III. Foreign Exchange Markets
- International Monetary Fund
- Published Date:
- December 2008
The foreign exchange market is the most fundamental for a smaller economy with its own currency and is thus considered first.14 Even in the absence of a financial system, foreign exchange must be traded because it is needed for international transactions. In some cases, foreign exchange serves as a store of value and as a unit of account for large-scale transactions. Further, central banks in countries with undeveloped domestic markets will use foreign exchange operations as the main instrument of monetary policy. Foreign exchange swaps and spot transactions are used as the main monetary instrument in many smaller economies with thin money and government securities markets (IMF, 2005a). An active foreign exchange market boosts financial sector development by building trust among banks and providing basic infrastructure and liquidity for further financial market development.
This chapter focuses on interbank markets, as opposed to retail markets. The interbank market consists of banks that informally or formally commit to quote bid and offer prices tradable for minimum amounts of foreign exchange. The focus is on the interbank market, rather than the retail market, because the former is more concentrated and governed by market forces, more subject to government policies, and closely linked with the other essential financial markets.
Markets of the 44 percent of smaller economies that adhere to a floating exchange rate arrangement are the main topic of this chapter. Floating exchange rate arrangements are (1) managed floating with no predetermined path for the exchange rate; and (2) independently floating. A floating exchange rate varies enough to allow for a high degree of market development.15
This chapter is structured as follows. First, the stylized facts based on the available information are summarized. Second, the sequence of steps for developing the interbank foreign exchange market are presented. Third, special topics pertaining to foreign exchange markets in fixed exchange rate countries are discussed.
The stylized facts are drawn from the technical assistance and surveillance work of the IMF, central bank publications and websites, and case studies. There appear to be no broad cross-country data sources for smaller economy foreign exchange markets. The source data and case studies are presented in Annex I.
The main stylized fact is that most smaller economy foreign exchange markets are relatively less developed:
Foreign exchange market turnover in the limited number of smaller economies that have available data shows that these markets are much smaller compared with those in emerging market countries.16
Only about half of smaller economies report the existence of a forward market, compared with 90 percent in both emerging market and advanced countries.
Relatively few smaller economies have market supporting arrangements, such as committees of market players, codes of conduct, and dealer systems.
Exchange markets with floating regimes in smaller economies are more volatile than in emerging market countries in the sense that smaller economies exhibit a relatively high share of days with large exchange rate changes.
The general lack of development of smaller economy foreign exchange markets probably reflects the following:
Smaller economies have relatively few banks, which greatly limits the number of market players. The median number of smaller economy banks is only five, compared with 27 for emerging market floating exchange regime countries.
Smaller economies tend to receive official rather than private capital flows, and official inflows are less likely to enter the economy through the foreign exchange market.
Central banks often dominate foreign exchange markets in smaller economies by supplying most of the foreign exchange and by influencing price setting. This limits market development.
Market Development: From Central Bank Dominance to Market-Led
Country experience indicates that foreign exchange market development follows a natural sequence. First, the government removes impediments. Then, the central bank takes steps to establish the basic elements of the market. Market deepening is then driven by the market players themselves. This sequence can be used by policymakers to help identify where their country fits into the experience of others and provides a natural order for policy implementation. Of course, many of the policy recommendations discussed at each stage can apply to others as well. Annex I provides instructive case studies for some of the countries referred to below.
The Removal of Impediments
A basic level of development of the foreign exchange market requires a minimal number of players and the removal of major impediments. Thus, a sufficiently liberal exchange system is a prerequisite.
Exchange System and Capital Account Liberalization
Government and central bank domination of foreign exchange allocation will impede market development. Controls on foreign exchange transactions and counterparties that severely limit access to foreign exchange and the ability to conduct foreign exchange transactions often induce parallel foreign exchange markets, multiple currency regimes, and rigidities in the market micro structure, all of which pose major obstacles to the development of an interbank market.
The elimination of surrender requirements is a necessary early step. Surrender requirements to the central bank will stymie market development. Surrender requirements to the banking system may not impede the initial levels of market development, but should be eliminated at more advanced stages to support the development of forward markets. In Nigeria, the requirement for banks to return unutilized foreign exchange 15 days after its purchase in central bank auctions was abolished to promote interbank trading. The former Yugoslav Republic of Macedonia also abolished surrender requirements, allowing exporters to freely trade and manage foreign exchange flows.
Capital controls implemented to support external stability can at the same time limit foreign exchange market development. Liberalization of capital controls supportive of macroeconomic stability and the lifting of trade restrictions can create an additional source of foreign exchange, which stimulates market activity and contributes to a deeper and more liquid market. In Iceland, the completion of the liberalization process for capital movements between Iceland and the European Economic Area in early 1995 triggered an important increase in the source of foreign exchange. Of course, capital control liberalization can also increase the risk of sudden stops and must be undertaken carefully.
Competitive Banking Sector17
A competitive banking system is essential. Policies to develop the banking sector generally will in many smaller economies develop the foreign exchange market as well. Specific banking sector impediments to foreign exchange market development include channeling the bulk of foreign exchange inflows to a single state-owned bank (as in Azerbaijan), and regulations or other less-formalized procedures that compel enterprises to deal with selected banks. Foreign banks can boost market development by bringing experience and skills in trading and managing foreign exchange risk that are transferable to local banks. In Serbia, foreign banks comprised most of the small number of banks that began to quote continuous foreign currency prices.
Scaling Back the Dominant Market Role of the Central Bank
Shifting the central bank from a market-controlling to a market-supporting role is the main policy lever over foreign exchange market development. The central bank will often dominate the foreign exchange market in its role as fiscal agent even after the removal of exchange restrictions. The dominant market role of the central bank means that it has to drive foreign exchange market reform in the early stages. Furthermore, the important monetary operations role of the foreign exchange market makes it in the interest of the central bank to take the lead at early stages of market development.
Cutting back the role of the central bank provides a wide array of benefits by introducing market forces. The early phase of market development provides the benefits of (1) limiting disruptions to the real sector from the sporadic availability of foreign exchange; (2) reducing the level of precautionary holdings of foreign exchange; (3) improving the effectiveness of foreign exchange monetary instruments; and (4) laying the basic groundwork for the development of other financial markets.
However, a minimal degree of market development is necessary before the central bank can shift away from a dominant role. The conditions for shifting the central bank away from a dominant market position include (1) an exchange rate policy that does not depend on large-scale intervention; (2) foreign exchange flows managed directly through the interbank market, rather than the central bank, and a regulatory framework that does not unnecessarily restrict access to foreign exchange; (3) an interbank market consisting of a competitive banking sector, generally accepted industry rules for market making, and a code of conduct; (4) a market infrastructure that provides for a transparent price discovery mechanism; and (5) risk management instruments and systems to assess exchange rate risk.
Scaling Back Direct Central Bank Control of Market Flows
The first step is to reduce the foreign exchange intermediation role of the central bank. Central banks will dominate the supply of foreign exchange when foreign aid is the main source of external financing (e.g., in Tanzania), or when a state-owned exporter that earns a large share of export revenues sells foreign exchange to the central bank. Central banks will dominate the demand for foreign exchange when for security reasons they undertake a significant share of payments in foreign exchange. One example of this is when central banks directly pay—rather than selling foreign exchange to the market—for oil imports to ensure energy security, or for debt payments to ensure continued access to international financing (Guyana). Although access to foreign exchange for oil and debt payments can raise legitimate security concerns, the authorities’ consideration of the dominant role of the central bank should account for benefits of foreign exchange market development.
Establishing a Market-Friendly Trading Mechanism
As the central bank reduces its direct control of flows, it can at the same time set up a trading mechanism that allows for the influence of market forces. As the market develops, the central bank can enhance deepening by implementing successively more market-oriented trading mechanisms that enhance price discovery:
Fixing session—Trading takes place in fixing sessions managed by the central bank, with it playing a significant role in the price formation process, buying and selling in the fixing session to meet a certain exchange rate objective. In Serbia, the central bank provided foreign exchange to the market in a daily fixing session, and for the rest of the day banks transacted with each other at the fixing rate. A drawback of administrative fixings is that the confinement of trading to the fixing session can slow the introduction of continuous interbank trading (Iceland).
Foreign exchange auctions—Foreign exchange auctions, conducted according to a frequent and transparent schedule, provide predictability in the supply of foreign exchange, limit the need for direct central bank involvement, and allow exchange rate variability driven by market forces (Trinidad and Tobago). The use of cutoff exchange rates should be avoided because they can lead to excess demand (Nigeria, Mozambique).
Multilateral trading sessions—These can be managed by the central bank and scheduled frequently enough to approach continuous trading. Banks participate by providing their bids in an open bidding system until the market clears, with all transactions conducted at that single price. This concentrates liquidity during the session. The Bank of Israel introduced a daily multilateral trading session as a first step toward an interbank market following the introduction of a horizontal trading band.
During the early stage of market development, the central bank can serve as a market maker to maintain confidence in the market. The market-making central bank can encourage banks to provide continuous two-way prices. Thereafter, the central bank can encourage banks to become market makers themselves by limiting its own involvement to banks that provide firm two-way quotations for an established minimum amount. Once interbank market activity picks up, the central bank should completely phase out its own market-making role. This can start with it serving as a market maker of “last resort” by quoting less attractive prices than the market to encourage participants to first trade among themselves, and promote additional measures to reinforce the market-making commitment of the banking system (former Yugoslav Republic of Macedonia). Ulti-mately, the central bank can take measures to shift the market-making function entirely to banks. The central bank can help identify a group of banks that can start acting as market makers by posting bid and offer prices for the most important currencies, establishing a market committee that assumes responsibility for developing a market-making agreement and a code of conduct guiding interbank market activity, and urging the development of credit lines (Canales Kriljenko and others, 2003. In small markets with few banks, expanding the market-making function to foreign exchange bureaus may help increase competition, in particular where collusion has led to nonmarket pricing or allocation of foreign exchange.
The commitment to market making can be reinforced by linking it with the right to participate in the central bank’s foreign exchange market operations. In small markets with few banks, central banks have formalized their own counterparty relationship by, for example, establishing a primary dealer system. These systems can be even more important to encourage market making and are employed in smaller advanced countries. In Iceland, for example, only three banks act as market makers and they are exclusively entitled to conduct foreign exchange transactions with the central bank in exchange for their commitment to make two-way interbank prices.18 While market-maker agreements are typically initiated and formed by the interbank market and a primary dealer agreement by the central bank, a combined approach promoted the emergence of continuous interbank trading in the former Yugoslav Republic of Macedonia. After introducing an electronic trading platform in 2005, the central bank signed a market-maker agreement with four banks that also made them the direct counterparties for central bank interventions.
The central bank can take other steps to foster the market development role of the market makers. The central bank can set minimum criteria for market-making performance and activity, conduct regular reviews of market-making performance, and discuss these in meetings with the banks. In Iceland, the central bank requires market makers to update two-way prices with a defined frequency (every 30 seconds) and has instituted a commission-based market-making system.
Market-Supportive Foreign Exchange Intervention19
Foreign exchange intervention can be designed to enhance foreign exchange market development. Excessive central bank intervention aimed at smoothing short-run volatility can dampen market development by reducing the perception of exchange rate risk and removing incentives to manage it properly using the interbank market. At the same time, intervention may be needed to maintain an orderly market, especially for smaller economies given their vulnerability to large daily exchange rate movements (Annex I). Interventions using market instruments at the market prices and in a transparent manner can help smooth volatility without impairing market development. The use of information gained from careful monitoring of the market as input to the liquidity forecasting and monetary operations framework also enhances the effectiveness of foreign exchange intervention. Systematic monitoring and continuous communication with the market should be performed through a dialogue that is separate from regulation and supervision. In Uganda, the division of central bank foreign exchange operations into sterilization and intervention transactions reduced uncertainty for interbank market participants.
Central bank interference with the market constrains market development. Market activity is repressed when central banks decide on what spreads and for what purpose they sell foreign exchange to eligible financial intermediaries, use moral suasion to smooth exchange rate volatility, or compel banks to limit foreign exchange movement through formal agreements. Further, procedures that involve monitoring of individual transactions, excessive market presence, or attempts to set ex ante daily ranges for the exchange rate interfere with a market-based price discovery mechanism.
Banks and other market players should take over from the central bank as drivers of market deepening once continuous trading commences. Market-driven deepening provides the benefits of (1) a wider choice of monetary instruments; (2) more cost-efficient allocation of foreign exchange; (3) better risk transfer, including with derivatives; (4) synergies with the development of other financial products, for example, collateral for repos; and (5) better absorption of exchange rate shocks, allowing the option of more exchange rate flexibility.
Industry-accepted agreements should replace initial voluntary arrangements. A market-making agreement sets out trading rules, including minimum trading amount, bid and ask spreads, rules for confirmation and settlement, and trade resolution. The formation of dealer associations can further strengthen the markets’ ownership role of the market guarantor function.20 Agreements and rules must be market supportive—excessive documentation requirements, restrictions on access to foreign exchange on individual counterparties, instruments, or maturity of instruments, and short selling are types of measures that impede the ability of market makers to take foreign exchange positions and thus inhibit their role as liquidity providers.
The technical infrastructure should facilitate continuous postings of bid and offer prices and ensure that the price formation process is transparent. Once market activity increases, continuous posting of bid and offer prices should be done electronically to increase transparency in the interbank market. In some countries, like Costa Rica, Mexico, and Hungary, the stock exchange offers a formal trading infrastructure for currency trading, including forward trades.
Electronic trading platforms increase operational efficiency and improve market transparency. The simultaneous processing of large amounts of market information and the opening up of integrated solutions reduces transaction costs. Operational risk is reduced by integrated solutions such as straight-through processing to middle and back offices. Electronic trading platforms include a variety of systems and different degrees of interaction between various market participants. Electronic trading platforms in over-the-counter markets traditionally involve a segmentation between an inter-dealer and a dealer-to-customer market.21 Electronic trading platforms (e.g., Reuters Dealing) that are designed to cater to the full trading process (execution, confirmation, and settlement) enable a smoother trading process and make the trade resolution process easier by reducing operational risk. In Serbia, the development of an electronic infrastructure played an important role in providing the tools for market making and trading. Uganda developed an information system to widen interbank market access to price information, which increased market transparency.
Hedging instruments facilitate the transfer of exchange rate risk, which enhances systemic stability and allows entities to better manage exchange rate variability. In addition, hedging instruments can feed back into deepening the spot foreign exchange market. Traditional risk management instruments, such as foreign exchange forwards and swaps, typically emerge first. A lack of sophisticated market players limits the potential for hedging instruments in many smaller economies, but other impediments can be addressed by policy.
The introduction of hedging instruments can be held back by regulatory obstacles. The appropriate balance must be struck between market development measures and regulatory requirements.22 Permitting access to hedging instruments for a use broader than hedging underlying transactions can help boost activity and liquidity in the interbank market. Some degree of speculation is necessary to “absorb” flows emanating from hedging activity. This can help reduce the risk of a one-sided market because these speculators are willing to take the opposite position of the hedger. In Poland, dropping the requirement that foreign exchange swaps required a permit from the central bank helped boost the swap market, as well as the liquidity and depth of the spot market.
A domestic money market yield curve helps create liquid hedging instruments. Forwards and swaps are priced on the interest rate parity condition, that is, the forward or discount priced by market makers will reflect the interest rate differential between local and foreign currency. The absence of such a price indicator, or a less reliable one, may lead to a wide variation of interbank prices because market participants may base their prices mostly on their own interest or positions. The more efficient pricing mechanism provided by liquid money and government securities markets can therefore boost hedging instruments. These complementary markets, which are encouraged by the move toward a market-based monetary and debt management framework, were essential in developing forward markets in many countries (e.g., Czech Republic, Israel, and Poland), but the absence of these markets has slowed forward market development in some countries (e.g., Serbia, Uruguay).
The design of prudential requirements in support of stability should take into account the impact on foreign exchange market development. Overly restrictive limits on net-open positions reduce the capacity of the interbank market to trade and take positions. Indeed, overly restrictive limits might instead have the adverse effect of increasing volatility unnecessarily as banks are forced to immediately enter the interbank market to cover customer transactions. Forward markets can be inhibited by restrictions on trading foreign exchange forwards. Restrictions on nonresident activity can contribute to the emergence of an offshore nondeliverable forward market (NDF), which in some circumstances can complicate policy and local market development. Other prudential requirements that can impact market development include minimum holding periods, maturity restrictions, and reporting and approval requirements.
Increased sophistication of the foreign exchange market should lead to an upgrade of the supervision of bank risk management practices. A more developed market transfers exchange rate risk from the central bank to the banking system, potentially ratcheting up exchange-rate-related risks.
Fixed Exchange Rate Regime Issues
Two foreign exchange market issues are relevant for the one-quarter of smaller economies that operate a pegged exchange rate regime. First, some of the benefits of price discovery can be realized under a fixed exchange rate with a trading band. Second, foreign exchange market development is an important prerequisite for moving to a floating exchange regime.
Foreign Exchange Markets in a Pegged Regime with a Trading Band
Some of the benefits of an interbank market can be realized even under a pegged exchange rate.23 Even small movements in the exchange rate convey information about market tightness and provide price discovery, which facilitates private sector decision making as well as policy formulation. A horizontal band can permit exchange rate fluctuations that create an incentive for interbank market participants to start negotiating trades among themselves. The exchange rate should be flexible in both directions around the central rate to make risk transfer possible, thus giving an incentive for market participants. Further, the degree of flexibility should provide scope for profitability in the market-making activity. There are several examples of small developed countries with active foreign exchange markets under pegged exchange rate regimes. In Denmark, the interbank market is active despite very small fluctuations under a pegged exchange rate regime (Box 3.1). In Iceland, the interbank market was developed already under the pegged exchange rate system in 1993.
Transitioning to a Floating Regime
Foreign exchange market development is a key ingredient in the transition from a fixed to a floating exchange rate regime. Country experiences suggest that a gradual increase in exchange rate variability accompanied by parallel measures to reinforce the market structure help prepare for a smoother transition between regimes. Putting in place supporting elements such as a deep and liquid interbank foreign exchange market, instruments and systems to manage and assess exchange rate risk, as well as intervention policies consistent with a greater degree of exchange rate variability and market development, have enabled countries to transition to exchange rate variability in a smooth and orderly manner (IMF, 2005b).
An important step is to create a trading mechanism that allows the interbank market to gradually drive exchange rate movement. Central banks should cease to be market makers and establish an intervention framework that supports interbank market activity. In Israel, the central bank reduced its market domination in the fixing sessions by shifting to a multilateral trading session, which was later phased out and replaced by an interbank system to prepare for more exchange rate flexibility in the transition to a crawling band. In parallel, the intervention policy was designed to be consistent with the aim of developing interbank market activity and risk management instruments, which meant that intervention activity gradually decreased as exchange rate variability increased.
Box 3.1.The Danish Foreign Exchange Market
The foreign exchange market in Denmark provides significant economic benefits notwithstanding the fixed exchange rate regime. The exchange rate is pegged to the euro within an official band of +/-2.25 percent, although in practice the central bank maintains the krone closer to a +/-1 percent range and the foreign exchange market is free of restrictions. Relatively little trading is driven by speculation on the euro-krone exchange rate owing to the flexibility of the goods and labor markets and sound policies. The market is used to hedge against currencies such as the U.S. dollar. The market infrastructure is well developed and most transactions take place over electronic trading platforms, resulting in a high degree of transparency. Quoted bid-ask spreads are narrower than those of neighboring Scandinavian currencies with floating exchange rate regimes, and average daily turnover reached $86.1 billion in April 2007. This is close to the local currencies in comparable countries with independently floating regimes, such as Norway and New Zealand.
The foreign exchange market provides a wide range of instruments to efficiently manage foreign exchange flows and exposure. Market makers actively provide liquidity in spot, forward, and foreign exchange swaps, as well as foreign exchange options and currency swaps, although turnover in these instruments is much smaller. Forward transactions, which accounted for 12 percent of overall turnover in April 2007, are mostly done to hedge exchange rate exposure against currencies other than the euro. Foreign exchange swaps—which were 71 percent of overall activity—are actively used as a short-term money market product to manage liquidity in the domestic currency. Foreign exchange swaps greatly exceed turnover in the spot market, which is consistent with the global foreign exchange market.
Money market development eases the transition toward greater exchange rate flexibility by boosting foreign exchange market development. In particular, money market development provides a stable and transparent pricing mechanism for foreign exchange forwards. In Israel and Poland, money market development was essential for the development of foreign exchange hedging instruments, while in Uruguay, the absence of a developed domestic money market initially hindered the foreign exchange market from developing (IMF, 2005b).