Organization of The Foreign Exchange Market

If there were a single international currency, there would be no need for a foreign exchange market. As it is, in any international transaction, at least one party is dealing in a foreign currency. The purpose of the foreign exchange market is to permit transfers of purchasing power denominated in one currency to another—that is, to trade one currency for another currency. For example, a Japanese exporter sells automobiles to a U.S. dealer for dollars, and a U.S. manufacturer sells machine tools to a Japanese company for yen. Ultimately, however, the U.S. company will likely be interested in receiving dollars, whereas the Japanese exporter will want yen. Similarly, an American investor in Swiss-franc-denominated bonds must convert dollars into francs, and Swiss purchasers of U.S. Treasury bills require dollars to complete these transactions. It would be inconvenient, to say the least, for individual buyers and sellers of foreign exchange to seek out one another, so a foreign exchange market has developed to act as an intermediary.

Most currency transactions are channeled through the worldwide interbank market, the wholesale market in which major banks trade with one another. This market, which accounts for about 95% of foreign exchange transactions, is normally referred to as the foreign exchange market. It is dominated by about 20 major banks. In the spot market, currencies are traded for immediate delivery, which is actually within two business days after the transaction has been concluded. In the forward market, contracts are made to buy or sell currencies for future delivery Spot transactions account for about 33% of the market, with forward transactions accounting for another 12%. The remaining 55% of the market consists of swap transactions, which involve a package of a spot and a forward contract.1

The foreign exchange market is not a physical place; rather, it is an electronically linked network of banks, foreign exchange brokers, and dealers whose function is to bring together buyers and sellers of foreign exchange. The foreign exchange market is not confined to any one country but is dispersed throughout the leading financial centers of the world: London, New York, Paris, Zurich, Amsterdam, Tokyo, Hong Kong, Toronto, Frankfurt, Milan, and other cities.

Trading has historically been done by telephone, telex, or the SWIFT system. SWIFT (Society for Worldwide Interbank Financial Telecommunications), an international bank-communications network, electronically links all brokers and traders. The SWIFT network connects more than 7,000 banks and broker-dealers in 192 countries and processes more than five million transactions a day, representing about $5 trillion in payments. Its mission is to transmit standard forms quickly to allow its member banks to process data automatically by computer. All types of customer and bank transfers are transmitted, as well as foreign exchange deals, bank account statements, and administrative messages. To use SWIFT, the corporate client must deal with domestic banks that are subscribers and with foreign banks that are highly automated. Like many other proprietary data networks, SWIFT is facing growing competition from Internet-based systems that allow both banks and nonfinancial companies to connect to a secure payments network.

Foreign exchange traders in each bank usually operate out of a separate foreign exchange trading room. Each trader has several telephones and is surrounded by terminals displaying up-to-the-minute information. It is a hectic existence, and many traders burn out by age 35. Most transactions are based on verbal communications; written confirmation occurs later. Hence, an informal code of moral conduct has evolved over time in which the foreign exchange dealers’ word is their bond. Today, however, much of the telephone-based trading has been replaced by electronic brokering.

Although one might think that most foreign exchange trading is derived from export and import activities, this turns out not to be the case. In fact, trade in goods and services accounts for less than 5% of foreign exchange trading. More than 95% of foreign exchange trading relates to cross-border purchases and sales of assets, that is, to international capital flows.

Currency trading takes place 24 hours a day, but the volume varies depending on the number of potential counterparties available. Exhibit 7.1 indicates how participation levels in the global foreign exchange market vary by tracking electronic trading conversations per hour.

The Participants

The major participants in the foreign exchange market are the large commercial banks; foreign exchange brokers in the interbank market; commercial customers, primarily multinational corporations; and central banks, which intervene in the market from time to time to smooth exchange rate fluctuations or to maintain target exchange rates. Central bank intervention involving buying or selling in the market is often indistinguishable from the foreign exchange dealings of commercial banks or of other private participants.