I. Introduction¹

1. Good systemic liquidity management practices and well functioning money and foreign exchange markets are essential preconditions for ensuring that funds are allocated efficiently in the economy and to underpin London’s role as an international financial center. Consequently, the Bank of England’s monetary operating procedures were reviewed from the perspective of systemic liquidity management, as were the functioning of the sterling money and foreign exchange markets. The review was based on information provided by the U.K. authorities, as well as discussions with a broad range of financial market participants.

2. In the case of the Bank of England’s operating procedures, particular attention was paid to its ability to forecast the daily shortage in the sterling money market; the frequency and tenor of its daily monetary operations; and the ways in which it manages the risks associated with the collateral received in its repo operations. The Bank’s operating procedures are fundamentally sound, and have benefited significantly from the reforms introduced in recent years. In that context some points are as follows:

• The uncertainty inherent in projecting the demand for bank notes results in some residual uncertainty in the process used to forecast the daily shortage. However, the liquidity forecasting process works well.

• Over time, the Bank may wish to consider streamlining the number of daily operations it conducts in the market if the daily liquidity forecasting process can be improved. At the margin, this could have the salutary effect of encouraging market participants to sharpen further the management of their liquidity positions in the market, thereby contributing to a more efficient sterling money market.

• The methods used to manage the market risks of the collateral received in the course of executing monetary operations are appropriate. Credit and liquidity risk of collateral is not an issue for securities issued by the Bank of England or the U.K. government (the Bank’s shareholder). While the Bank closely monitors the collateral it accepts, and has not encountered any problems in practice, prudent risk management practice would suggest that some controls be introduced for other securities accepted as collateral, particularly in light of the substantial widening of eligible collateral that has taken place in recent years, even though all of the collateral accepted by the Bank is of high quality. Such controls could include, for example, adopting minimum liquidity or credit rating thresholds, or limits on the amount of securities of a single issuer that can be pledged by a counterparty.

• Down the road, the Bank may wish to consider reactivating the longer-term operations that were used to manage the demand for term liquidity during the millennium date change period to manage the composition of its balance sheet. This would enable it to acquire longer-term assets at prevailing market interest rates and manage the growth in the stock of refinancing, which has been slowly rising since April 2000. The need for such operations could become acute if the government should decide to repay the Ways and Means advance. No change is recommended to the two-week tenor for the policy interest rate given the market’s comfort with the current arrangements and the U.K.’s close economic and financial linkages with the rest of Europe, where the European Central Bank also uses a two-week tenor.

3. Turning to the behavior of the sterling money and foreign exchange markets, the review of these markets focused on the ability of the sterling money market to distribute the daily liquidity provided by the Bank of England, and the resiliency of these markets in periods of stress. The mission’s findings and recommendations can be summarized as follows:

• The money market does a good job in distributing the liquidity supplied by the Bank of England, as evidenced by the fact that the demand for precautionary balances at the Bank of England has been only £50 million compared to the £28 billion traded each day in the sterling interbank and gilt repo markets. The money and foreign exchange markets are also very liquid, although the increasing ‘lumpiness’ of the order flows could potentially make it difficult for traders to manage their positions in stressful situations. In light of the risks inherent in unsecured interbank exposures, the authorities were encouraged to continue with their efforts to strengthen their surveillance of bilateral unsecured exposures between banks so that they can obtain a better sense of the distribution of systemic risk in the banking system. They may also wish to consider publishing the results obtained, albeit in a highly aggregated form, so that the banks can take them into account when they decide on how much unsecured credit they are willing to extend to one another.

• Although the interbank market functions well, the available data on interbank exposures suggest that if one of the largest banks failed to honor its obligations to other banks, some of them (notably small and medium-sized banks) might experience financial difficulties. To some extent, this reflects the fact that the sterling money market mainly consists of unsecured obligations issued by banks. In this regard, the authorities may wish to champion measures that encourage netting, where feasible, and more trading between banks on a secured basis, possibly using euro-denominated securities as collateral.²

• The Sterling Stock Liquidity Ratio, used to supervise the liquidity of the major U.K.-owned banks, seems to have come to the end of its useful life, in that the benefits it offers of encouraging a market-based solution to liquidity problems are now being outweighed by perverse behavioral effects. First, the ratio does not fully take into account the maturity distribution (in a contractual, behavioral, and stressed context) of these banks’ sterling assets and liabilities. Second, it allows banks to count (to a limited extent) CDs issued by other banks as an offset against maturing wholesale liabilities. This does not encourage the greater use of unsecured instruments, which could reduce systemic vulnerabilities. Third, it does not take into account these banks’ significant foreign currency-denominated assets and liabilities. The FSA is reviewing its approach to the supervision of liquidity (including bank liquidity). The approach will involve both a quantitative and qualitative assessment against a common framework. This framework will include liquidity data on a consolidated basis where appropriate and will take into account the maturity distribution of assets and liabilities in a contractual, behavioral, and stressed context.

4. The rest of the chapter discusses the recommendations in more detail. Section A reviews the Bank of England’s monetary operating procedures, while the functioning of the sterling money and foreign exchange markets are discussed in Sections B and C respectively.

II. Monetary Operating Procedures

5. The Bank implements monetary policy by lending to its counterparties in the sterling money market at rates that are anchored by the official two-week repo rate chosen by the MPC.³ The Bank holds on its balance sheet assets acquired from its counterparties in its money market operations. These are mostly repos involving mainly U.K. government bonds (gilts) and euro-denominated European government securities as collateral, they are short-term, and a portion of them matures every business day. This means that at the start of each day, the private sector is due to pay money to the Bank to redeem these obligations. However, in order to do so, the Bank’s counterparties typically have to borrow additional funds from the Bank. This gives the Bank the opportunity to provide the necessary funds once more, at a rate tied to its official repo rate. The fact that this ‘stock of refinancing’ is turning over regularly is the main factor creating the demand for base money (the ‘shortage’) in the market each day.

6. In its open market operations, the Bank deals with a small group of counterparties who are active in the money market: banks, securities dealers, and building societies are eligible to take on this role.⁴ Funds are supplied by the Bank primarily in the form of repo. Counterparties sell assets to the Bank with an agreement to repurchase them in about two weeks time.⁵ The Bank also buys outright treasury bills and other eligible bills with remaining maturities of about two weeks or less. See Box 1 for a summary of some key reforms that have been made to the Bank’s operations in recent years.

7. Liquidity forecasts are published and market operations are conducted by the Bank several times over the course of a trading day. At 9:45 a.m., the Bank announces the estimated size of that day’s shortage and the main factors behind it.⁶ On non-MPC meeting days, the first round of operations is held at that time (12:15 p.m. on MPC meeting days, 15 minutes after the publication of the meeting’s outcome). Results from each operations are announced to the market about 10 minutes later. The liquidity forecast is updated again at 2:30 p.m., and a second round of operations is conducted. If the remaining shortage is not entirely relieved at 2:30 p.m., the Bank holds a round of overnight repo operations at 3:30 p.m. at a rate of one percent above the Bank’s repo rate. If the system is still short at 4:20 p.m. after the money market has closed, the Bank deals directly via a late-repo facility with the settlement banks, whose accounts at the Bank need to be in credit at the end of the day. As with the 3:30 p.m. operation, the rate on the 4:20 p.m. facility is one percent above the Bank’s repo rate.

8. In June 2001, the Bank supplemented its daily open market operations with a collateralized overnight deposit facility (i.e., an overnight reverse repo facility) in order to moderate the extent to which overnight interest rates trade below the Bank’s two-week repo rate. This facility also enhances the means available to the Bank to intermediate between firms with liquidity shortages and surpluses in rare circumstances where market mechanisms are impaired (e.g., because of infrastructure or confidence problems). As noted previously, the Bank already had in place an overnight repo lending facility, which helped to limit the extent to which overnight rates trade above its official repo rate. The deposit facility puts the Bank’s overnight operations at the end of each day on a more symmetrical basis, and reportedly has helped to reduce some of the volatility in sterling overnight rates.

9. Like the lending facility, the new deposit facility is available to the Bank’s counterparties at 3:30 p.m. every business day. (If deposits are made at 3:30, the Bank adds the funds deposited to the amount of liquidity supplied to settlement banks at 4:20 p.m.). To ensure that it does not discourage active trading between market participants, the interest rate that the Bank pays on overnight deposits has been set at one percent below the Bank’s two-week repo rate.

10. Bank officials noted that the width of the corridor for the overnight rate (200 basis points) represents a trade-off between a desire to limit excessive volatility in the overnight rate, and the Bank’s preference that private sector participants regularly test their names by trading with each other as much as possible before accessing central bank facilities. This imposes a market discipline on banks to manage their liquidity prudently so that they can maintain their access to the markets for funding purposes. In addition, the corridor allows for credit tiering in the market, since widening spreads might be an important signal for market participants and financial sector supervisors of potential financial distress. Allowing these market mechanisms to operate thus contributes to financial stability. Market participants generally welcomed the introduction of the new deposit facility, noting that it has helped to limit short-term interest rate volatility, and may help to broaden the range of participants in the market over time.

11. There are no statutory reserve requirements in the United Kingdom.⁷ Settlement banks are also able to obtain intraday credit from the Bank on a collateralized basis. This credit is available in both sterling and euro to facilitate the smooth functioning of the sterling and euro CHAPS payment systems operating in the United Kingdom. No interest is charged on this credit, but it must be repaid before the payment system closes for the day. To help ensure that intraday liquidity does not spill over into overnight liquidity (and potentially affect monetary conditions), the Bank has taken steps to: (i) apply early cut-offs, first for customer payments and a little later for interbank CHAPS payments, within the RTGS operating day so that CHAPS banks have a final period in which to square their positions; and (ii) by applying penal rates for any overnight repo required to prevent a bank that has failed to balance its books by the end of the business day from going into overdraft. The penalty charged by the Bank for the provision of such a repo depends on the circumstances in which the overdraft arises, but is usually a minimum of 300 basis points above the Bank’s repo rate.

12. The Bank auctions three- and six-month euro-denominated bills each month, and also auctions three-year euro-denominated notes in order to obtain the euro liquidity it needs to support the functioning of the TARGET payment system for banks located in the United Kingdom. The arrangements agreed with the European Central Bank under which the Bank of England may provide intraday liquidity incorporate a €3 billion limit on the total amount of intraday liquidity that can be provided to the U.K. market by the Bank of England (€1 billion limit to any one participant). Excess funds are held in the Bank of England’s own foreign exchange reserves.

13. The Bank has not conducted any foreign exchange market intervention for monetary policy purposes since the introduction of the current monetary framework in 1997. The Government is responsible for determining the exchange rate regime for the U.K., but the Bank is allowed to have its own separate pool of foreign exchange reserves, which it can use at its discretion to intervene in support of its monetary objectives. It is also required to execute foreign exchange market intervention as the government’s agent for non-monetary policy purposes, such as intervention carried out by the U.K. in support of coordinated G-7 intervention, using the government’s foreign exchange reserves. These interventions are automatically sterilized. When sterling money market shortages have been large, the Bank occasionally used foreign exchange swaps to supply liquidity to the sterling money market.

Key issues

The Bank’s ability to forecast the daily shortage

14. The transfer of the management of Exchequer cash management from the Bank to the DMO in April 2000 has modestly helped to improve the Bank’s ability to forecast the shortage. The two principal factors that now influence the money market’s need for financing from the Bank are changes in the note issue and the maturity of the existing stock of refinancing operations. Table 1 summarizes the Bank’s daily forecast errors from January 1999 through December 2001. The liquidity forecasting process functions well, and the mean absolute forecasting errors have fallen sharply since the transfer of government cash management to the DMO in April 2000. However, the improvement in the standard deviation of the forecast errors—perhaps a more precise indicator of the consistent ability of the forecasters to achieve better forecasts—is less pronounced in level terms at the 2:30 and 4:20 rounds, and it is not clear that there has been any significant improvement at the 9:45 round. This not to say that the forecasts are weak. Indeed, the standard deviations of the errors were less than 10 percent of the average daily shortages in 2001. Instead, there has been, and continues to be, some residual uncertainty in the remaining items of the forecast, particularly the note issue. This should decline further when the Bank completes the restructuring of its bank note operation. Further improvements to the shortage forecasting process could, if the Bank wished, help set the stage for less frequent operations by the Bank in the sterling money market.

Table 1.

United Kingdom: Daily Shortage Forecast Errors ^1/

(GBP millions)

Source: Bank of England.

^1/Errors are defined as projections minus actual shortage.

Table 1.

United Kingdom: Daily Shortage Forecast Errors ^1/

(GBP millions)

		Mean of Absolute Daily Errors			Standard Deviation of Daily Errors
		9.45am	2.30pm	4.20pm	9.45am	2.30pm	4.20pm
	Date	forecast	forecast	forecast	forecast	forecast	forecast
1999		145	51	31	224	94	72
	2000 (Jan. - Mar.)	181	50	23	237	109	53
	2000 (Apr. - Dec.)	89	38	17	130	78	38
2001		81	33	13	216	67	49

Source: Bank of England.

^1/Errors are defined as projections minus actual shortage.

View Table

Table 1.

United Kingdom: Daily Shortage Forecast Errors ^1/

(GBP millions)

		Mean of Absolute Daily Errors			Standard Deviation of Daily Errors
		9.45am	2.30pm	4.20pm	9.45am	2.30pm	4.20pm
	Date	forecast	forecast	forecast	forecast	forecast	forecast
1999		145	51	31	224	94	72
	2000 (Jan. - Mar.)	181	50	23	237	109	53
	2000 (Apr. - Dec.)	89	38	17	130	78	38
2001		81	33	13	216	67	49

Source: Bank of England.

^1/Errors are defined as projections minus actual shortage.

Frequency and tenor of the Bank’s monetary operations

15. Notable features of the Bank of England’s monetary operations are the number of operations conducted each day (four if one includes the late-day round for settlement banks) and the two-week tenor of the policy rate. Reasonable questions one could pose are: (i) could the Bank operate less frequently each day, and (ii) would it be more appropriate to set the target policy rate with reference to an overnight interest rate given that central banks typically have more control over interest rates at this tenor in their operations? Turning to the first question, Bank officials suggested that the multiple rounds of operations is a handy means of building relations with market participants because the operations in the market provide a starting point for discussions on market developments, which can be a useful source of intelligence on emerging vulnerabilities in the financial system. In addition, multiple rounds of operations help the market cope with the uncertainties surrounding the forecasted shortage, which tend to decline as the day goes on. While these are important arguments, they should be kept in perspective. For example, some market participants indicated that their willingness to speak with the Bank reflects the quality of the discussions and their overall respect for the Bank, not the operations themselves. Thus, as the shortage forecasting process improves over time, the Bank may want to reflect on whether it could operate with fewer rounds in the market (for example, by aiming for two rounds of daily operations in the long run). This could further reduce the presence of the Bank in the market over the course of the day, and perhaps, at the margin, impose some added market discipline on market participants to trade more efficiently with one another. So long as the Bank’s discussions with the market continue to offer value to market participants, it is not clear that this would necessarily impede the Bank’s ability to gather market intelligence.

16. Turning to the question of the tenor of the policy rate, Bank officials indicated three major reasons in support of the current arrangement. First, by operating at the two-week tenor, it is easier for the Bank to influence one month interest rates—the tenor that is thought to be important for the transmission of monetary policy actions to tenors further out the yield curve. Operating directly at the one month tenor is probably not practical because at that point interest rates start becoming sensitive to factors other than monetary policy actions, thereby impairing the clarity of the monetary policy signal. Second, changes to the Bank’s operations have evolved gradually over time, and a policy rate defined with respect to two-week interest rates has been the practice for many years, and is one that the market is comfortable with.

17. And third, some might argue that a two-week tenor is useful from a balance sheet management perspective because, compared to an overnight tenor, it obviates the need to rollover all operations each day, thereby helping to limit the Bank’s presence in the sterling money market. This is not a major constraint. The Bank could always follow the practice of some other central banks and adjust the composition of its balance sheet by conducting some longer-term operations at prevailing market interest rates, such as it did over the millennium date changeover period. Indeed, at some point in the future, the Bank may wish to consider reactivating the longer-term repo facilities used during the millennium date change period, and acquire assets on a repo basis in order to reduce the average size of the stock of refinancing, which has been on an upward trend since April 2000 (from £14 billion in April 2000 to £18 billion in January 2002). This issue could become acute if the government should decide at some point to repay the Ways and Means advance.⁸

18. Of course, a two-week tenor also offers the added convenience of being consistent with the tenor used by the European Central Bank to signal its monetary policy intentions. In practice, there is little to choose between operating at either tenor. Given the market’s comfort with the current arrangements and the U.K.’s close economic and financial linkages with the rest of Europe, continued focus on the two-week tenor is appropriate.

Managing the risks associated with the collateral underpinning monetary operations

19. All securities held as collateral by the Bank are valued daily in sterling at the close of business; the aggregate exposure to each open market operation counterparty is calculated. Any counterparty whose margin-adjusted value of collateral is more than £1 million lower than the amount (including interest) owed to the Bank is required to post additional collateral (i.e., a variation margin) the next day to reconstitute the appropriate amount of margin.

20. Margins are set using a value-at-risk (VAR) approach, which is reviewed annually to ensure that the assumptions underpinning the margin requirements are appropriate. The requirements are designed to protect the value of the collateral against both interest rate risk, and where appropriate, exchange rate risk. Also, close contact is maintained between the Bank’s front and back office staff, and the causes of persistent or unusual variation margin calls are monitored and investigated if necessary. Given the high-quality of the underlying collateral, the Bank has not introduced formal credit or liquidity risk controls for the collateral it accepts, although it does monitor the quality and liquidity of the collateral being pledged and has not encountered any problems in practice. Moreover, it indicated a willingness to introduce more formal measures should they be required. It also sets limits on the amount of acceptances that eligible financial institutions can issue in the market. (The Bank can take them as repo collateral or purchase on an outright basis). By limiting the amount of securities each institution can issue, the Bank indirectly places a ceiling on its potential exposure to any one accepting institution. Each institution’s issuing limit is based on a calculation of its capital and scale of its sterling business.

21. While the credit and liquidity risk of collateral is not an issue for securities issued by the Bank of England or the U.K. government (the Bank’s shareholder), prudent risk management practice would suggest that some controls be introduced for other securities accepted as collateral by the Bank even though the remaining collateral is all high-grade in nature. In this regard, the Bank may wish to follow the practice of some other central banks and consider the practicality of introducing minimum liquidity or credit rating thresholds or limiting the amount of securities of a single issuer that can be posted by a counterparty in order to achieve a broader diversification of the collateral. Although the Bank closely monitors the collateral it accepts and has not encountered any difficulties in practice, application of good risk management practices in-house helps to set a good example for market participants, and is a concrete way to demonstrate the Bank’s commitment to a more resilient financial system.

III. Sterling Money Market

22. The sterling money market is primarily a market for unsecured short-term interbank deposits and certificates of deposits (CDs). As of the end of 2001, interbank deposits and CDs accounted for 58 percent of sterling money market instruments outstanding (Table 2).⁹ Most of them are issued by the nine major U.K. banks, although some European banks are also large issuers of CDs (Table 3). The stock of interbank deposits and CDs has grown by about 4 percent annually since 1990. However, their share of the money market has declined markedly from the 80 percent level that prevailed prior to the introduction of gilt repos (repos collateralized by U.K. government bonds) in the mid-1990s. Since 1997, gilt repos have grown rapidly—to about a 24 percent share of the money market—as banks took advantage of the introduction of the repo market to shift from holding gilts on an outright basis to a repo basis so that they could better manage their liquidity positions. Other segments of the money market are fairly small; for example, treasury bills and commercial paper represent less than 5 percent of sterling money market instruments outstanding.¹⁰

Table 2.

Sterling Money Markets

(Amounts Outstanding, £ billions)

Source: Bank of England.

^1/Numbers in parentheses represent percent of total sterling money market claims.

^2/As of November 2001.

^3/As of September 2001

^4/As of August 2001

^5/Includes Treasury bills, sell/buybacks, and local authority bills

Table 2.

Sterling Money Markets

(Amounts Outstanding, £ billions)

	1990			1995		2001
Interbank	89	(49)	1/	93	(48)	185	(34)
CDs	53	(29)		66	(34)	131	(24)
Gilt Repo	…			…		129	(24)	2/
Stock Lending	…			…		52	(10)	3/
Eligible bills	23	(13)		20	(10)	11	(2)
Commercial Paper	5	(3)		6	(3)	21	(4)	4/
Other 5/	13	(7)		10	(5)	14	(3)
Total	183	(100)		195	(100)	555	(100)

Source: Bank of England.

^1/Numbers in parentheses represent percent of total sterling money market claims.

^2/As of November 2001.

^3/As of September 2001

^4/As of August 2001

^5/Includes Treasury bills, sell/buybacks, and local authority bills

View Table

Table 2.

Sterling Money Markets

(Amounts Outstanding, £ billions)

	1990			1995		2001
Interbank	89	(49)	1/	93	(48)	185	(34)
CDs	53	(29)		66	(34)	131	(24)
Gilt Repo	…			…		129	(24)	2/
Stock Lending	…			…		52	(10)	3/
Eligible bills	23	(13)		20	(10)	11	(2)
Commercial Paper	5	(3)		6	(3)	21	(4)	4/
Other 5/	13	(7)		10	(5)	14	(3)
Total	183	(100)		195	(100)	555	(100)

Source: Bank of England.

^1/Numbers in parentheses represent percent of total sterling money market claims.

^2/As of November 2001.

^3/As of September 2001

^4/As of August 2001

^5/Includes Treasury bills, sell/buybacks, and local authority bills

Table 3.

Distribution of Banks’ Wholesale Sterling Liabilities by Group of Banks at end-December 2001

(in percent)

Table 3.

Distribution of Banks’ Wholesale Sterling Liabilities by Group of Banks at end-December 2001

(in percent)

	Interbank	CDs Issued	Gilt Repo
U.K.-owned	80.5	45.1	36.1
Other EU-owned	8.8	47.2	33.3
U.S.-owned	3.5	0.3	0.0
Japan-owned	1.4	1.3	0.8
Other	5.8	6.0	29.8
o/w other developed	5.4	5.9	29.8
o/w other	0.4	0.1	0.0

View Table

Table 3.

Distribution of Banks’ Wholesale Sterling Liabilities by Group of Banks at end-December 2001

(in percent)

	Interbank	CDs Issued	Gilt Repo
U.K.-owned	80.5	45.1	36.1
Other EU-owned	8.8	47.2	33.3
U.S.-owned	3.5	0.3	0.0
Japan-owned	1.4	1.3	0.8
Other	5.8	6.0	29.8
o/w other developed	5.4	5.9	29.8
o/w other	0.4	0.1	0.0

23. Market participants report that the rapid growth of the repo market has also benefited from the introduction of more stringent capital adequacy regulations and a contraction in unsecured credit lines in the interbank market. More stringent capital adequacy rules have contributed to lower costs for repo financing relative to unsecured financing because the institution providing the funds does not need to hold as much capital against a secured investment as it would against an unsecured one given the high quality of the underlying collateral in a repo transaction. In addition, many institutions are reportedly shifting toward dealing on a repo basis in order to limit the use of unsecured credit lines, which are declining in aggregate as banks merge. Credit departments in banks tend to grant smaller credit lines to a newly-merged institution than the sum total of those previously granted to the antecedent institutions.

24. The importance of the interbank and CD markets in the U.K. stands in marked contrast to money markets in the United States and Canada, for example, where securities issued by governments and nonfinancial corporations tend to dominate.¹¹ However, it is similar to that in the euro area, where unsecured bank claims also represent the largest segment of the market. Several factors explain the difference between the sterling and North American money markets. First, the amount of government debt outstanding in the U.K. is fairly modest at less than 30 percent of GDP, and it is heavily skewed toward issues of long-term bonds reflecting: (i) a preference in the early 1990s to limit the issuance of Treasury bills to avoid potential conflicts with monetary policy;¹² and (ii) the government’s desire to minimize its exposure to market and rollover risks. As a result, the government has not issued much in the way of treasury bills. Second, U.K. corporations have tended to rely more on bank loans to meet their short-term credit needs than commercial paper or bank-guaranteed paper. Third, CD issuance activity by major banks grew rapidly in the latter half of the 1990s as the introduction of gilt repo led some banks to repo gilts on to their balance sheets in exchange for CDs. And fourth, banks’ willingness to hold each other’s CDs was helped by the introduction of the stock sterling liquidity regime (SSLR) in 1996 (see Box 2), which allowed U.K. banks to count (to a limited extent) their holdings of CDs issued by other banks as liquidity to meet the SSLR requirement.

25. Secondary market trading in the money market is dominated by trading in short sterling futures contracts and options on these futures contracts, both of which are traded on the London International Financial Futures Exchange (LIFFE) (Table 4). The futures and options markets are accessible to a wide range of participants, provided they are able to meet the margin requirements, and trading now takes place electronically via the exchange’s computer system, rather than on the floor of the exchange. Major banks in London actively transact in these markets to hedge their exposures to future movements in short-term interest rates, and to arbitrage any pricing discrepancies between the futures and underlying interbank markets. Trading activity on the exchange is particularly heavy in periods of heightened uncertainty about the future course of sterling interest rates, since traders can take advantage of the leverage inherent in the margin requirements to create large speculative positions, and avail themselves of the security provided by the fact that the London Clearing House (LCH) interposes itself as counterparty to all trades executed on the exchange.

Table 4.

Turnover of Sterling Money Market

(Average Daily Amounts, £ billion)

Source: U.K. authorities. (a) Figures based on unsecured cash transactions brokered in London as reported to the WMBA.

Table 4.

Turnover of Sterling Money Market

(Average Daily Amounts, £ billion)

	1997	1998	1999	2000	2001
Short Sterling Futures	40	67	54	45	67
Short Sterling Options	6	15	13	8	15
Interbank (overnight) (a)	6	7.5	8	10	10
Gilt Repo	15	15	14	18	18
CDs, bank bills and treasury bills	…	…	…	…	12

Source: U.K. authorities. (a) Figures based on unsecured cash transactions brokered in London as reported to the WMBA.

View Table

Table 4.

Turnover of Sterling Money Market

(Average Daily Amounts, £ billion)

	1997	1998	1999	2000	2001
Short Sterling Futures	40	67	54	45	67
Short Sterling Options	6	15	13	8	15
Interbank (overnight) (a)	6	7.5	8	10	10
Gilt Repo	15	15	14	18	18
CDs, bank bills and treasury bills	…	…	…	…	12

Source: U.K. authorities. (a) Figures based on unsecured cash transactions brokered in London as reported to the WMBA.

26. Transactions in the traditional cash markets and non-exchange-traded derivatives markets, such as the SONIA swap market, are conducted between counterparties on an over-the-counter (OTC) basis, usually through screen-based interdealer brokers, but in some cases directly by telephone. The broker simply brings the counterparties together. They are then responsible for settling transactions and managing their own counterparty risk exposures. Usage of screen-based inter-dealer brokers helps to minimize search costs and protect the anonymity of the traders until the transaction is completed, thereby lowering the risk that the market might move against a trader before he or she can complete the transaction. In some market segments, notably gilt repo, electronic proprietary trading systems such as Broker Tec are growing in popularity, and are helping traders discover prices with fewer transactions and execute their transactions more efficiently.

27. Trading volumes have been fairly stable in recent years in both the gilt repo and the unsecured segments of the money market. However, market participants noted that the trading flow in the interbank market is becoming more lumpy over time, and thus harder for traders to manage, as the number of active participants dwindles in response to consolidation in the number of large institutions in the financial services industry and as the size of average transactions—which now range between £100 and £500 million for interbank deposits and CDs—increases. In times of stress, this lumpiness may foster the emergence of disorderly markets as traders shy away from taking positions for fear of being caught offside by the course of events. In contrast, those institutions that are major players in the gilt repo market report that that market is very deep and liquid, with most counterparties willing to regularly trade in lots of £100 million in the broker market rather than the £25 million minimum transaction size. Indicative bid-offer spreads in the various segments of the money market have been fairly stable, widening by only a few basis points in periods of heightened uncertainty, such as the millennium date change and post-September 11 (Figure 1).

Sterling Money Market, Bid Offer Spreads

Citation: IMF Staff Country Reports 2003, 208; 10.5089/9781451814200.002.A002

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Sterling Money Market, Bid Offer Spreads

Citation: IMF Staff Country Reports 2003, 208; 10.5089/9781451814200.002.A002

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Sterling Money Market, Bid Offer Spreads

Citation: IMF Staff Country Reports 2003, 208; 10.5089/9781451814200.002.A002

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28. Interest rates paid by banks to fund themselves in the interbank deposit and CD markets do not vary much in relation to the credit rating of the banks. Instead, market participants report that the size of informal, normally stable bilateral credit lines governs the allocation of credit in the market. Access to the market on an unsecured basis is generally limited to banks that are perceived by their peers to have a credit rating equivalent to single-A or better. Weaker institutions typically are only able to raise funds on a secured basis. This contributes to the resiliency of the unsecured market because there is less risk that it will be undermined by the failure of a weak institution.

29. Participants in the sterling interbank market report that they generally review the credit lines granted to other banks on a regular basis (quarterly appears to be the norm), although more frequent ad-hoc reviews are conducted when a counterparty is hit by a shock (such as when the news broke of large foreign exchange trading losses at Allied Irish Bank). In the past, such shocks would have led market participants to limit their interbank exposures to all banks from the country or region in question, whereas now participants believe that the market is more discriminating, assessing each participant’s credit lines more on a case-by-case basis, and less on its country or region of origin.

30. Market participants also noted that bank credit lines are often adjusted in response to shifts in trading activity between counterparties, even when there has not been any change in the credit assessment of the bank counterparty. This suggests that credit line determination is not only a function of the credit standing of the counterparty, but is also governed to some extent by the potential profits to be earned from the trading relationship. There is also a widespread view that the credit lines extended to the most active participants in the sterling interbank market—the major U.K. clearing banks—may be somewhat larger than their credit standing might suggest owing to a latent belief that the Bank of England will ultimately stand behind the unsecured interbank obligations of these banks if one of them was to fail. However, this is thought to be a less important factor now; the failure of Barings in 1995 (its obligations were not covered by the Bank of England) has encouraged banks to be more cautious in the granting of unsecured credit lines to one another. In addition, to the extent that such a distortion exists, it is not perceived to be simply a U.K. phenomenon; similar treatment is reportedly granted to the largest domestic banks in other currency interbank markets. The interest rates paid by the largest U.K. banks on their sterling CDs are also thought to be a few basis points less than those paid by similarly-rated institutions in the market; however, this was mainly attributed to a liquidity premium effect, since the sterling CDs issued by those banks tend to be the most active-traded in the market.

31. The Bank of England and the FSA play an active role in working with market participants to champion the development of the sterling money market. In addition to a continuous bilateral relationship with market participants, the Bank and FSA liaise with them through three key committees—the Foreign Exchange Joint Standing Committee, the Sterling Money Markets Liaison Group (MMLG), and the Stock Lending and Repo Committee (SLRC). All three are chaired by senior Bank officials, they include a wide range of private and public sector participants, and minutes of meetings of the groups are posted on the Bank’s internet web site. Market participants generally praised the Bank’s willingness to work with them in an open collaborative fashion to foster the development of well-functioning deep and liquid money and foreign exchange markets. Examples of some issues that have been dealt with by these committees include: preparations in financial markets for the millennium date change; the preparation of guidance on good trading practices in wholesale financial markets; a review of money market instruments and plans for their dematerialization so that they can be settled in the CREST system; and reviews of the main legal agreements used in the various markets.

Key issues

Efficiency of the sterling money market in distributing monetary liquidity

32. As noted previously, the Bank of England in its monetary policy operations normally aims to supply the market’s net liquidity requirement each day plus a small margin to address the market’s demand for precautionary balances. This encourages market participants to trade in the money market with each other to clear their long and short positions. A key issue is whether the market is in fact able to distribute the liquidity supplied by the Bank in an effective fashion so that at the end of the day market participants do not need to access the Bank’s facilities for amounts significantly in excess of the daily shortage. The data suggest that this is indeed the case (Table 5). First, the average amount of liquidity provided by the Bank each day (about £2.5 billion in 2001 with a standard deviation of £1.5 billion) is low relative to the £28 billion average daily volumes transacted in the interbank and repo markets. More importantly, the demand for precautionary balances at the Bank of England appears to be quite modest—around £50 million in 2001 with a standard deviation of 70 million—and not sensitive to the degree of uncertainty in the market. For example, the level of balances held at the Bank of England did not rise following the terrorist attack on September 11.

Table 5.

Daily Liquidity Supplied by Bank of England

(£ billions)

Sources: Bank of England and Fund staff calculations.

Table 5.

Daily Liquidity Supplied by Bank of England

(£ billions)

				1999	2000	2001
	Average Liquidity Supplied by Bank of England			1.2	2	2.5
		(Standard deviation)		(0.8)	(1.0)	(1.5)
		of which:
			Overnight	0.2	0.3	0.6
			Two-week	1.0	1.7	1.9
	Average End-of-Day Balances at Bank of England			0.1	0.1	0.05
		(Standard deviation)		(0.1)	(0.07)	(0.07)
	Average Daily Turnover in Gilt Repo			23	28	28

Sources: Bank of England and Fund staff calculations.

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Table 5.

Daily Liquidity Supplied by Bank of England

(£ billions)

				1999	2000	2001
	Average Liquidity Supplied by Bank of England			1.2	2	2.5
		(Standard deviation)		(0.8)	(1.0)	(1.5)
		of which:
			Overnight	0.2	0.3	0.6
			Two-week	1.0	1.7	1.9
	Average End-of-Day Balances at Bank of England			0.1	0.1	0.05
		(Standard deviation)		(0.1)	(0.07)	(0.07)
	Average Daily Turnover in Gilt Repo			23	28	28

Sources: Bank of England and Fund staff calculations.

33. One issue that has concerned market participants in the past was attempts by some banks to hoard the liquidity provided by the Bank of England to fund their own operations, rather than make it available to other market participants. Some participants argued that this practice contributed to undue concentration of the Bank’s liquidity injections among a few market participants that were not willing to on-lend the funds to the rest of the market, thereby contributing to excessive volatility in overnight interest rates. This, in turn, may have discouraged a broader range of institutions from trading in the market, thereby impeding the liquidity of the market. In December 2001, the Bank notified its counterparties that to avoid undue concentration it may individually scale counterparties’ bids in its open market operations (for which there is a general provision in the Operational Notice governing these operations). Such a step would help to ensure that access to the liquidity provided by the Bank is available as smoothly as possible to all market participants.

34. Discussions with market participants revealed that they are pleased with the Bank’s action, and that it has helped to alleviate technical distortions in the overnight market. For example, several banks reported that short-term interest rates are now more in-line with the Bank’s two-week policy rate since the Bank’s action (in an unchanged policy rate environment). However, they cautioned that the Bank will need to be vigilant against attempts by participants to collude with an aim of hoarding the Bank’s liquidity and avoiding the triggering of the scaling back of bids to the detriment of others in the market. The Bank, in fact, does this by monitoring correlations in the trading behavior of major participants. In addition, some market participants admitted that they are not exactly sure how much liquidity they can bid for before their bids would be scaled back, although the Bank has indicated it would let them know ahead of time if there was any risk of their bids being scaled back. This lack of certainty reflects the fact that there is no fixed ratio or formula used by the Bank to set the degree of scaling; indeed, it could be relaxed in circumstances of general financial strain. And some uncertainty in this regard can be a useful tactical device to prevent market participants from ‘gaming’ the Bank.

Resiliency of the unsecured sterling interbank market in periods of stress

35. As noted previously, the interbank market primarily allocates credit on the basis of quantity credit rationing through credit lines granted by market participants to one another. Some observers argue that there is a deficiency in pricing according to counterparty risk in that it can lead to excessive dependence on central banks during periods of crisis because the size of credit lines in the market is highly dependent on the degree of confidence participants have in one another in an environment of imperfect information.¹³

36. The failure of banks to honor their unsecured interbank deposit and CD obligations has been a rare event in the United Kingdom, and mainly limited to smaller institutions. As a result, the market has generally performed well across a wide range of trading conditions, such as in the wake of the failure of LTCM; over the millennium date change; and in the days following the September 11 terrorist attack. The sterling interbank market has not experienced a loss of confidence due to the failure of a major U.K. bank for many years. The most recent cases of official emergency liquidity support to U.K. banks occurred in the early 1990s, when the Bank lent to a few small banks in order to prevent a wider loss of confidence in the banking system. A rather larger group of small banks experienced difficulties and was subject to intensified supervision by the authorities; 25 banks failed or closed due to problems during this period.¹⁴ In contrast, the Bank did not intervene to prevent the collapse of Barings in 1995, which was a larger and more prominent institution, but whose problems did not in fact threaten the system given the economic and market conditions at that time. The interbank market took this event in stride, which is a good indicator of its resiliency in periods of heightened uncertainty. U.K. authorities stressed that when they are considering whether to intervene to provide emergency assistance, the decision is determined by whether they are dealing with a systemically important situation, rather than by the size of the institution.

37. Although the interbank market functions well, there is the potential for the interbank market to act as a contagion channel in the unlikely event that a major U.K. clearing bank was unable to honor its unsecured interbank and CD obligations. This is due to the fact that these banks stand at the fulcrum of the sterling market inasmuch as banks hold significant portions of their sterling liquid assets in the form of claims issued by other banks (Table 6), and the major U.K.-owned banks are large issuers of sterling interbank deposits and CDs (Table 3). Thus, it is important to assess the extent to which the U.K. interbank market is dependent on the financial condition of individual participants and the adequacy of the methods used to supervise bank liquidity management practices.

Table 6.

U.K. Banks’ Sterling Liquid Assets as of December 2001

(in percent of Total Sterling Liquid Assets)

Source: Bank of England

^1/Negative numbers reflect the repo-ing of gilts in exchange for cash.

Table 6.

U.K. Banks’ Sterling Liquid Assets as of December 2001

(in percent of Total Sterling Liquid Assets)

	Major U.K.	Other Large	Small U.K.	Foreign
	Banks	U.K. Banks	Banks	Banks
Bank Obligations	53	79	82	53
U.K. Government Gilts and Treasury Bills 1/	-21	…	15	-105
Other U.K. Debt Securities	19	21	2	32
Gilt Repo	39	…	…	101
Other Repo	3	…	…	17
Bank notes and Bank of England Deposits	7	…	1	2
Total	100	100	100	100

Source: Bank of England

^1/Negative numbers reflect the repo-ing of gilts in exchange for cash.

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Table 6.

U.K. Banks’ Sterling Liquid Assets as of December 2001

(in percent of Total Sterling Liquid Assets)

	Major U.K.	Other Large	Small U.K.	Foreign
	Banks	U.K. Banks	Banks	Banks
Bank Obligations	53	79	82	53
U.K. Government Gilts and Treasury Bills 1/	-21	…	15	-105
Other U.K. Debt Securities	19	21	2	32
Gilt Repo	39	…	…	101
Other Repo	3	…	…	17
Bank notes and Bank of England Deposits	7	…	1	2
Total	100	100	100	100

Source: Bank of England

^1/Negative numbers reflect the repo-ing of gilts in exchange for cash.

Bilateral interbank market exposures of U.K. banks

38. One way to assess the vulnerability of the interbank market to the financial condition of individual participants could be to examine data on bilateral unsecured interbank claims between individual banks. In the course of the discussions on how to conduct the stress testing exercise for U.K. financial institutions, the FSAP team noted for illustrative purposes only that these data could be used to prepare frequency distributions of the exposures so that the authorities can obtain a sense of whether the market would be vulnerable in the event of a failure of one or more institutions. The exposures that are most likely to generate problems for the authorities would be those that involve large unsecured liabilities of some banks that are held by a small number of banks—i.e., the ‘tails’ of the distribution of bilateral interbank exposures rather than the mean exposures. In turn, these can lead to ‘chain-reactions’ whereby the failure of one bank, by contributing to the failure of another, can raise the probability of others encountering difficulties. The implication being that the potential vulnerability of the system as a whole can be larger than what is implied by simply looking at the bilateral exposures of individual banks—one must also examine how they interact with one another. The authorities were encouraged to continue with their efforts to increase their surveillance of bilateral unsecured exposures between banks (including sterling and foreign currency-denominated interbank deposits and CDs, foreign exchange, and payment system exposures) so that they can conduct a more thorough regular assessment of the systemic vulnerability of the interbank market to undue concentration of risk.¹⁵ This point was accepted by the authorities, and they have stepped up its surveillance in this area. However, in order to obtain a complete picture of these exposures, there could ultimately be a need for close collaboration with authorities in other jurisdictions, since many of these exposures involve foreign institutions that are not supervised by the U.K. authorities.

39. The authorities may also wish to consider publishing the results obtained, albeit in a highly aggregated form to protect the confidentiality of individual banks. Individual market participants are not able to obtain such information on their own, since the raw data are considered to be highly confidential by individual institutions. By publishing highly-aggregated frequency distributions of the results, the authorities would inject some market discipline into the process by enabling market participants to gain an appreciation over time of the vulnerability of the market as a whole to the failure of an institution(s) without impairing the confidentiality of individual banks. In turn, this could help bank credit departments set credit lines on a more informed basis.

40. The available data suggest that if a bank failed, other banks might also be threatened. As noted previously, many banks hold a large share of their sterling liquidity in the form of claims issued by other banks. Moreover, more than half of sterling and foreign currency interbank claims are held by less than ten institutions. Relative to their total balance sheets, these claims were estimated by IMF staff to represent about 4 percent of total assets for the largest U.K.-owned banks, and more than 12 percent for other U.K.-owned banks, or about 35 percept of Tier 1 capital for both groups. However, this does not take into account the potential chain-reactions that may feed back onto the largest banks if the failure of one bank undermined the health of others in the system. Nor does it take into account any interbank exposures denominated in foreign currencies, or those that arise through foreign exchange trading or payment system activities.

Supervision of bank liquidity management practices

41. As indicated previously, Box 2 summarizes the FSA’s approach to regulating commercial bank liquidity management practices. Several features were identified in the sterling stock liquidity ratio that appear to be adversely affecting the functioning of markets. Indeed, some of the smaller banks that are supervised under the SSLR appear to be focusing too much on meeting the supervisory requirement, and not using the more sophisticated liquidity management practices found elsewhere in the market.

• While perhaps a good starting point for monitoring the liquidity condition of the largest U.K.-owned banks, the SSLR does not fully take into account the maturity distribution of their assets and liabilities. However, as noted in Box 2, maturity mismatch data are collected for other banks operating in the U.K. In the absence of other information, one could easily miss potentially significant liquidity mismatches lying outside the five business-day horizon used in the ratio. This deficiency may not be too significant, since these institutions are subject to intensive day-to-day supervision by the FSA. Thus, the authorities may be able to spot emerging liquidity concerns at individual institutions through the broad range of information at their disposal. Nonetheless, the authorities should also monitor the liquidity risks in the banking system at a systemic level so that they can be prepared to deal with the chain-reactions that can result when the failure of one bank threatens the stability of other banks in the system. To conduct such an exercise, maturity mismatch data would need to be collected using a common reporting system that is applicable to all banks. A potential benefit of collecting these data from the major U.K.-owned banks too, is that it might encourage some of them to focus more on their mis-match positions when managing liquidity, rather than focusing on whether they have met the SSLR by a comfortable margin.

• The SSLR allows the major U.K.-owned banks to net (to a certain extent) their holdings of sterling CDs issued by other banks against their own maturing deposits for purpose of calculating their SSLRs. Liquidity held in the form of sterling CDs issued by other U.K. banks may not be readily available when the failure of one bank threatens the stability of other banks in the U.K. banking system. Moreover, as noted previously, this provision has contributed to the growth of CDs in recent years—an outcome that is incompatible with encouraging banks to deal with one another on a secured basis. The latter is an important ingredient for reducing systemic risks in the sterling money market with its already large amounts of unsecured exposures. Consequently, the authorities were encouraged to reconsider the treatment of owned CDs in the calculation of the SSLR. It is conceivable that the banks might be willing to go along with such a review if it is linked to the recommendation contained in the next bullet.

• No consideration is given to the major U.K.-owned banks’ significant holdings of foreign currency liquid assets (except those euro-denominated securities that are accepted by the Bank as collateral in its market operations) and their foreign currency liabilities in the calculation of the SSLR. Should one of these banks experience difficulties, these liabilities could also run-off fairly quickly. Investors tend to behave the same regardless of their location or the currency denomination of their investments. And, to the extent that the banks’ foreign currency liquid assets are held in securities and currencies that enjoy deep and liquid markets (such as those in the euro area and the United States), they could be used by the bank to help address a liquidity crisis. Liquidity is fungible in normal market conditions. So long as the assets involved can be readily liquidated and the proceeds converted into sterling, the liquidity of all banks should be supervised on a global basis, as is done for some foreign-owned banks, although the authorities may want to give some preference to holding liquidity in sterling assets, since this is the currency whose liquidity over which they have the most control.

42. The FSA recognizes the deficiencies inherent in its current approach to supervising commercial bank liquidity management practices, and plans to revise its approach in the near future. In March 2002, it issued a consultation paper to begin the dialogue with stakeholders on how best to regulate and supervise bank liquidity management practices, and indicated to the FSAP team that it will bear in mind the above points as it goes through the consultation process. Implementation of the FSA’s proposals is expected to take place in 2004 and 2005.

Measures to encourage banks to deal with one another on a secured basis

43. An active unsecured segment of the sterling money market can be a useful instrument for encouraging banks to test their names on a regular basis, thereby imposing some market discipline on their activities. However, this could still continue to take place if the unsecured segment was a much smaller segment of the market than it is today, where it constitutes more than half of the sterling money market. Moreover, the discussions with market participants alluded to earlier suggest that banks may still, at the margin, be setting credit limits on the basis that there is a non-zero probability that the Bank of England will not allow a major U.K. clearing bank to fail. So what steps can be taken to encourage more trading on a secured basis? The suggestion above to remove the preferential treatment given to CDs in the SSLR might at least ensure that the supervision of bank liquidity management practices is not inadvertently encouraging more unsecured trading. Similarly the suggestion to supervise liquidity positions on a global basis might, at the margin, remove an impediment to the major U.K.-owned banks adopting a more efficient approach to global liquidity management. In addition, given the limited supply of sterling government securities in the market, the authorities may wish to consider championing measures that would facilitate netting arrangements and other risk mitigation techniques, such as trading of sterling liquidity using other sterling securities and euro-denominated instruments as collateral. (The latter securities could be used with the help of foreign exchange swaps to minimize exchange rate risk.) This will obviously not happen overnight, but continued improvements to payment and securities settlement procedures and systems may make render such an option increasingly attractive over time. However, there is also a need to ensure that such steps do not go so far as to unduly undermine the positions of a bank’s unsecured creditors

IV. Pound Sterling Foreign Exchange Market

44. Complementing the sterling money market is a very active foreign exchange market for the pound. According to the results of the triennial foreign exchange market survey conducted by central banks in April 2001, the pound was the fourth most actively-traded currency in the world, accounting for 13 percent of global market turnover (Table 7). Most transactions are conducted against the U.S. dollar, although pound-euro transactions are not insignificant. In terms of transaction-type, most are conducted in the form of foreign exchange swaps for tenors ranging up to 12 months (Table 8)—a finding that is also true in other currency markets. These swaps are used by market participants to transfer liquidity between domestic money markets on a fully-hedged basis, and to smooth pricing discrepancies that can arise from time to time in domestic money markets due to local liquidity imbalances. Thus, foreign exchange swaps play an important role in helping to ensure that covered interest parity holds between interest rates in different countries.

Table 7.

Average Daily Global Trading in Pounds Sterling Relative to Other Currencies

(Billions of US$ equivalent)

Source: Bank for International Settlements.

^1/Because 2 currencies are involved each transaction, the sum of individual currencies equals twice the repeated total.

Table 7.

Average Daily Global Trading in Pounds Sterling Relative to Other Currencies

(Billions of US$ equivalent)

	1992	1995	1998	2001
US Dollar	672	991	1301	1094
Euro Currencies	453	710	782	455
Japanese Yen	192	287	301	275
Pound Sterling	112	112	164	160
Swiss Franc	69	87	106	74
Other	142	193	326	362
Total 1/	820	1190	1490	1210
Memo:
Pound Sterling/US Dollar	77	78	118	125
Pound Sterling/Eurocurrencies	23	21	31	24

Source: Bank for International Settlements.

^1/Because 2 currencies are involved each transaction, the sum of individual currencies equals twice the repeated total.

View Table

Table 7.

Average Daily Global Trading in Pounds Sterling Relative to Other Currencies

(Billions of US$ equivalent)

	1992	1995	1998	2001
US Dollar	672	991	1301	1094
Euro Currencies	453	710	782	455
Japanese Yen	192	287	301	275
Pound Sterling	112	112	164	160
Swiss Franc	69	87	106	74
Other	142	193	326	362
Total 1/	820	1190	1490	1210
Memo:
Pound Sterling/US Dollar	77	78	118	125
Pound Sterling/Eurocurrencies	23	21	31	24

Source: Bank for International Settlements.

^1/Because 2 currencies are involved each transaction, the sum of individual currencies equals twice the repeated total.

Table 8.

Average Daily Trading in Pounds Sterling by Type of Transaction in April 2001

(Transactions Booked in London)

Source: Bank of England

Table 8.

Average Daily Trading in Pounds Sterling by Type of Transaction in April 2001

(Transactions Booked in London)

			US$ Billion Equivalent	Percent
Spot			28	23
	of which: Local		12	9
		Cross-Border	16	13
Outright Forward			14	11
	of which: Local		7	5
		Cross-Border	7	6
Foreign Exchange Swaps			81	66
	of which: Local		34	28
		Cross-Border	47	38
Total			123	100

Source: Bank of England

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Table 8.

Average Daily Trading in Pounds Sterling by Type of Transaction in April 2001

(Transactions Booked in London)

			US$ Billion Equivalent	Percent
Spot			28	23
	of which: Local		12	9
		Cross-Border	16	13
Outright Forward			14	11
	of which: Local		7	5
		Cross-Border	7	6
Foreign Exchange Swaps			81	66
	of which: Local		34	28
		Cross-Border	47	38
Total			123	100

Source: Bank of England

45. Reported trading volumes for the pound declined in absolute terms between 1998 and 2001, but the pound’s share of global foreign exchange market activity rose from 11 to 13 percent. However, the contraction in trading volumes for the pound and other currencies does not appear to be a cause for concern, and may in fact suggest that the foreign exchange market is becoming more efficient. Market participants and the authorities reported that the decline in trading volumes in the foreign exchange market can be partly explained by consolidation in the banking industry, and also by an increase in the use of electronic broking, particularly in the spot inter-dealer market. Consolidation in the banking industry has enabled banks to handle a larger share of their customer flows in-house without having to trade in the inter-dealer market to manage their exposures. As for electronic broking, market estimates suggest that that over two-thirds of U.K. inter-dealer spot activity is now conducted using electronic brokers, such as EBS and Reuters, compared to 30 percent in 1998.¹⁶ Electronic trading systems increase the transparency of market prices meaning that deals traditionally executed between dealers by phone to facilitate price discovery are no longer necessary, leading to a more efficient market, less opportunities for arbitrage, and an overall decline in turnover.

46. The depth and liquidity of the market for pound sterling is corroborated by indications that transaction costs in the wholesale market are low and that traders can execute large transactions without moving the market against them. Market participants report that bid-offer spreads in the interdealer market for the pound are less than 5 basis points for spot and short-term swap transactions and consistent with spreads seen for transactions involving euros. In addition, if a trader is willing to work a large order patiently in the market and not try to trade it all at once, transactions of several hundred million pounds reportedly can be absorbed by the market without triggering a significant move in the exchange rate.

47. There are standard confirmation and messaging systems used to settle transactions in the market, for example SWIFT. Within foreign exchange settlement, there exists the well-documented Herstatt Risk, where two legs of the same trade may not be settled simultaneously because of international time zone differences. The introduction of the Continuous-Linked Settlement Bank (CLS) in September 2002, initially covering trades between CLS members in the seven largest currencies (including the pound), should help to reduce this risk as settlement of both legs of the transaction will be undertaken at the same time. In the case of foreign exchange swaps, unsecured credit risk can also arise during the tenor of a swap because if a counterparty failed to deliver its side of the transaction at the maturity of a swap, a bank would have to re-enter the market to offset the resulting unexpected exposure at prevailing exchange rates. Banks manage their exposures in this regard using limits on the amount of swaps they can undertake with individual counterparties, similar to what is done in the domestic interbank deposit market.