Foreign Exchange markets

This IFSL report gives an overview of the foreign exchange market, the
largest and most liquid financial market in the world. The rapid growth in the
volume of foreign exchange turnover over the past two decades reflects the
continuing growth of international trade and expansion in global finance and
investment. The UK, and London in particular, is by far the largest global
market for foreign exchange trading, well ahead of the US and Japan.
OVERVIEW OF THE MARKET
Size of market Average daily turnover in traditional foreign exchange
market transactions totalled a record $3.2 trillion in April 2007 (Chart 1)
according to a triennial survey published by the Bank for International
Settlements (BIS). Overall turnover, including non-traditional foreign
exchange derivatives and products traded on exchanges, averaged nearly
$3.6 trillion a day.
Foreign exchange trading increased by 70% between 2004 and 2007. The
increase was broad-based across all instruments and was due to a number of
factors: growing importance of foreign exchange as an asset class; an
increase in fund management assets, particularly of hedge funds and pension
funds and growth of financial derivatives. The diverse selection of execution
venues and development of electronic platforms has also made it easier for
retail traders to access the market.
Traditional foreign exchange instruments which include spot transactions,
outright forwards and foreign exchange swaps accounted for nearly 90% of
global turnover in April 2007. Over-the-counter (OTC) currency swaps and
options generated 8.1% of turnover and foreign exchange futures and options
traded on derivatives exchanges the remainder.
Trading locations Because foreign exchange is an OTC market where
brokers/dealers negotiate directly with one another, there is no central
exchange or clearing house. The UK was the main geographic centre for
foreign exchange trading having extended its share of the global total from
31% to 34% between 2004 and 2007. Most other large centres showed a
decline in their share during this period, US from 19% to 17%, Japan from
8% to 6% and Germany, from 5% to 3%. Singapore increased its share, from
5% to 6%. Most of the remainder was accounted for by Switzerland,
Australia, Canada, France and Hong Kong.
London as a centre for foreign exchange trading Average daily turnover on
the UK’s foreign exchange market totalled $1,359bn in April 2007, with a
further $80bn traded in currency derivatives. This was 80% up on the total
three years earlier. Twice as many dollars are traded on the foreign exchange
market in the UK than in the US, and more than twice as many euros are
traded in the UK than in all the euro-area countries combined. The bulk of
trading in the UK was conducted in London which is by far the largest
global centre for foreign exchange business.
1
1 April; 2 spot transactions, outright forwards and fx swaps
3 currency swaps and options & exchange traded contracts
Source: Bank for International Settlements; IFSL estimates
US dollars
(billions)1
Chart 1 Average daily turnover of global
foreign exchange
0
500
1000
1500
2000
2500
3000
3500
4000
Other foreign exchange instruments
Traditional markets
2007 2006 2004 2001 1998 1995 1992 1989 1986
0
20
40
60
80
100
2007 2006 2004 2001
Source: Bank for International Settlements; IFSL estimates
% share
Chart 2 Main countries for foreign exchange
trading
Other
Germany
Singapore
Japan
US
UK 31.3%
4.9%
31.1%
5.2%
8.3%
19.2%
31.2%
5.5%
32.3%
6.2%
9.1%
15.7%
32.4%
3.9%
32.2%
5.7%
7.6%
18.2%
34.1%
2.5%
35.0%
5.8%
6.0%
16.6%
DECEMBER 2007 WWW.IFSL.ORG.UK/RESEARCH
FOREIGN EXCHANGE
2007
IFSL RESEARCH
In partnership with:
Foreign owned institutions, accounted for close to 70% of foreign exchange
trading in London in April 2007. EU institutions alone generated more than
a quarter of the overall total. The 250 foreign banks located in London exceed
that of any other city (Chart 4). Although their share has decreased somewhat
during the past decade, foreign banks still held the majority (53%) of UK
banking sector assets at the of 2006.
London’s leading position as a centre for foreign exchange trading reflects its
position as the main financial centre in Europe and the leading global
international financial centre. Some of the many factors which contribute to
this are listed above. Around a half of European investment banking activity
is conducted through London, which is also Europe’s main centre for primebrokerage
services. This is particularly important for the growing hedge fund
sector. Although prime brokers are usually associated with equities, foreign
exchange prime broking is increasing in importance reflecting the rise of
foreign exchange as an asset class.
CHARACTERISTICS OF THE FOREIGN EXCHANGE MARKET
A foreign exchange transaction is a transfer of funds, from one country and
currency to another. The exchange rate is a price, i.e. the number of units of
one currency that buys one unit of another currency. The market exchange
rate is determined by the interaction of the official participants in the market
(governments) and private buyers and sellers.
The foreign exchange market consists of the Interbank market, customers
(banks, corporations, individuals, fund managers, etc.) and derivatives
exchanges.
The Interbank market is a wholesale
market which does not have a
centralized location for trading
(Chart 5). Participants in this
market, mostly commercial and
investment banks, trade directly
with each other or through brokers.
Business is conducted over the
telephone or electronically.
The foreign exchange market is a
IFSL Foreign Exchange - December 2007
2
1 OTC currency swaps and options; 2 as defined in Chart 1
3 April
Source: Bank for International Settlements, Bank of England
Chart 3 UK foreign exchange market average
daily turnover
US dollars
billion3
0
300
600
900
1,200
1,500
2007 2004 2001 1998 1995 1992
Traditional markets2
Non-traditional derivatives1
Main advantages of London as a centre for foreign exchange trading
- A central geographical location and position between the US and Asian timezones;
- Easy access to markets combined with a tradition of welcoming foreign firms;
- High quality professional and support services;
- Substantial physical assets, particularly office accommodation;
- Efficient telecommunications infrastructure;
- Concentration of financial institutions. London has more foreign banks than any other
centre.
- Perception of a proportionate approach in its regulatory climate;
- Use of the English language.
Source: Prentice Hall
Chart 5 Structure of the foreign-exchange market
Foreign exchange
brokers
OTC interbank
market
(spot and forward
transactions)
Banks Banks Clients Clients
Securities brokers Securities brokers Securities Exchanges
(futures and options)
1 31/12/04
Source: Bank of England, Bank of Japan, US Federal Reserve,
Banque de France, European Banking Federation
Number, March 2005
Chart 4 Branches and subsidiaries of
foreign banks
0
50
100
150
200
250
300
Tokyo Frankfurt Paris1 New York London
24-hour market. The trading day begins in Asia, extends into Europe and then
into the US. As Chart 6 shows, trading activity is highest when major
markets overlap, particularly early in the morning European time and at the
opening of the North American markets.
In foreign exchange every position involves buying one currency and selling
another so as long as there are movements in the exchange rate the
potential for profit exists. The leverage in this market can be high and traders
can take both long and short positions as short selling is virtually
unrestricted. Leverage in this market means that actual funds required to
open a transaction can sometimes amount to only 1% or 2% of the value of
the opened position. One of the few limitations in the foreign exchange
market is that some emerging market countries exercise exchange control and
prevent their currencies from being freely traded. Due to the high liquidity of
the foreign exchange market the cost of trading is typically lower than on
other financial markets.
FOREIGN EXCHANGE AS AN ALTERNATIVE INVESTMENT
Foreign exchange has developed into an asset class (a type of investment
such as for example stocks or bonds) over the past decade. This is partly
because it is uncorrelated to any other asset class. Pressures on fund
managers to deliver greater returns from their assets have led them to
looking outside traditional asset classes. As the world’s largest over-thecounter
market, foreign exchange is attractive to investors due to its deep
liquidity, volatility, and low-cost per trade. Although there is no widely
followed benchmark for foreign exchange, Deutsche Bank’s Currency index
can be used as an indicator of annual returns of generic foreign exchange
strategies (Chart 7).
Traditional instruments generated 90% of foreign exchange turnover in April
2007. This included spot transactions, which accounted for 31% of
traditional trading (down from 38% in 1998), outright forwards 11% (up
from 9% in 1998) and foreign exchange swaps 53% (up from 49%) (Chart 8).
Non-traditional transactions were in OTC currency swaps and options which
generated 8.1% of overall turnover and exchange traded contracts 2.0%.
3
IFSL Foreign Exchange - December 2007
Historical overview of the foreign exchange market
Many centuries ago, the value of goods were expressed in terms of other goods. Eventually
forms of metal like bronze, silver and gold came to be used to facilitate the exchange of
merchandise. Coins were eventually minted from metal in stable political regimes. During the
late middle ages, a variety of paper IOUs started gaining popularity as an exchange medium and
these formed the basis for the development of currencies.
Eventually most countries supported their currencies with convertability to gold. This was the
basis of the gold standard. The Bretton Woods accord in July 1944 fixed the
dollar to 35 dollars per ounce and other currencies to the dollar. This peg came under
increasing pressure as national economies moved in different directions during the 1960s. In
1971, president Nixon suspended convertibility to gold and in 1973 the Group of Ten industrial
nations allowed their currencies to 'float' against each other. In 1978, the free-floating system
was officially mandated.
0
20
40
60
80
100
2007 2004 2001 1998
1incomplete reporting of deals or incomplete coverage of the
range of transactions
Source: Bank for International Settlements
Chart 8 Global foreign exchange market
turnover by transaction type
% share of traditional
market instruments
Spot transactions
Gaps in reporting1
Outright forwards
Foreign exchange
swaps
5%
31%
53%
11%
4%
38%
49%
9%
Source: Reuters
Electronic conversations per hour (1992-1993), London time
Chart 6 Time-of-day turnover of global
foreign exchange
0
5,000
10,000
15,000
20,000
25,000
30,000
35,000
40,000
45,000
2300 2100 1900 1700 1500 1300 1100 900 700 500 300 100
Asia
coming
in
Europe
going
out
US
coming
in
Europe
coming
in
US
going
out
Asia
going
out
Average number
Peak number
1 Risk adjusted return on investment
2 Annualised return in excess of the risk-free return
Source: Deutsche Bank
% for excess return, value for Sharpe Ratio1
Chart 7 Annual returns by asset class
2.5%
0.79
3.9%
0.25
3.5%
0.60
0.0
0.5
1.0
1.5
2.0
2.5
3.0
3.5
4.0
Sharpe Ratio1
Excess return2
Deutsche Bank
Currency Index
Equities Bonds
Main trading currencies The dollar is by far the most widely traded
currency. This is because of its multiple roles: as an investment currency in
many capital markets; a reserve currency for many central banks (Chart 14);
a transaction currency in many international commodity markets; and an
invoice currency in many contracts.
The US dollar was involved in 86% of foreign exchange transactions in April
2007, followed by the euro 37%, Japanese yen 17%, pound sterling 15%,
Swiss franc 7% and Australian dollar 7% (Chart 9). Because two currencies
are involved in each transaction, the sum of the percentage shares of
individual currencies totals 200%. Sterling’s share fell from 17% in 2004 to
15% in 2007 but was still up on its 9% share a decade earlier. The shares of
other leading currencies also fell as trading in emerging market currencies
increased.
US dollar/euro was the most widely traded currency pair in April 2007 with
27% of overall turnover. US dollar/yen was the next most traded currency
pair, generating 13% of turnover, followed by US dollar/pound sterling with
12% and US dollar/Swiss franc with 5% (Chart 10). Emerging market
IFSL Foreign Exchange - December 2007
4
Source: Bank for International Settlements
Chart 10 Foreign exchange turnover
by currency pair
$bn
0
100
200
300
400
500
600
700
800
900
April 2007
April 2004
EUR/JPY USD/CHF USD/GBP USD/JPY USD/EUR
Types of foreign exchange trading
Investors can trade directly or indirectly in foreign exchange through foreign exchange OTC
instruments and exchange traded contracts:
a) OTC instruments are traded on the global Interbank market and include:
Outright contracts Straightforward exchanges of one currency for another that are conducted
on the Interbank market with various settlement dates:
- Spot transactions settle two business days after the deal date. The spot rate is the current
market price.
- Forward transactions are settled on any pre-agreed date three or more business days after the
deal date.
Foreign exchange swaps are transactions where one currency is swapped for another and than
swapped back at a pre-agreed rate on a pre-arranged date;
Currency swaps are transactions where counterparties exchange and re-exchange both
principal and streams of fixed or floating interest payments in two different currencies;
OTC currency options An option is a contract that gives the holder the right, but not the
obligation to buy or sell a currency at a specified price within a specific time frame. OTC
currency options are customised options where no clearing house stands between the two
parties.
b) Exchange-traded contracts cover trade in a number of foreign exchange products through
organised derivatives exchanges. US exchanges account for around 90% of trading in foreign
exchange contracts:
Currency futures are contracts for future delivery of a specified unit of foreign
currency at a fixed price at a specified date. Futures contracts are in standard amounts,
whereas forward contracts are once-only transactions.
Exchange traded currency options are options traded in standardized contracts and amounts for
a limited number of currencies and maturity dates.
Source: Bank for International Settlements
Chart 9 Currency distribution of reported
foreign exchange market turnover
% share
Other
Pound
Sterling
Yen
Euro
US dollar
0
50
100
150
200
2007 2004 2001
86%
15%
45%
17%
37%
90%
13%
36%
23%
38%
89%
17%
37%
20%
37%
currencies accounted for around 6% of market turnover. Their share has
grown in recent years as they offer potential for higher profits although the
risks involved are generally higher.
Exchange rate trends Factors which can influence the level of an exchange
rate include political and economic conditions, most importantly interest rate
differentials and balance of payments imbalances. Governments sometimes
participate in the foreign exchange market to influence the value of their
currency. Chart 11 shows the movements in exchange rates since 1999 of the
three most widely traded currency pairs. The volatility of the US dollar
versus the yen and euro is generally higher than of US dollar/pound sterling.
In the period between the launch of the euro in 1999 and mid-2000 the
dollar appreciated against most major currencies. Since then it has generally
been on a downward trend. The euro weakened against the major currencies
in the two years following its launch but subsequently has been appreciating
(Charts 11 and 12).
MARKET PARTICIPANTS
Foreign exchange traders include governments, commercial and investment
banks, international corporations, fund managers and hedge funds and
individual private investors and speculators.
Interbank market The traditional foreign exchange market is made up of
commercial and investment banks and other financial institutions which
handle spot, outright forwards and foreign exchange swaps on the OTC
market. These major dealer banks developed into an Interbank market for
foreign exchange through their frequent dealings with each other in an effort
to find buyers and sellers of currency. There are around 2,000 dealer
institutions worldwide. This has declined since the mid-1990s due to
mergers and acquisitions.
Dealers In the Interbank market dealers trade foreign exchange directly with
other dealers via the telephone (voice brokers) or through electronic
brokerage systems. Dealing companies are mainly commercial and
investment banks which trade amongst themselves based on strong credit
relationships as part of their system of balancing accounts. Trades are
usually to fill customer orders. Banks also trade on their own account
although these are usually short term positions.
The largest traders deal in all major currencies and cross-trades as well as
some developing countries’ currencies. They also handle forwards, options
and swaps and conduct market research for their customers. Some dealers
act as market makers for a selected number of currencies. Market
makers regularly quote both bid and offer prices for a currency and are
willing to commit their own capital to complete transactions at the prices they
quote.
Inter-dealer trading generated 43% of foreign exchange activity in April 2007
(Chart 13), down from 63% in 1998. The large volume of trading is because
a customer transaction often leads to further multiple transactions as banks
IFSL Foreign Exchange - December 2007
0
20
40
60
80
100
2007 2004 2001 1998
Source: Bank for International Settlements
Chart 13 Global foreign exchange market
turnover by counterparty
% share
With reporting
dealers
With other
financial institutions
43%
17%
40%
63%
17%
20%
With non-financial
customers
5
60
70
80
90
100
110
120
130
2007 2006 2005 2004 2003 2002 2001 2000 1999
1Higher index equals stronger euro
Source: Oanda
index %1,
(100% = 4/1/1999)
Chart 12 Foreign exchange rates of major
non-US dollar currency pairs
euro/british pound
euro/yen
1Higher index equals stronger US dollar
Source: Oanda
index %1,
(100% = 4/1/1999)
Chart 11 Foreign exchange rates of major
currency pairs
70
80
90
100
110
120
130
140
150
2007 2006 2005 2004 2003 2002 2001 2000 1999
US dollar/
euro
US dollar/
British pound
US dollar/yen
readjust their own positions to hedge, manage or offset the risks involved.
Inter-dealer trading as a proportion of total business has fallen over the past
decade due to advances in technology which have reduced the need for
intermediaries.
The largest volume of foreign exchange trading involves large banks. Table
1 shows the estimated market share of leading OTC dealers. This market is
relatively concentrated with Deutsche Bank, UBS AG and City accounting
for more than 40% of trading in May 2007. This was up on the 22% share of
the top three dealers in 2000.
Brokers The role of a broker in the Interbank market is to bring together a
buyer and a seller of a currency in return for a commission. Usually broker
companies quote currency with a spread, that includes their fee. Whereas a
dealer may take one side of a transaction and commit their own capital, a
broker does not take a position and relies purely on the commission received
for the services provided. The share of business conducted through brokers
varies in different countries due to differences in market structure and ranges
from 10-15% in Switzerland and South Africa to around 50% in France,
Netherlands and Ireland.
Clients of banks on the interbank market generated 57% of foreign exchange
turnover in the 2007 BIS survey, of which financial customers 40% and
non-financial customers 17%. Clients include corporations, fund managers,
individuals and central banks. In the past most foreign exchange transactions
were a result of companies’ processing of import and export transactions or
to fund payrolls for international offices. Over the past thirty years, however,
investment in financial assets has increased more rapidly than trade.
Institutional investors, hedge funds and other fund managers are major
participants in the foreign exchange market. Retail investors participation has
also grown rapidly since the mid-1990s. This was facilitated by the advent of
internet trading platforms.
Central banks are also clients on the Interbank market. They are large
players with access to significant capital reserves as shown in Chart 14.
Central banks can buy and sell their domestic currency on the market to
influence exchange rates or may seek to accumulate, reallocate or reduce
their foreign exchange reserves. Many also handle a large proportion of
foreign exchange transactions for the government and other public sector
enterprises.
Speculation versus investment Foreign exchange trading is by nature
speculative. Speculators are attracted to the opportunities that volatile and
changing market conditions create. Some traders take on positions on a
leveraged basis which magnify market movements. Almost anyone who buys
or sells foreign exchange takes a view on the future direction of exchange
rate movements. An arbitrary line can be drawn between those who deal in
currency to insure against exchange rate changes to cover exports or imports
of goods or services, and those who deal in currency aiming to make a
profit on exchange rate fluctuations. Some estimates indicate that as much as
95% of foreign exchange trading is speculative.
IFSL Foreign Exchange - December 2007
6
Source: Euromoney FX survey
% of overall volume, May 2007
Deutsche Bank
UBS AG
Citi
Royal Bank of Scotland
Barclays Capital
Bank of America
HSBC
Goldman Sachs
JPMorgan
Morgan Stanley
Other
19.3
14.9
9.0
8.9
8.8
5.3
4.4
4.1
3.3
2.9
19.1
Table 1 Largest currency traders
Source: Wikipedia, IMF
% share by country
and currency, September 2007
Chart 14 Official foreign exchange reserves
Others
US
1%
Russia
Euro-area
Japan
China
20%
4% 7%
7%
15%
21%
Total: $6,500bn
35%
65%
Other
US
dollar
India
CHANGING STRUCTURE OF THE MARKET
Consolidation and concentration The number of companies providing
foreign exchange dealing services has fallen since the mid-1990s. This
consolidation is largely due to increased competition, falling commissions,
and rising costs related to the development and operation of new systems and
trading platforms. Table 2 shows that the number of banks covering threequarters
of local foreign exchange turnover in major trading countries fell
from 74 to 42 between 1995 and 2004. Comparable data for 2007 was not
available at the time of publishing of this reports but it is likely that
concentration increased further. The UK market for foreign exchange has
become increasingly concentrated over the past decade. As shown in Chart
15, the share of the largest 10 institutions rose from 61% to 70% between
2004 and 2007, continuing the trend from the 1998 and 2001 survey.
Electronic broking and internet There are two basic types of electronic
systems. Those that connect dealers amongst themselves in the Interbank
market and those that connect dealers with customers. Until the early 1990s
all brokered business in the OTC markets was handled by telephone. Over the
past few years electronic broker systems or automated order matching
systems have gained a significant share of the spot Interbank market. This has
increased transparency and allowed smaller banks access to the same prices
traded by the bigger dealers. The market took a giant leap forward when
banks started offering their clients direct access to proprietary platforms with
streaming prices.
Electronic trading of foreign exchange accounted for over 60% of turnover in
2007 according to Tabb Group (Chart 16). This will approach the 80 per cent
mark by 2010. Celent estimates that three-quarters of the interdealer spot
market volume and a half of dealer-to-client volume is traded electronically.
The development of internet trading platforms has made the customer
segment of the foreign exchange business more competitive and has allowed
for the emergence of non-bank service providers. This has also prompted a
greater need for peripheral and add-on services for customers such as, for
example, research. Internet trading remains however, in the early stages of
development and still accounts for only a small percentage of the overall
trading volume.
IFSL Foreign Exchange - December 2007
7
Source: Bank for International Settlements
Number of banks
UK
US
Japan
Germany
Total
Table 2 Number of banks covering 75%
of local foreign exchange turnover
1995
20
20
24
10
74
1998
24
20
19
9
72
2001
17
13
17
5
52
2004
16
11
11
4
42
Source: Bank of England
% share of daily
turnover in
April
Chart 15 Concentration of foreign exchange
market in the UK
0
20
40
60
80
100
Other firms
Next largest 10 firms
Largest 10 firms
2007 2004 2001 1998
70%
20%
10%
61%
19%
20%
58%
22%
20%
50%
19%
31%
Source: TABB Group
% share of
turnover
Chart 16 Electronic trading in FX markets
0
10
20
30
40
50
60
70
80
2010 2009 2008 2007 2006 2000
forecast
IFSL Foreign Exchange - December 2007
LINKS TO OTHER SOURCES OF INFORMATION:
Bank for International Settlements
Triennial central bank survey of foreign exchange and derivatives market activity
www.bis.org
Bank of England
The foreign exchange and over-the-counter derivatives markets in the UK
www.bankofengland.co.uk
European Central Bank
Review of the foreign exchange market structure
www.ecb.int
Federal Reserve Bank of New York
The foreign exchange market in the US
www.ny.frb.org
Foreign Exchange Joint Standing Committee
www.bankofengland.co.uk/markets/forex/fxjsc/index.htm
New York Foreign Exchange Committee
www.newyorkfed.org/fxc
Singapore Foreign Exchange Market Committee
www.sfemc.org
Tokyo Foreign Exchange Market Committee
www.fxcomtky.com/index_e.html
Data files
Datafiles in excel format for all charts and tables published in
this report can be downloaded from the Research section of
IFSL’s website www.ifsl.org.uk
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IFSL Research:
Report author: Marko Maslakovic
Director of Economics: Duncan McKenzie
d.mckenzie@ifsl.org.uk +44 (0)20 7213 9124
Senior Economist: Marko Maslakovic
m.maslakovic@ifsl.org.uk +44 (0)20 7213 9123
International Financial Services London
29-30 Cornhill, London, EC3V 3NF
www.ifsl.org.uk/research
------------------------------------------------------
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© Copyright December 2007, IFSL
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