Chapter

Annex I: Structure of the Global Foreign Exchange Market

Author(s):
International Monetary Fund
Published Date:
January 1993
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The foreign exchange market is the world’s largest financial market by virtually any measure. It is the only truly global financial market: currencies are traded in financial centers around the world, connected by communications systems that allow nearly instantaneous transmission of price information and trade instructions. The market has grown rapidly over the last decade since cross-border capital flows have been liberalized and the regulatory constraints on institutional investments relaxed. The increased liquidity of securities markets, particularly in the industrial countries, which has resulted from privatization and from larger and more efficient markets for government debt securities, has also increased the range of foreign assets available to investors and made foreign investment easier. This expansion of cross-border capital flows has been actively promoted by governments seeking broader investor bases for their own debt and for securities issued by domestic firms. Improvements in trading and settlement practices and in technology have increased the liquidity of secondary markets for foreign exchange instruments and allowed participating financial institutions to handle larger volumes of transactions safely.

The rapid expansion of foreign exchange trading has been documented in surveys whose results are reported in Table 5.1 Total daily net turnover in the nine markets that were included in the 1989 survey grew to $910 billion in 1992, an increase of 37 percent in relation to 1989.2 This brings worldwide net turnover to an estimated $1 trillion a day; this may be compared with total nongold reserves of all industrial countries (of $555.6 billion) at the end of April 1992.3 According to the most recent survey, the United Kingdom remains the most active foreign exchange market with average net daily turnover estimated at $300 billion; it also showed the fastest growth of turnover: 60 percent between 1989 and 1992. It is followed by the United States ($192 billion); Japan ($128 billion); Singapore ($74 billion); and Switzerland ($68 billion).

Table 5.Net Foreign Exchange Market Turnover(In billions of U. S. dollars a day)
MarchAprilApril
198619891992
United Kingdom90187300
United States59129192
Japan48115128
Singapore5574
Switzerland5768
Hong Kong4961
Germany57
France2635
Australia3030
Canada91522
Sources: Bank of Canada; Bank of England; Bank of Japan; Banque de France; Deutsche Bundesbank; Federal Reserve Bank of New York; Monetary Affairs Branch, Hong Kong; Monetary Authority of Singapore; Reserve Bank of Australia; and Swiss National Bank.
Sources: Bank of Canada; Bank of England; Bank of Japan; Banque de France; Deutsche Bundesbank; Federal Reserve Bank of New York; Monetary Affairs Branch, Hong Kong; Monetary Authority of Singapore; Reserve Bank of Australia; and Swiss National Bank.

Foreign exchange market activity still consists mainly of transactions involving the U.S. dollar, as documented in Table 6. In April 1992, for example, 76 percent of net turnover in the United Kingdom and 89 percent of net turnover in the United States involved the U.S. dollar on one side of the transaction. The use of other currencies is gaining in importance, however. The decline of the dollar as the vehicle currency in foreign exchange transactions is due in particular to the increased use of the deutsche mark, in response to the liberalization of capital flows within Europe and the greater stability of exchange rates within the exchange rate mechanism (ERM) of the European Monetary System (EMS).

Table 6.Distribution of Turnover by Currency(In percent of total turnover)
Local CurrencyU.S. DollarsDeutsche MarkOthers
198619891992198619891992198619891992198619891992Total1
United Kingdom2313124968976292734445366200
United States2878589343344798267200
Japan72901028200
Singapore4817724299590200
Switzerland46733447200
Hong Kong1514939021327164200
France4752594841200
Australia5541878715204352200
Canada68666599999613132226200
Sources: Bank of Canada; Bank of England; Bank of Japan; Banque de France; Federal Reserve Bank of New York; Monetary Affairs Branch, Hong Kong; Monetary Authority of Singapore; Reserve Bank of Australia; and Swiss National Bank.

Individual currency proportions sum to 200 percent because both sides of a transaction are included.

Data for 1986 and 1989 refer to proportions of gross turnover.

Sources: Bank of Canada; Bank of England; Bank of Japan; Banque de France; Federal Reserve Bank of New York; Monetary Affairs Branch, Hong Kong; Monetary Authority of Singapore; Reserve Bank of Australia; and Swiss National Bank.

Individual currency proportions sum to 200 percent because both sides of a transaction are included.

Data for 1986 and 1989 refer to proportions of gross turnover.

Market Participants

The foreign exchange market comprises transactions among four groups of participants: dealers, brokers, customers, and central banks. Dealers buy and sell foreign exchange on their own account and may take open positions in currencies. They are employed by banks and other financial institutions that need to have a continuing presence in the market. Brokers, as in other markets, match orders to buy and sell currencies for a fee, and do not take positions themselves. They reduce their customers’ costs of finding a counterparty by accumulating information about the prices at which traders will buy and sell particular currencies.

Customers include nonfinancial corporations, as well as some financial institutions that do not maintain a continuous presence in the market as dealers. Customers enter the market to satisfy their need for foreign exchange to import goods and services and to sell foreign currency received from exports for domestic currency. Customers may also use the forward, swaps, and derivatives markets to hedge foreign currency exposures arising out of foreign trade and investment. In addition, they may enter the market for speculative purposes. Central banks, the fourth class of participants in the market, enter the foreign exchange market both to satisfy the needs of their governments and to influence the exchange rate.

Foreign exchange transactions are organized at two levels: the wholesale (often called “interbank”) market in which dealers trade with each other and with the central banks, and the retail market, which comprises customer transactions. Brokers and dealers participate in both markets, as do some central banks. The distinction between the retail and wholesale markets has become further blurred as some of the larger customers have gained access to the wholesale market through automated trading systems and direct communication links with a large number of dealing banks and financial institutions. The essential difference between dealers and customers is that the latter generally initiate most of their trades whereas dealers also buy and sell foreign currencies in response to orders received from their clients.

Dealers

The wholesale market is an over-the-counter (OTC) market with no central clearinghouse or exchange. Foreign exchange market activity is dominated by transactions among dealers, as shown in Table 7. But the share of wholesale transactions in total net turnover is decreasing.4 In the United Kingdom, the share of wholesale trade declined from 91 percent in 1986 to 77 percent in 1992, while in the United States, wholesale transactions as a share of total gross turnover declined from 82 percent in 1986 to 72 percent in 1989.5 The trend is less evident in other markets; indeed, in Canada the share of wholesale transactions in total turnover has been increasing since 1986.

Table 7.Net Foreign Exchange Market Turnover by Counterparty(In percent of total turnover)
Wholesale Turnover1Retail Turnover
198619891992198619891992
United Kingdom91867791423
United States2827269182831
Japan677162332938
Singapore89901110
Switzerland85821518
Hong Kong89891111
France89851115
Australia79812120
Canada687276322824
Sources: Bank of Canada; Bank of England; Bank of Japan; Banque de France; Federal Reserve Bank of New York; Monetary Affairs Branch, Hong Kong; Monetary Authority of Singapore; Reserve Bank of Australia; and Swiss National Bank.

Includes turnover in derivative securities unless otherwise attributed.

Data presented for 1986 and 1989 are for gross turnover. The 1992 data for wholesale and retail turnover proportions incorporate a more detailed presentation, which allowed disaggregation of OTC options by counterparty.

Sources: Bank of Canada; Bank of England; Bank of Japan; Banque de France; Federal Reserve Bank of New York; Monetary Affairs Branch, Hong Kong; Monetary Authority of Singapore; Reserve Bank of Australia; and Swiss National Bank.

Includes turnover in derivative securities unless otherwise attributed.

Data presented for 1986 and 1989 are for gross turnover. The 1992 data for wholesale and retail turnover proportions incorporate a more detailed presentation, which allowed disaggregation of OTC options by counterparty.

The dominance of wholesale transactions reflects dealers’ position-taking activity; however, most banks have internal controls, as discussed in Annex III below, limiting the size of their open positions. In addition, each retail transaction gives rise to a greater number of wholesale transactions. The limits on open positions, especially overnight positions, mean that dealers will generally try to offset the exposures that result from retail trades. If the bank cannot find another customer interested in undertaking exactly the reverse of the original transaction on the same day, it generally tries to close the position by trading on the wholesale market. If another bank is willing to undertake the reverse transaction, this generates a 1:1 ratio between wholesale orders and retail orders; otherwise, offsetting the original trade would require two or more wholesale transactions. More wholesale transactions are often required to cover an exposure involving forward, swap, or derivatives contracts, particularly if the bank is exposed to changes in a nondollar exchange rate.6

The foreign exchange market is dominated by the dealing banks, many of which specialize in making markets in particular currencies—that is, posting public bid and ask prices. For example, the 1992 survey of activity in the United States found that 83 percent of total gross turnover was accounted for by market makers, while the nonbank financial institutions that dealt in the market accounted for only 17 percent. The market is also highly concentrated. In the United Kingdom, the ten most important banks (measured by gross transaction volume) accounted for 43 percent of market activity in 1992, up from 35 percent in 1989 and 36 percent in 1986. Similarly, in the United States, the ten largest dealing banks accounted for 41 percent of total activity, although this was essentially unchanged from the 1989 figure of 42 percent.

Brokers

As in other financial markets, the broker’s role in the wholesale market is to match buyers and sellers of foreign exchange, in return for a commission that is usually specified as a percentage of the volume of the transaction. This role is important, owing to the large number of dealing banks; in conducting the 1992 survey, for example, the Bank of England contacted 352 dealers and the Federal Reserve Bank of New York contacted 187 dealers. The broker maintains a “limit book” of the public bid and ask prices of the various market-makers and the limit prices (if any) of nonmarket-making dealers it has contacted, and will match incoming demands for, or supplies of foreign currency with the dealer currently offering the best price. Brokers’ prices are clearly only as good as the prices they get from the dealers they contact, which depend on how frequently they contact market-makers for quotes and how intense the activity in the market. Larger banks therefore dispense with brokers, and maintain close working relationships directly with the market-makers in order to have access to timely quotes. Table A1 shows that brokers’ share of trading activity has declined as the introduction and increased use of automated dealing systems has to a certain extent replicated their activities.7

Institutional Investors

The most important nonbank financial participants in the market for foreign exchange are institutional investors, particularly those in the large industrial countries. These include pension funds, insurance companies, investment funds (e.g., mutual funds, hedge funds) and bank trust departments.8 These institutions are so large that their foreign assets, even though they often constitute a relatively small proportion of their total assets, greatly exceed the quantities of foreign exchange held by most nonfinancial corporations.

Table 1 in Section II presents data on the investment patterns of leading money managers in Europe and the United States, indicating the importance of institutional investors in international securities markets, and by extension in the foreign exchange market.9 Participants in the surveys from which these data are drawn included some institutional investors and firms hired by other institutions to manage their assets. The funds managers included in this table controlled assets in excess of $8 trillion at the end of 1991. Of this, 55 percent was controlled by U.S. firms, and 14.5 percent by U.K. based firms.

The European and U.S. managers invested approximately equal proportions of their assets in equity and debt. The main difference in investment patterns lies in the relative weight of domestic and foreign assets in their portfolios. The European funds managers invested approximately 10 percent of their assets in foreign equity and a similar amount in foreign fixed-income securities. U.S. managers are estimated to have invested only about 5 percent of their assets in foreign securities, two-thirds of which is in equity. This implies that at the end of 1991 these 200 firms alone invested a total of just under $1 trillion abroad. A recent report suggests that investment funds worldwide devote up to $10 billion of their capital to currency speculation; leveraging these positions could allow them to mobilize up to $50 billion.10

The rising importance of institutional investors in the international financial markets follows their expanding role in the U.S. economy. They steadily increased their share of total outstanding assets in the United States from 8.4 percent in 1950 to 20.5 percent in 1990 so that at the end of that year these institutions held assets worth $6.5 trillion. A breakdown of the assets of U.S. institutional investors by type of institution during recent years is given in Table A2.

Pension funds are the most important institutions, with total assets estimated at $5.2 trillion at the end of 1991, of which $2.7 trillion was held in U.S. pension funds. Some evidence on the foreign investments of funds in selected countries is available in Table 8. For each of the countries for which pension fund data are reported, the proportion of foreign investments in total securities holdings has increased substantially since 1980. For example, private pension funds in the United States increased their share of foreign securities in total assets from 1 percent in 1980 to about 5 percent or $125 billion in 1991, of which about 80 percent was held as equity; and in the United Kingdom, the proportion of foreign securities in total securities rose from 18 percent in 1985 to 24 percent in 1990.

Table 8.Institutional Investors’ Foreign Securities Investments in Selected Industrial Countries(In percent of total value of securities held)
19801985198619871988198919901991
United Kingdom
Insurance companies7.716.718.314.616.119.618.0
Pension funds17.719.816.116.925.423.6
Memorandum item:
Total assets of insurance companies and pension funds (billions of pounds)313.6382.3406.2452.8633.0579.2
United States
Private pension funds1.03.04.04.04.04.14.04.6
Collective investment funds1.41.31.71.72.44.04.85.7
Japan
Life insurance companies9.026.428.931.431.133.930.028.4
Nonlife insurance companies7.419.421.521.522.326.129.128.5
Postal life insurance6.79.211.211.311.211.612.1
Bank trusts2.214.017.116.715.317.019.422.1
Pension funds8.07.0
Memorandum item:
Total insurance company assets (trillions of yen)48.294.1111.7132.4157.7172.9202.8222.0
Germany
Investment companies11.430.025.527.541.142.240.637.6
Canada
Life insurance companies6.73.84.94.03.94.53.23.6
Pension funds5.86.97.17.07.27.37.7
Netherlands
Insurance companies22.925.828.728.123.420.220.3
Private pension funds28.135.735.838.538.636.238.2
Public pension funds9.910.110.711.113.416.617.2
Sweden
Insurance companies1.51.64.010.412.5
Italy
Insurance companies11.710.18.18.410.410.012.811.6
Sources: Bank of Canada; Bank of Italy; Bank of Japan; De Nederlandsche Bank; Deutsche Bundesbank; Federal Financial Institutions Examination Council; InterSec Research Corporation; Sveriges Riksbank; Turner (1991), p. 67; and United Kingdom, Central Statistical Office.
Sources: Bank of Canada; Bank of Italy; Bank of Japan; De Nederlandsche Bank; Deutsche Bundesbank; Federal Financial Institutions Examination Council; InterSec Research Corporation; Sveriges Riksbank; Turner (1991), p. 67; and United Kingdom, Central Statistical Office.

The trend of increasing foreign investments by pension funds is projected to continue as they seek out new, more profitable markets in which to invest in order to satisfy greater pension claims. InterSec Research Corporation, which tracks the investments of pension funds worldwide, projects that by 1996, global pension fund assets will have risen to approximately $7.2 trillion, of which $880 billion, or 12 percent, will be invested abroad. In the United States, the share of foreign securities in total assets is projected to double to 10 percent, while the other countries’ share of foreign assets will increase less.

Insurance companies are the second most important class of institutional investors. Life insurers in the United States had total assets in 1991 of $1.9 trillion, but information on their holdings of foreign securities is unavailable.11 Some information on the investment patterns of other countries’ insurance companies is presented in Table 8. Japanese life insurance companies held 28 percent of their securities abroad at the end of 1991, compared with only 9 percent in 1980.12 A similar increase in foreign investment, from 7 percent in 1980 to 28 percent in 1991, is reported for Japanese nonlife insurance companies. In Sweden, insurance companies increased their share of foreign securities from 1.5 percent at the end of 1987 to over 12 percent at the end of 1991. In the United Kingdom the share rose from 8 percent of securities owned in 1980 to 18 percent in 1990.

Investment funds (such as mutual funds) have been growing in importance and managed assets approaching $3 trillion at the end of September 1992. Of this amount, $1,533 billion (54 percent) was held by U.S.-based funds. Table 2 in Section II illustrates the distribution of fund assets between domestic and foreign bonds and equity in France, Germany, Japan, the United Kingdom, and the United States at the end of 1991. Among these countries, German and British funds invested the highest proportion of their assets in foreign securities, 34.9 percent and 39.2 percent, respectively, while the much larger French and U.S. funds invested much smaller proportions abroad, only 4.3 percent and 6.6 percent, respectively.13 The data in Table 8 indicate that the share of foreign securities in German investment company portfolios has increased from 11 percent in 1980 to close to 38 percent in 1991.

The fourth group of institutional investors are the trust departments of commercial banks. These departments manage funds on behalf of, and subject to the conditions imposed by, the clients who initiate the trust account. In the United States, bank trust departments managed assets of $785 billion at end-1990, of which $401.7 billion was held in collective investment funds (CIFs). Foreign investment by U.S. banks’ CIFs increased from 1.4 percent of total assets in 1980 to 5.7 percent at the end of 1991, of which 90 percent was held in foreign equity (see Table A4). In Japan, 22 percent of the securities held by bank trusts at the end of 1991 were foreign securities, a substantial increase over the 2.2 percent share recorded in 1980.

Instruments Traded

Three broad categories of products are traded in the foreign exchange market: contracts for spot delivery, forwards and swaps, and other foreign exchange derivatives. Settlement of a spot trade will require the transfer of two currencies on the value date, which by convention is generally specified as the second working day after the day on which the deal is struck.14

Many transactions involve delivery at a date later than the spot value date.15 Such transactions include forward, futures, and option contracts. Forward contracts and most options are sold over the counter, usually between a bank and its customer, and have no secondary market, while futures and some standardized options are traded on organized exchanges. There are also options exchanges in which standardized options are traded.

Forwards and Swaps

Forward contracts are concluded either in isolation (so-called outright forward purchases or sales) or in combination with a spot or another forward contract in what is referred to as a swap. An outright forward contract is an agreement to exchange specified amounts of one currency for another at some date beyond the spot value date and at an exchange rate specified in the contract.16 Forward contracts generally come in standard maturities of one month, two months, and so on.17 Outright forward contracts are not generally concluded between dealers but are common transactions in retail business: they can be closely matched to the customer’s needs by being written with nonstandardized quantities and with customer-specific value dates and delivery locations.

Most forward contracts are written as part of a swap arrangement, the simplest form of which matches an exchange of one currency for another on the current spot value date and a reverse exchange on a forward basis. Since the two foreign exchange transactions are made at preset exchange rates, there is no exchange risk in this transaction, but considerable counterparty risk can be involved as one transaction is not made until the contract matures. Swaps are highly flexible instruments that provide a means of hedging against specific maturity exposures in foreign countries or of moving an exposure forward or back in time. The use of forwards, swaps, and other derivatives to hedge foreign currency exposures is discussed in Annex II below.

Table 9 provides a breakdown of the turnover in nine markets by type of contract. Spot transactions continue to dominate trading, with approximately half of the value of transactions being contracted for spot delivery. However, the share of spot transactions in total turnover has declined since 1986. In April 1992, spot transactions accounted for 50 percent of gross turnover in the United Kingdom, down from 64 percent in 1989 and 73 percent in 1986. In the United States, spot transactions as a proportion of total gross turnover declined from 62 percent in 1989 to 51 percent in 1992. This decline is explained by the surge in swaps and derivatives transactions, as banks and their customers became increasingly concerned with hedging their foreign exchange positions. In the United Kingdom and most other centers, the growth in swap transactions is mainly responsible, whereas in the United States it is the exchange-traded derivatives that showed the greatest expansion.

Table 9.Distribution of Net Turnover by Type of Transaction(In percent of total turnover)
SpotForwardSwaps1Futures and Options
Country198619891992198619891992198619891992198619891992
United Kingdom2736450627354113
United States26162515562925315812
Japan2,3404065146
Singapore2,3545381
Switzerland535459403324
Hong Kong6152339441
France258524363866
Australia614254325133
Canada434135554525461
Sources: Bank of Canada; Bank of England; Bank of Japan; Bank for International Settlements (BIS); Banque de France; Federal Reserve Bank of New York; Monetary Affairs Branch, Hong Kong; Monetary Authority of Singapore; Reserve Bank of Australia; and Swiss National Bank.

Some entries in 1986 and 1989 combine outright forwards and swaps.

Data give percentages of total gross turnover by types of transaction except for futures and options in Japan.

Figures reported by the BIS, except for futures and options in Japan.

Sources: Bank of Canada; Bank of England; Bank of Japan; Bank for International Settlements (BIS); Banque de France; Federal Reserve Bank of New York; Monetary Affairs Branch, Hong Kong; Monetary Authority of Singapore; Reserve Bank of Australia; and Swiss National Bank.

Some entries in 1986 and 1989 combine outright forwards and swaps.

Data give percentages of total gross turnover by types of transaction except for futures and options in Japan.

Figures reported by the BIS, except for futures and options in Japan.

Swaps are most commonly entered into by banks and other financial institutions. For example, in the United Kingdom in 1992, only 12 percent of retail business was accounted for by swaps involving nonfinancial customers. Swaps accounted for 41 percent of the total gross market turnover but only 34 percent of retail turnover. On the other hand, outright forward contracts are more often entered into by customers than dealers. For the United Kingdom, 12 percent of customer business (about evenly split between financial customers and nonfinancial customers) was in outright forward contracts compared with only 6 percent for the market as a whole.

The maturity structure of swaps and forwards activity is concentrated in the shorter terms. In April 1992, 70 percent of the U.K. contracts matured in seven days or less, while 63 percent of the contracts in the United States and 66 percent of Canadian contracts fell in the same category. The Bank for International Settlements (1992, p. 52) reports that the weighted average maturity of interbank swaps—those involving members of the International Swaps Dealers Association (ISDA)—shrank from six to three years between 1987 and 1991.

Table A5 describes the annual evolution of the currency swap market from 1987 to 1991. At the end of 1987, the total outstanding volume, as measured by the notional principal of all contracts, was $183.8 billion. By the end of 1991, this had grown to $807.2 billion, an average annual growth rate of 64 percent. The most commonly swapped currency is the U.S. dollar, which was involved in 36.2 percent of all deals by volume in 1991. The dollar’s share has declined from 44.2 percent in 1987—a development accounted for mainly by the increased volume of currency swaps involving the yen.

Other Derivatives

Futures and options contracts on foreign exchange have become important means by which open positions can be hedged. They also provide opportunities for highly leveraged speculation, since the purchaser is only required to put up a small fraction of the value of the underlying currency. A foreign exchange futures contract, like a forward contract, is an agreement to purchase a specified amount of foreign currency for delivery at a particular date. Unlike forward contracts, however, they are traded on exchanges and are therefore highly standardized with regard to expiration dates and currencies. Although this feature enhances the secondary market’s liquidity, it restricts the degree to which these contracts can be tailored to a particular user, thereby reducing their effectiveness in hedging.

The most important institutional feature of a futures market is the clearinghouse, which verifies trades and settles the account of each member of the exchange at the end of each trading day. It guarantees each side of the futures contract, as these contracts are not made between the two parties on each side of the contract, but between each party and the clearinghouse. The clearinghouse, therefore, carries the credit risk in all trades. It has an interest in minimizing this risk, which it implements by requiring that members of the exchange post margins as a partial guarantee of payment and by adjusting this margin requirement as investors’ positions are marked to market at the close of each business day. For example, if the price of the futures contract increases, the margin account of an investor with a short position is debited by an amount equal to the price change multiplied by the number of contracts the investor has sold. If the margin falls below a specified maintenance level, the investor will be called to add to the account.

A currency option gives the holder the right, but not the obligation, to purchase (call option) or sell (put option) a particular amount of foreign currency at or before a specified expiration date. Options are written either on U.S. exercise terms, in which the option can be exercised at any time prior to maturity, or on European terms in which the option can be exercised only at maturity. Options exchanges also revolve around a clearinghouse, although only the writers of the options must post margin—the purchasers’ losses are limited to the premiums they paid up front while the writer of an option is exposed to almost unlimited risk.18 Members of the exchange must also make deposits with the clearinghouse equal to the purchase price of every option purchased on the exchange until the transaction is cleared.

Most currency options are sold over the counter. The OTC market is dominated by wholesale trading, but to a lesser extent than are the spot and swap markets. Wholesale trading accounted for approximately 50 percent of currency options turnover in Japan and the United States and 80-85 percent of turnover in Canada and Germany in 1991.19 The average transaction size for OTC options is in the $10-20 million range, and notional principals of up to $1 billion are not rare.

Futures and options transactions are the fastest-growing segment of the market (see Table 9), although they remain only a small proportion of total foreign exchange turnover of the financial institutions included in the survey. In the United Kingdom, turnover in these markets increased by more than 300 percent between 1989 and 1992 to just over $8 billion. Currency derivatives are traded on ten exchanges in seven countries: The Chicago Mercantile Exchange’s (CME) International Monetary Market (IMM) (futures and options) and the Philadelphia Stock Exchange (PHLX) (options) dominate trading in currency futures and options. The share of total net foreign exchange market turnover in the United States that is due to derivatives transactions rose from 5 percent in 1986, to 8 percent in 1989, and to 12 percent in 1992. This growth is due almost entirely to the expansion in the volume of OTC options, which grew from 0.4 percent of gross turnover in 1986, to 3.5 percent in 1989, and to 7 percent in 1992. The activity of currency dealers accounted for a substantial amount of this turnover.

Annual turnover in currency futures contracts worldwide was 29.2 million contracts in 1991, up from 19.7 million in 1986. Worldwide annual turnover in exchange-traded currency options and options on futures was 21.5 million contracts in 1991 versus 13 million in 1986.20 The most actively traded contracts are denominated in deutsche mark, Japanese yen, pounds sterling, and Swiss francs. Table A6 provides a description of some exchange-traded futures and options contracts as of September 1992.

While OTC options provide more flexibility than exchange-traded options in terms of the contract specifications, options writers are increasingly using standardized terms and language that allow OTC options to be traded. The resulting increase in the liquidity of OTC options is apparently attracting business away from the exchanges.

In response, exchanges have recently launched initiatives to expand trading hours (for example, with the start-up of overnight trading of derivatives on GLOBEX) and to introduce futures and options contracts in cross-currency exchange rates and in currency baskets such as the ECU and FINEX’s dollar index.

Foreign Exchange Payments Systems

Foreign exchange transactions require both parties to exchange equivalent amounts of two currencies. In practical terms, the two parties have to exchange funds held in bank deposits. Since banks hold accounts at a central bank, the key role of a payments system in foreign exchange markets is to effect the transfer of “good funds” (deposits held with central banks) denominated in different currencies among the transacting banks.

The payments system over which most dollar foreign exchange transactions are settled is the Clearing House Interbank Payments System (CHIPS), an electronic dollar clearing system that is owned by the New York Clearing House, a group of major New York banks. CHIPS transactions are settled through a special account held at the Federal Reserve Bank of New York. The pound sterling leg of a transaction is likely to settle over the Clearing House Association Payments System (CHAPS), an electronic pound payments system with 14 banks and the Bank of England as settlement members. Only members can settle payments directly. However, other banks can participate by holding accounts with members. CHAPS transactions are settled through banks’ accounts held at the Bank of England. The deutsche mark leg of a transaction is settled over Elekronische Abrechnung mit Filetransfer (EAF), the German electronic payments system owned and operated by the Bundesbank, via an account at the Bundesbank.

Because most dollar foreign exchange transactions are settled over CHIPS and because approximately three-fourths of all foreign exchange transactions have a dollar leg, the growth in the volume of CHIPS transactions is a good proxy for the growth in the total volume of foreign exchange transactions. As shown in Table A7, CHIPS volume has expanded over 25-fold since 1980 to $950 billion a day—a trend that is consistent with the survey results on the growth of the forex market summarized at the beginning of this annex.21

On both CHIPS and CHAPS, settlement occurs at the end of the business day, when banks with a net due-to position transfer funds into accounts at the New York Federal Reserve Bank and the Bank of England, respectively.22 Members with a net due-from position with other members receive a transfer from the special account. Participants that do not have such an account can settle their positions through a bank that does. CHIPS and CHAPS are both net settlement systems, in which banks subtract the amount they are owed from what they owe before transferring funds.23

Payments messages in both CHIPS and CHAPS are exchanged between banks before funds are actually transferred between accounts held at the respective central banks. An important question for a recipient of foreign exchange is whether he has claim to those funds when his bank receives the message of payment or whether he must wait until the actual foreign currency has been delivered. If receipt of the message is as good as delivery of funds, the payments system is said to have “settlement finality.” CHIPS currently has explicit settlement finality, while EAF and CHAPS do not.

The party receiving foreign exchange obviously prefers settlement finality because it permits immediate use of foreign exchange funds for their intended purpose. If he has to await actual transfer of funds, he might have to keep his funds in a bank deposit overnight (if financial markets are closed by the time he receives good funds). However, settlement finality does not come without cost. Some party must guarantee that a payment message is as good as the delivery of the payment. With CHIPS, this guarantee is provided by the collective members of the payments system. These members have devised a set of rules that allocate losses among the total membership.24 Collective responsibility for individual risks creates moral hazards that tend to increase risk in payments systems. However, members and participants on systems such as CHIPS find that the costs associated with potential moral hazard problems are outweighed by the benefits of facilitating settlement on the basis of net positions among banks.

Netting Foreign Exchange Contracts by Novation

The fact that foreign exchange transactions must clear over two different payments systems creates risks that do not arise in domestic transactions. These additional risks may result from different rules for payments finality, or simply from differences in hours of operation of clearing systems. For example, CHIPS does not open until 10:00 a.m. New York time, which is 3:00 p.m. in London. If the pound sterling leg of a transaction is executed in the morning in London when CHIPS is closed, the bank delivering pound sterling is exposed to the risk that the bank promising to deliver U.S. dollars (when CHIPS opens) might fail to deliver. To reduce the settlement risks associated with foreign exchange transactions, a foreign exchange netting system called FXNET (owned by subsidiaries of 12 banks in the United Kingdom) has been established. Unlike CHIPS, CHAPS, and EAF, FXNET is not a payments system; instead, it creates a legal document that converts (multiple) foreign exchange contracts between two parties into a single obligation to make one net payment in each currency on each settlement date. Such an arrangement is called “netting by novation.” Since each party’s exposure is limited to the net payment due—rather than to a whole string of individual payments—the risks borne by the payments system as a whole is reduced.

Trading Securities Denominated in Different Currencies

If a financial institution decides to sell sterling-denominated assets and buy U.S. dollar-denominated assets, it must not only engage in a foreign exchange funds transfer but must also buy, sell, and deliver securities. To do this, it will generally use a securities clearinghouse. The most prominent European securities clearing systems are Euroclear and Cedel. These clearinghouses have rules governing the conditions under which securities can be sold for cash.

In both systems, a seller must hold the securities to be sold in an account with the clearing system. Physical securities are held by the clearinghouses in a depository. Depositories hold book-entry securities as claims on the national book-entry systems. Final settlement is usually the next business day. Short selling of securities is permitted to creditworthy customers. Such shorted securities are guaranteed by a bank associated with the system (for example, J.P. Morgan at Euroclear). These banks also provide credit lines to members of the system.

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