although the move also curtailed currency speculation, it effectively cut off Malaysia from investors elsewhere in the world.
A fourth (less common) goal is to keep resident individuals and businesses from investing in other nations. These policies can generate more rapid economic growth in a country by forcing investment to remain at home. Unfortunately, although this might work in the short term, it normally slows long-term economic growth. The reason is that there is no guarantee that domestic funds held in the home country will be invested there. Instead, they might be saved or even spent on consumption. Ironically, increased consumption can mean further increases in imports, making the balance-of-trade deficit even worse.
Policies for Restricting Currencies
Certain government policies are frequently used to restrict currency convertibility. Governments can require that all foreign exchange transactions be performed at or approved by the country’s central bank. They can also require import licenses for some or all import transactions. These licenses help the government control the amount of foreign currency leaving the country.
Some governments implement systems of multiple exchange rates, specifying a higher exchange rate on the importation of certain goods or on imports from certain countries. The government can thus reduce importation while ensuring that important goods still enter the country. It also can use such a policy to target the goods of countries with which it is running a trade deficit.
Other governments issue import deposit requirements that require businesses to deposit certain percentages of their foreign exchange funds in special accounts before being granted import licenses. In addition, quantity restrictions limit the amount of foreign currency that residents can take out of the home country when traveling to other countries as tourists, students, or medical patients.
Finally, one way to get around national restrictions on currency convertibility is countertrade—the practice of selling goods or services that are paid for, in whole or in part, with other goods or services. One simple form of countertrade is a barter transaction, in which goods are exchanged for others of equal value. Parties exchange goods and then sell them in world markets for hard currency. For example, Cuba once exchanged $60 million worth of sugar for cereals, pasta, and vegetable oils from the Italian firm Italgrani. And Boeing (www.boeing.com) has sold aircraft to Saudi Arabia in return for oil. We detail the many different forms of countertrade in Chapter 13.
Practice of selling goods or services that are paid for, in whole or in part, with other goods or services.
1. What are the world’s main foreign exchange trading centers? Identify the currencies most used in the foreign exchange market.
2. Describe the three main institutions of the foreign exchange market.
3. What are the reasons for restrictions on currency conversion? Identify policies governments use to restrict currency conversion.
Bottom LineFOR BUSINESS
Well-functioning financial markets are essential to conducting international business. International financial markets supply companies with the mechanism they require to exchange currencies, and more. Here we focus only on the main implications of these markets for international companies.
International Capital Market and Businesses
The international capital market joins borrowers and lenders in different national capital markets. A company unable to obtain funds in its own nation may use the international capital market to obtain financing elsewhere and allow the firm to undertake an otherwise impossible project. This option can be especially important for firms in countries with small or emerging capital markets.
Similar to the prices of any other commodity, the “price” of money is determined by supply and demand. If its supply increases, its price (in the form of interest rates) falls. The international capital market opens up additional sources of financing for companies, possibly financing projects previously regarded as not feasible. The international capital market also expands lending opportunities, which reduces risk for lenders by allowing them to spread their money over a greater number of debt and equity instruments and benefiting from the fact that securities markets do not move up and down in tandem.