1 l The Foreign Exchange Market - Learn Forex

Today’s over-the-counter global market in foreign exchange meets many of the standards that classical economists expected of a smoothly functioning and effective market.
There are many buyers and many sellers. Entry by new participants is generally not too
difficult.
The over-the-counter market is certainly not confined to a single geographical area as the classical standards required. However, with the advance of technology, information is dispersed quickly and efficiently around the globe, with vast
amounts of information on political and economic developments affecting exchange rates.

As in commodity markets, identical products are being traded in financial centers all around the world. Essentially, the same marks, dollars, francs, and other currencies are being bought and sold, no matter where the purchase takes place. Traders in different centers are continuously in touch and buying and selling from each other.

With trading centers open at the same time, there is no evidence of substantial price differences
lasting more than momentarily. Not all features of today’s over-the-counter market fully conform to the classical ideals. There is not perfect “transparency,” or full and immediate disclosure of all trading activity.

Individual traders know about the orders and the flow of trading activity in their own firms,
but that information may not be known to everyone else in the market. However, transparency
has increased enormously in recent years.

With the growth of electronic dealing systems and electronic brokering systems, the price discovery process has become less exclusive and pricing information more broadly disseminated—at least for certain foreign exchange products and currency pairs. Indeed, by most measures, the over-the-counter foreign exchange market is regarded by observers as not only extremely large and liquid, but also efficient and smoothly functioning.

Why the need for Foreign Exchange

Almost every nation has its own national currency or monetary unit—its dollar, its peso,
its rupee—used for making and receiving payments within its own borders. But foreign
currencies are usually needed for payments across national borders. Thus, in any nation
whose residents conduct business abroad or engage in financial transactions with persons in
other countries, there must be a mechanism for providing access to foreign currencies, so that
payments can be made in a form acceptable to foreigners. In other words, there is need for
“foreign exchange” transactions—exchanges of one currency for another.

The exchange rate is a price—the number of units of one nation’s currency that must be surrendered
in order to acquire one unit of another nation’s currency. There are scores of “exchange rates”
for the U.S. dollar. In the spot market, there is an exchange rate for every other national currency
9 l The Foreign Exchange Market in the United States some basic concepts: foreign exchange,
the foreign exchange rate, payment and settlement systems


1. WHY WE NEED FOREIGN EXCHANGE
3. ROLE OF THE EXCHANGE RATE
2. WHAT “FOREIGN EXCHANGE” MEANS
traded in that market, as well as for various composite currencies or constructed monetary
units such as the International Monetary Fund’s “SDR,” the European Monetary Union’s “ECU,”
and beginning in 1999, the “euro.” There are also various “trade-weighted” or “effective” rates
designed to show a currency’s movements against an average of various other currencies (see
Box 2-1). Quite apart from the spot rates, there are additional exchange rates for other delivery
dates, in the forward markets. Accordingly, although we talk about the dollar exchange rate in
the market, and it is useful to do so, there is no single, or unique dollar exchange rate in the
market, just as there is no unique dollar interest rate in the market.

A market price is determined by the interaction of buyers and sellers in that market, and a
market exchange rate between two currencies is determined by the interaction of the official and
private participants in the foreign exchange rate market. For a currency with an exchange rate that
is fixed, or set by the monetary authorities, the central bank or another official body is a key
participant in the market, standing ready to buy or sell the currency as necessary to maintain the
authorized pegged rate or range.

But in the United States, where the authorities do not intervene in the
foreign exchange market on a continuous
basis to influence the exchange rate, market participation is made up of individuals,
nonfinancial firms, banks, official bodies, and other private institutions from all over the world
that are buying and selling dollars at that particular time.
The participants in the foreign exchange market are thus a heterogeneous group. Some
of the buyers and sellers may be involved in the “goods” market, conducting international
transactions for the purchase or sale of merchandise. Some may be engaged in “direct
investment” in plant and equipment, or in“portfolio investment,” dealing across borders
in stocks and bonds and other financial assets, while others may be in the “money
market,” trading short-term debt instruments internationally.

The various investors, hedgers, and speculators may be focused on
any time period, from a few minutes to several years. But, whether official or private, and
whether their motive be investing, hedging, speculating, arbitraging, paying for imports,
or seeking to influence the rate, they are all part of the aggregate demand for and supply
The Foreign Exchange Market in the United States l 10 some basic concepts: foreign exchange,
the foreign exchange rate, payment and settlement systems

ALL ABOUT... BILATERAL AND TRADE-WEIGHTED
EXCHANGE RATES
Market trading is bilateral, and spot and forward market exchange rates are quoted
in bilateral terms—the dollar versus the pound, franc, or peso. Changes in the
dollar’s average value on a multilateral basis—(i.e., its value against a group or
basket of currencies) are measured by using various statistical indexes that have
been constructed to capture the dollar’s movements on a trade-weighted average,
or effective exchange rate basis. Among others, the staff of the Federal Reserve
Board of Governors has developed and regularly publishes such indexes, which
measure the average value of the dollar against the currencies of both a narrow
group and a broad group of other countries. Such trade-weighted and
other indexes are not traded in the OTC spot or forward markets, where only
the constituent currencies are traded. However, it is possible to buy and sell
certain dollar index based futures and exchange-traded options in the exchangetraded
market.
B O X 2 - 1
Just as each nation has its own national currency, so also does each nation have
its own payment and settlement system— that is, its own set of institutions and
legally acceptable arrangements for making payments and executing financial transactions
within that country, using its national currency. “Payment” is the transmission of an
instruction to transfer value that results from a transaction in the economy, and “settlement”
is the final and unconditional transfer of the value specified in a payment instruction.
Thus, if a customer pays a department store bill by check, “payment” occurs when the
check is placed in the hands of the department store, and “settlement” occurs when the
check clears and the department store’s bank account is credited. If the customer pays the
bill with cash, payment and settlement are simultaneous.

When two traders enter a deal and agree to undertake a foreign exchange transaction, they
are agreeing on the terms of a currency exchange and committing the resources of their respective
institutions to that agreement. But the execution of that exchange—the settlement—does not
take place until later. Executing a foreign exchange transaction
requires two transfers of money value, in opposite directions, since it involves the
exchange of one national currency for another. Execution of the transaction engages the
payment and settlement systems of both nations, and those systems play a key role in the
operations of the foreign exchange market.

Payment systems have evolved and grown more sophisticated over time. At present, various
forms of payment are legally acceptable in the United States—payments can be made, for
example, by cash, check, automated clearinghouse (a mechanism developed as a substitute for certain
forms of paper payments), and electronic funds transfer (for large value transfers between banks).
Each of these accepted forms of payment has its own settlement techniques and arrangements.
By number of transactions,most payments in the United States are still made with cash
(currency and coin) or checks. However, the electronic funds transfer systems, which
account for less than 0.1 percent of the number of all payments transactions in
the United States, account for more than 80 percent of the value of payments. Thus,
of the currencies involved, and they all play a role in determining the market exchange rate
at that instant.

Given the diverse views, interests, and time frames of the participants, predicting
the future course of exchange rates is a particularly complex and uncertain business.
At the same time, since the exchange rate influences such a vast array of participants
and business decisions, it is a pervasive and singularly important price in an
open economy, influencing consumer prices, investment decisions, interest rates, economic
growth, the location of industry, and much else. The role of the foreign exchange
market in the determination of that price is critically important.
11 l The Foreign Exchange Market in the United States
some basic concepts: foreign exchange,
the foreign exchange rate, payment and settlement systems
ALL ABOUT...

4. PAYMENT AND SETTLEMENT SYSTEMS
electronic funds transfer systems represent a key and indispensable component of the
payment and settlement systems. It is the electronic funds transfer systems that execute
the inter-bank transfers between dealers in the foreign exchange market. The two
electronic funds transfer systems operating in the United States are CHIPS (Clearing House
Interbank Payments System), a privately owned system run by the New York Clearing
House, and Fedwire, a system run by the Federal Reserve (see Box 2-2).
Other countries also have large-value interbank funds transfer systems, similar to
Fedwire and CHIPS in the United States. In the United Kingdom, the pound sterling leg of a
foreign exchange transaction is likely to be settled through CHAPS—the Clearing House
Association Payments System, an RTGS system whose member banks settle with each
other through their accounts at the Bank of England. In Germany, the Deutsche mark leg of
a transaction is settled through EAF—an electronic payments system where settlements
are made through accounts at Germany’s central bank, the Deutsche Bundesbank.

A new payment system, named Target, has been designed to link RTGS systems within the
European Community, to enable participants to handle transactions in the euro upon its
introduction on January 1, 1999. Globally, more than 80 percent of global
foreign exchange transactions have a dollar leg. Thus, the amount of daily dollar settlements is
huge, one trillion dollars per day or more.

The settlement of foreign exchange transactions accounts for the bulk of total dollar payments
processed through CHIPS each day. The matter of settlement practices is of
particular importance to the foreign exchange The Foreign Exchange Market in the United States l 12
some basic concepts: foreign exchange, the foreign exchange rate, payment and settlement systems.


PAYMENTS VIA FEDWIRE AND CHIPS
When a payment is executed over Fedwire, a regional Federal Reserve Bank debits on
its books the account of the sending bank and credits the account of the receiving
bank, so that there is an immediate transfer from the sending bank and delivery to the
receiving bank of “central bank money” (i.e., a deposit claim on that Federal Reserve
Bank).A Fedwire payment is “settled”when the receiving bank has its deposit account at
the Fed credited with the funds or is notified of the payment. Fedwire is a “realtime
gross settlements” (or RTGS) system. To control risk on Fedwire, the Federal
Reserve imposes charges on participants for intra-day (daylight) overdrafts beyond a
permissible allowance.

In contrast to Fedwire, payments processed over CHIPS are finally “settled,”
not individually during the course of the day, but collectively at the end of the business day,
after the net debit or credit position of each CHIPS participant (against all other CHIPS
participants) has been determined. Final settlement of CHIPS obligations occurs by
Fedwire transfer (delivery of “central bank money”). Settlement is initiated when those
CHIPS participants in a net debit position for the day’s CHIPS activity pay their day’s
obligations. If a commercial bank that is scheduled to receive CHIPS payments makes
funds available to its customers before CHIPS settlement occurs at the end of the
day, that commercial bank is exposed to some risk of loss if CHIPS settlement cannot
occur.To ensure that settlement does, in fact, occur, the New York Clearing House has put
in place a system of net debit caps and a losssharing arrangement backed up by collateral
as a risk control mechanism.
B O X 2 - 2

Market because of “settlement risk,” the risk that one party to a foreign exchange transaction will
pay out the currency it is selling but not receive the currency it is buying. Because of time zone
differences and delays caused by the banks’ own internal procedures and corresponding banking
arrangements, a substantial amount of time can pass between a payment and the time the
counter-payment is received—and a substantial credit risk can arise. Efforts to reduce or
eliminate settlement risk are discussed.