The foreign exchange market is, by most accounts, the oldest, largest, and most extensive financial market in the world. In its most recent triennial survey of foreign exchange markets, the Bank for International Settlements (BIS) estimated that average daily turnover in the global foreign exchange market was $1,190 billion in April 1995. In comparison, average daily turnover during the same period in the next largest financial market--US government securities--was $175 billion (excluding repurchase and reverse repurchase agreements); in the world's ten largest stock markets together, it was a mere $42 billion.
Despite its vast liquidity and geographic breadth--or perhaps, in part, because of them--the foreign exchange market has the capacity to bring modern global financial markets to their knees. Recognizing that the large and numerous cross-border settlements that accompany foreign exchange trading pose a systemic risk, the public and private sectors have proposed various mechanisms for managing this risk.
Despite its vast liquidity and geographic breadth--or perhaps, in part, because of them--the foreign exchange market has the capacity to bring modern global financial markets to their knees. Recognizing that the large and numerous cross-border settlements that accompany foreign exchange trading pose a systemic risk, the public and private sectors have proposed various mechanisms for managing this risk.
The state of the market
Although participants in the foreign exchange market are increasingly scattered around the globe, most transactions still take place in London, New York, and Tokyo. London dominates the foreign exchange markets, with 30 percent of all transactions; New York's share is 16 percent. Tokyo's share, now 10 percent, has been whittled away by the markets of Singapore and Hong Kong, which are fast gaining prominence. Singapore has become the world's fourth largest foreign exchange market, and Hong Kong has overtaken Switzerland to become the fifth largest. Even though 56 percent of the world's foreign exchange transactions are executed in the three largest financial centers, between one-half and three-fourths of daily turnover is cross-border during the centers' business hours, suggesting that one side of many transactions occurs outside of their business hours.
Although participants in the foreign exchange market are increasingly scattered around the globe, most transactions still take place in London, New York, and Tokyo. London dominates the foreign exchange markets, with 30 percent of all transactions; New York's share is 16 percent. Tokyo's share, now 10 percent, has been whittled away by the markets of Singapore and Hong Kong, which are fast gaining prominence. Singapore has become the world's fourth largest foreign exchange market, and Hong Kong has overtaken Switzerland to become the fifth largest. Even though 56 percent of the world's foreign exchange transactions are executed in the three largest financial centers, between one-half and three-fourths of daily turnover is cross-border during the centers' business hours, suggesting that one side of many transactions occurs outside of their business hours.
Market concentration
Nearly two-thirds of daily foreign exchange transactions take place between bank dealers. About 16 percent of transactions involve nonfinancial customers, an increasingly diverse group. Originally, this group consisted primarily of customers executing transactions related to trade; it now includes international investors, speculators, and other new players. The remaining 20 percent of transactions involve financial institutions other than bank dealers, mostly securities firms active in the international debt and equity markets that have entered the foreign exchange market as intermediaries, providing one-stop shopping for their customers.
Despite the growing diversity of customers, market concentration has increased since 1992, as the proportion of trading carried out by the top banks continues to rise. This trend is most evident in the smaller markets, which are being abandoned by foreign banks seeking to consolidate their business in the major centers, but it is also being seen in the major centers. Between 1992 and 1995, the market share of the top ten dealers in Tokyo rose from 44 percent to 51 percent, in New York from 41 percent to 47 percent, and in London from 43 percent to 44 percent. The top 20 banks accounted for 70 percent of daily foreign exchange transactions in New York in 1995, up from 60 percent in 1992, and 68 percent in London, up from 63 percent in 1992. The picture of the foreign exchange market that emerges from the 1995 survey resembles the flight map of a growing airline, in which the hubs are getting bigger and the spokes more numerous--and market participants are increasingly interconnected.
Despite the growing diversity of customers, market concentration has increased since 1992, as the proportion of trading carried out by the top banks continues to rise. This trend is most evident in the smaller markets, which are being abandoned by foreign banks seeking to consolidate their business in the major centers, but it is also being seen in the major centers. Between 1992 and 1995, the market share of the top ten dealers in Tokyo rose from 44 percent to 51 percent, in New York from 41 percent to 47 percent, and in London from 43 percent to 44 percent. The top 20 banks accounted for 70 percent of daily foreign exchange transactions in New York in 1995, up from 60 percent in 1992, and 68 percent in London, up from 63 percent in 1992. The picture of the foreign exchange market that emerges from the 1995 survey resembles the flight map of a growing airline, in which the hubs are getting bigger and the spokes more numerous--and market participants are increasingly interconnected.
Liquidity
The foreign exchange market is highly liquid--transactions tend to be large and are executed frequently. A typical dealing institution writes between 3,000 and 4,000 trading tickets for foreign exchange transactions during an average 24-hour day, and about 50 percent more than that on a busy day. Quoted prices can change 20 times a minute for major currencies, with the dollar-deutsche mark rate changing up to 18,000 times during a single day. During periods of extreme stress, a single dealer may execute a trade every two to four minutes. Single transactions worth between $200 million and $500 million are not uncommon in the foreign exchange market and, at most times, do not affect prices.
While often overshadowed by the spot market, there is a growing and vibrant derivatives market based on foreign exchange. Over-the-counter (OTC) derivative contracts involving foreign exchange accounted for 37 percent of the estimated $47.5 trillion in outstanding notional principal of derivatives contracts at the end of March 1995, as reported by the first BIS survey of derivatives. Since notional principal provides information only about the outstanding face value of the contracts being held and not about their economic value, the BIS estimates their gross market value as well. Foreign exchange contracts account for 64 percent of the gross market value of $2.2 trillion, which itself represents roughly 5 percent of reported notional principal.
Of total OTC derivative contracts, 6 percent were foreign exchange options contracts. While this is still a relatively small percentage, there is keen interest in foreign exchange options products. The hedging strategies of many "exotic" and "plain vanilla" options require the continuous buying and selling of the underlying currencies to maintain risk-free hedges. Thus, they are often written on the most liquid foreign currencies, increasing the volumes traded in the spot market.
While often overshadowed by the spot market, there is a growing and vibrant derivatives market based on foreign exchange. Over-the-counter (OTC) derivative contracts involving foreign exchange accounted for 37 percent of the estimated $47.5 trillion in outstanding notional principal of derivatives contracts at the end of March 1995, as reported by the first BIS survey of derivatives. Since notional principal provides information only about the outstanding face value of the contracts being held and not about their economic value, the BIS estimates their gross market value as well. Foreign exchange contracts account for 64 percent of the gross market value of $2.2 trillion, which itself represents roughly 5 percent of reported notional principal.
Of total OTC derivative contracts, 6 percent were foreign exchange options contracts. While this is still a relatively small percentage, there is keen interest in foreign exchange options products. The hedging strategies of many "exotic" and "plain vanilla" options require the continuous buying and selling of the underlying currencies to maintain risk-free hedges. Thus, they are often written on the most liquid foreign currencies, increasing the volumes traded in the spot market.
Settlement risks
Transactions in the foreign exchange market take place at all hours of the day and night and, more often than not, involve institutions in different national jurisdictions. It is this last feature--the cross-border, cross-time-zone nature of the transactions--that poses the greatest challenge for the efficient settlement of the nearly $2.4 trillion two-way payments or the estimated 250,000 to 300,000 exchanges of currency every day. Large settlements pose at least two types of risk.
Transactions in the foreign exchange market take place at all hours of the day and night and, more often than not, involve institutions in different national jurisdictions. It is this last feature--the cross-border, cross-time-zone nature of the transactions--that poses the greatest challenge for the efficient settlement of the nearly $2.4 trillion two-way payments or the estimated 250,000 to 300,000 exchanges of currency every day. Large settlements pose at least two types of risk.
Herstatt risk
The first has been called Herstatt risk, after Bankhaus Herstatt, which failed to deliver US dollars to counterparties after it was ordered into liquidation by the German authorities in 1974. Banks are exposed to large amounts of cross-border settlement risk because irrevocable settlement of the separate legs of a foreign exchange transaction may be made at different times. For example, delivery of yen to a New York bank's Japanese correspondent bank in Tokyo occurs during Tokyo business hours, while the corresponding delivery of dollars by a New York bank to a Japanese counterparty's US correspondent bank in New York occurs during New York business hours. Since the two national payment systems are never open at the same time, there is the risk that after the first counterparty has delivered one side of the transaction, the other counterparty may go bankrupt and fail to deliver the offsetting currency.
More than 20 years after the collapse of Herstatt, there is still no widely accepted method of quantifying settlement risk. The Foreign Exchange Committee, a private sector group sponsored by the Federal Reserve Bank of New York, was the first to survey foreign exchange dealers and provide a methodology for examining settlement risk, as well as a set of recommended best practices, in its report, "Reducing Foreign Exchange Settlement Risk." More recently, in March 1996, the Committee on Payment and Settlement Systems of the Group of Ten (the ten industrial countries with the largest economies) released the Allsopp Report, which, building on the earlier methodology, analyzes existing arrangements and sets out a strategy for reducing settlement risk.
More than 20 years after the collapse of Herstatt, there is still no widely accepted method of quantifying settlement risk. The Foreign Exchange Committee, a private sector group sponsored by the Federal Reserve Bank of New York, was the first to survey foreign exchange dealers and provide a methodology for examining settlement risk, as well as a set of recommended best practices, in its report, "Reducing Foreign Exchange Settlement Risk." More recently, in March 1996, the Committee on Payment and Settlement Systems of the Group of Ten (the ten industrial countries with the largest economies) released the Allsopp Report, which, building on the earlier methodology, analyzes existing arrangements and sets out a strategy for reducing settlement risk.
The Allsopp Report found that foreign exchange settlement is not just an intraday phenomenon and that payment lags can initially last at least one to two business days; another one to two business days may then elapse before a bank is assured that it has received the requisite payments. The amount at risk at a bank could exceed three days' worth of trades, so that the exposure to even a single counterparty could exceed a bank's capital. While the risk is only beginning to be recognized and quantified, recent foreign exchange payment defaults, including those of the Bank of Credit and Commerce International (BCCI) and Barings Plc, demonstrate that the risk cannot be ignored.
The liquidity risk
The second risk has to do with the possibility a counterparty will default because of an operational or systems problem that leaves it with insufficient liquidity to make payment. In most cases, operational failures can be resolved within 24 to 48 hours, and overnight funding can be obtained to cover a failed delivery of currency. It is not uncommon, however, to have more than $2 billion outstanding between banks overnight. A large operational failure could surpass the ability of even some of the best-capitalized institutions to access money markets, especially when notice of the failure is received during off-hours in the institution's domestic market or when the undelivered currency is not one in which the exposed institution customarily borrows. This is an especially important issue in emerging markets, where the physical infrastructure for payment and settlement may not be adequate to accommodate transactions that are increasing in size and number.
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