II The Foreign Exchange Market in International Investment Today: Players, Instruments, and Opportunities

International Monetary Fund
Published Date:
January 1993
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Liberalization and reform of the financial sector have been a common theme in the industrial countries over the past decade; in some of them, liberalization gained momentum even earlier. The competitive forces unleashed by liberalization have swept away market segmentation and have greatly increased the menu of tradable financial instruments.1 Liquid markets in central and local government securities, in corporate debt, in equity, in commercial paper, in bank certificates of deposit, in asset-backed securities, and in both exchange-traded and over-the-counter derivative instruments have become a prominent feature of the financial landscape in most Group of Ten countries. By 1992, the outstanding stock of publicly traded debt and equity securities in Europe and the United States had climbed to about $24 trillion, while the notional amounts of financial derivative instruments outstanding had reached $7 trillion. Retail and institutional investors—both domestic and foreign—now have a wide choice of liquid securities.

Liquid securities markets have grown hand in hand with the increasing concentration of savings in institutional funds (that is, in mutual investment funds, pension funds, insurance portfolios, unit trusts, and SICAVs);2 the role and quantitative importance of these institutional investors are examined in detail in Annex I. Total assets of U.S. institutional investors rose from $2 trillion (66 percent of GNP) in 1981 to $6.5 trillion (133 percent of GNP) in 1990. Similarly, the total assets of U.K. institutional investors climbed from £130 billion (52 percent of GNP) in 1980 to £550 billion (108 percent of GNP) in 1990. U.S. and European fund managers alone now control over $8 trillion in assets (Table 1). Thus investment decisions are becoming increasingly concentrated in the hands of professional fund managers. Simultaneously, as sophisticated information technology expands, “news” relevant to financial decision-making is more and more reaching these managers at the same time, wherever their geographical bases. Consequently, during those periods when fund managers share homogeneous perceptions about both the evolution of financial variables and the impact of news, the potential exists for new information to produce massive purchases/sales and sharp movements in prices.

Table 1.Distribution of Assets Managed by Leading Fund Managers in Europe and the United States, December 31, 19911
Number of FundsTotal AssetsEquityFixed-Income
TotalDomesticForeignTotalDomesticForeignOtherNot Specified
(In millions of U.S. dollars)
United Kingdom411,191,151682,729434,503248,226328,456168,630159,826149,96930,000
United States1004,486,6481,520,4281,366,701153,7271,788,6001,717,99570,6051,165.89111,729
Combined total22008,188,0862,518,6012,006,986511,6153,129,6672,711,047418,6201,543,325996,502
(Total assets as percent of combined total assets)(As percent of respective country total assets)
United Kingdom14.557.336.520.827.614.113.412.62.5
United States54.833.930.53.439.938.31.626.00.2
Combined total2100.030.824.56.338.
Sources: Constructed from data published in Institutional Investor (various issues); and IMF staff estimates.

“Leading” fund managers are the 100 largest managers in Europe and the United States as ranked by total assets. The smallest entities in the European and the U.S. lists had roughly comparable portfolio sizes.

Combined total of the European and the U.S. assets.

Sources: Constructed from data published in Institutional Investor (various issues); and IMF staff estimates.

“Leading” fund managers are the 100 largest managers in Europe and the United States as ranked by total assets. The smallest entities in the European and the U.S. lists had roughly comparable portfolio sizes.

Combined total of the European and the U.S. assets.

The progressive liberalization of cross-border financial flows—in tandem with the growth of liquid domestic securities markets and the increasing clout of institutional portfolio management—has induced growth in international portfolio investment that is historically unprecedented among the major industrial countries. Capital flows within most of the European Community (EC) were completely liberalized by July 1990. Total gross cross-border equity holdings in the United States, Europe, and Japan increased from $800 billion in 1986 to $1.3 trillion in 1991, while total cross-border ownership of tradable securities is estimated to have risen to $2.5 trillion.3 Institutional investors have played an important role in this international portfolio investment, and at present, those in Europe invest a higher proportion (about 20 percent) of their assets abroad than do those in the United States or Japan (where the corresponding percentages seem to fall in the 5-7 percent range). Although these percentages seem modest, the total portfolios under management are large enough to translate into potentially large financial flows. For example, a 4.6 percent share of U.S. pension fund assets means $125 billion, while a 6.6 percent share of U.S. mutual fund assets amounts to roughly $90 billion (see Table 2). Equally significant, the international diversification of institutional investors is widely expected to increase markedly over time. In this regard, the share of foreign-currency-denominated assets in the portfolios of the world’s 300 largest pension funds is estimated to increase from about 7 percent at present to about 12 percent by the mid-1990s.

Table 2.Foreign Investments of Pension and Open-End Mutual Funds for Selected Industrial Countries, 1991
Mutual FundsPension Funds
Total assetsShare of foreign assets in total assetsTotal assetsShare of foreign assets in total assets
(In billions of U.S. dollars)(In percentages)(In billions of U.S. dollars)(In percentages)
United Kingdom100.839.2560.020.0
United States1,346.76.62,725.04.6
Sources: InterSec Research Corporation and Investment Company Institute.
Sources: InterSec Research Corporation and Investment Company Institute.

Another noteworthy development is that relationship buy-and-hold finance is giving way to transactions-driven finance, leading to the observation that it is no longer clear what a “long-term investment” means. Improved liquidity allows investors to move quickly in and out of domestic and international investment positions. Likewise, advances in the technology of financial transactions—ranging from back-office clearance and settlement, to trading and information systems, to settlement of payments-have reduced transactions costs to the point where they less and less serve as an impediment to rearranging portfolios when expectations change. For example, it is increasingly common to see large investors switch between bond and equity funds as soon as expected yields diverge. Also, many of the major equity and government securities markets have become sufficiently liquid to permit automated program trading and hedging strategies. Trading volume in most major markets in the United States, Europe, and Japan has more than tripled in the last five years and is dominated by institutions, which is testimony to the propensity of fund managers to adjust their portfolios in light of changes in expectations. Where the transaction in the spot market is too expensive, the investor has the opportunity to take synthetic positions in the derivatives markets, where daily trading volume has nearly tripled since 1986. Annex II examines the use of foreign exchange instruments to synthesize money market instruments, as well as to implement hedging strategies.

The global forex market has grown even faster than international investing, with net turnover in the three largest markets (London, New York, and Tokyo) estimated to have undergone a threefold increase over the past six years. Market surveys conducted by the Federal Reserve Bank of New York, the Bank of Japan, and the Bank of England suggest that global net turnover now approaches $1 trillion a day (up from $640 billion in April 1989).4

The U.S. dollar remains by far the dominant currency in forex trading (accounting for 76 percent and 89 percent of 1992 net turnover in the London and New York markets, respectively). That being said, the share of cross-currency transactions (those that do not involve the dollar in one leg of the transaction) has gained ground over time, particularly cross-trading involving the deutsche mark—a development that traders ascribe primarily to the limited volatility of the deutsche mark vis-à-vis other ERM currencies (relative to that for dollar/ ERM exchange rates).

The most significant development in foreign exchange markets in recent years has been the expansion of trading in derivative securities. Spot transactions accounted for only 50 percent of gross turnover in the United Kingdom in 1992 versus 73 percent in 1986. In contrast, trading in forwards and swaps increased from 27 percent of gross turnover in 1986 to 47 percent in 1992 (of which only 6 percent involved straight forwards). The expansion of the currency swaps market has been dramatic, with outstanding notional principal increasing more than fourfold to $800 billion between end-1987 and end-1991. The most commonly swapped currency is the U.S. dollar.

Trading in the markets for currency futures and options contracts has also mushroomed. Daily turnover in these markets in London grew from negligible amounts in 1986 to $8 billion in 1992, and from $3 billion to $23 billion in the United States. Most of this activity is in the over-the-counter (OTC) options market (where average daily turnover is reported by dealers to be about $15 billion in the United States and $5 billion in the United Kingdom). Futures market activity in these countries is lower, about $6 billion and $3 billion, respectively.

The main players in the forex market have long been large international banks, securities houses, nonfinancial corporations, and central banks. As suggested earlier, these traditional players have increasingly been joined by a powerful, new set of players, namely, institutional investors (mutual funds, pension funds, insurance companies) and hedge funds. In their forex activities, hedge funds differ from institutional investors in two ways: they are unregulated, and their primary mode of operation is to take highly leveraged, speculative positions (typically using their assets as collateral or initial margin).5

Market activity is dominated by interdealer transactions. Indeed, it has been estimated that each customer order leads to four or five interdealer transactions, as dealers lay off their risk with other dealers, seek to earn profits by taking sometimes large intra-day positions, and engage in frequent price-discovery trades. On first impression, turnover in the forex market may seem startlingly high. But that turnover needs to be compared with that in other liquid markets. To take a specific example, the average daily volume of U.S. Government securities settled through the book entry system amounted to about $400 billion in 1990—on an end-of-year stock of U.S. Treasury marketable debt of $3.4 trillion ($2.6 trillion in the hands of the public). This means that the entire volume of marketable debt turns over on average once every eight days! Since the forex market can be considered a mechanism for pricing tradable wealth internationally, and since the stock of publicly traded debt and equity is probably about $24 trillion, an average daily turnover of $1 trillion in the global forex market is not so remarkable after all; in fact, daily turnover can be expected to continue to increase over time.

The 30-50 largest banks (along with a handful of the largest securities houses) serve as market makers in the key currencies. Banks and securities houses also use the information they gather in market making to help guide their own—albeit usually limited—position-taking. On the whole, banks and securities houses are best seen as intermediaries in the forex market, supplying liquidity and advice to their customers (some of whom will be less constrained in their forex activities). Corporations routinely cover their commercial exposure, funding themselves in the most advantageous markets and using the currency swap market to eliminate the exchange risk. The forex activities of corporate treasury operations have more and more come to be viewed as profit centers. In addition to the normal intervention operations undertaken by virtually all central banks, a relatively small number of central banks manage their (large) international reserve positions quite actively. In institutional funds management, the trend is to separate the exchange risk from the investment risk through hedging, and to treat the exchange risk as just another investment opportunity with its own risk/return profile. Hedge funds, using their capital as collateral, can generally leverage by a factor up to ten to take speculative positions. The hedge funds with superior (long-term) track records of profitability have an influence that is more powerful than might be suggested from their net position-taking, because of their role as market leaders.

A summary of the existing regulatory constraints on foreign-currency-denominated investments for banks and institutional investors in the larger industrial countries is presented in Table 3; these constraints are discussed in more detail in Annex III. In short, these constraints differ across types of financial institutions, as well as across countries—to say nothing of differences between financial and non-financial corporations. For example, whereas some Group of Ten countries have a standard limit on net open forex positions by banks relative to capital, others prefer to set limits on an individual bank-to-bank basis (with higher limits for banks with superior risk-management systems) as part of overall bank examination. Hedge funds and nonfinancial corporations are not subject to any regulation at all with respect to their forex activities. Securities houses also typically are not required to hold dedicated capital against open forex positions. As seen in Table 3, mutual funds, insurance companies, and pensions are usually subject to some type of “prudence rule” on their foreign-currency-denominated investments, but such prudent behavior is not uniformly defined. Existing prudential constraints are generally not binding, and internal risk-management guidelines tend to be more restrictive. In other words, whereas the existing regulatory framework prevents some players in the forex market from making large-scale currency speculation their main line of business, it does not much constrain the private sector’s ability to shift its currency preferences quickly.

Table 3.Regulatory Constraints on Foreign-Currency-Denominated Investments by Major Financial Institutions in Selected Industrial Countries1
Country/RegionBanksPension FundsInsurance CompaniesMutual Funds
FranceThe net foreign exchange position is limited to 15 percent of own funds for each currency and 40 percent overall.Investments are subject to the matching assets rule; the location rule; and the allocation of assets rule.Subject to disclosure and asset diversification rules. A fund may not hold more than 10 percent of any one category of securities of one issuer.
GermanyNet open foreign exchange positions (spot and forward combined) at the close of each business day must not exceed 30 percent of the liable capital.No more than 5 percent of assets can be invested in overseas bonds.Investment must adhere to the principle of localization; the principle of congruence, which matches the asset side with the liability side of an insurance company’s balance sheet to avoid currency risks.
ItalyCurrently no formal restrictions on foreign exchange position. New prudential provisions for foreign exchange exposure are to be introduced.Investment is subject to the matching requirement, i.e., commitments in a currency must be covered by assets denominated in the same currency.May not invest more than 5 percent of their resources in securities issued by the same company if quoted or more than 10 percent if unquoted on a stock exchange, and may borrow up to 10 percent of their assets including borrowing in foreign currency.
JapanAuthorized foreign exchange banks are subject to individual ceilings on their overall (spot and forward combined) net positions in foreign currencies at the end of each working day.Required to keep at least 30 percent of assets in guaranteed fixed-return domestic yen vehicles.Holding of securities issued by nonresidents is limited to 30 percent of total assets; the same ratio applies to purchases of foreign-currency-denominated assets.
United KingdomNet open dealing position in any one currency may not exceed 10 percent, and that of all currencies taken together may not exceed 15 percent, of the adjusted capital base. In practice limits for most individual banks are set lower than these general maxima after taking into account each bank’s experience and internal control system.Not subject to any specific limitations in their holdings of foreign currency assets.Subject to matching and localization rules, which require them roughly to balance liabilities expressed in a particular currency with assets in that currency.Collective investment schemes (unit trusts) are required to invest at least 90 percent of their assets in transferable securities in “approved markets,” which includes markets in virtually all member countries of the Organization for Economic Cooperation and Development (OECD).
United StatesForeign currency exposure of banks is not subject to any regulatory limitations, but it is monitored through weekly and monthly reports on spot and forward positions.Regulated by a special federal law—Employee Retirement Income Security Act (ERISA). Permissible investments subject to the “prudent expert” rule, which includes a requirement to give consideration to diversification and liquidity factors. Otherwise no explicit restrictions on holding foreign securities, including foreign equities and foreign-currency-denominated bonds.U.S. state insurance regulations attempt “to prevent or correct undue concentration of investment by type and issue and unreasonable mismatching of maturities of assets and liabilities.” These laws usually allow an unrestricted “basket” of investments for certain amount of assets, which can be allocated to foreign securities.Primarily regulated by the SEC under federal laws. An open-ended fund may not hold more than 15 percent of its net assets in illiquid assets. Otherwise no explicit restrictions are imposed on investment in foreign securities.
European CommunityUnder the EC directive on capital adequacy if a firm’s overall net foreign exchange position exceeds 2 percent of its total own funds, it will multiply the excess by 8 percent to calculate its own funds requirements against foreign exchange risk.2The EC Pension Fund Directive requires member states to abolish arbitrary investment requirements such as lists of permissible assets or minimum investment requirements. Member states cannot require funds to hold more than 80 percent of their assets in matching currencies and must take account of the effect of any currency hedging instruments held by the institution.The EC life and non-life insurance directives intend to remove all legal barriers for the creation of a common market in insurance. They also set out provisions to harmonize rules on admissible investment.The Undertakings for Collective Investment in Transferable Securities (UCITS) Directive introduced the principle of the single authorization requirement and aimed at coordinating the laws of member states. No guidelines are set out for restricting UCITS fund’s cross-border investment.

For the securities houses of these countries there are no explicit regulatory restrictions on foreign exchange positions and other cross-border investments.

The same regulatory constraints apply to security houses.

For the securities houses of these countries there are no explicit regulatory restrictions on foreign exchange positions and other cross-border investments.

The same regulatory constraints apply to security houses.

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