A CENTRAL BANK VIEW OF GLOBAL FX

Central bankers weigh in on the global foreign exchange market at CME Group's 2008 Global Financial Leadership Conference.

Central bankers have witnessed a sea change in the global foreign exchange (FX) market over the past decade, as trading volumes have exploded and the market has expanded in geography and participants, according to a panel of experts at CME Group's Global Financial Leadership Conference in September.

It has been a "huge transformation" over the last 10 to 15 years, says George Pickering, chief advisor, fi nancial markets for the Bank of Canada. While the biggest change has been the number and scope of market participants, he also cites an increase in national representation, with countries using their large levels of cash reserves, as well as an expansion in trading FX from financial institutions.

"You have also seen an expansion of the market into the professional trading community, players like hedge funds, commodity trading advisors, institutions, mutual funds, pension funds who have currency overlay strategies. And finally, you have the retail market," says Pickering.

Financial market globalization is promoting FX growth as well. "The more cross-border trading there is around the world, the more foreign exchange risk there is to hedge or to play with," says Paul Fisher, head of FX and chairman of the London Joint Standing Committee on Foreign Exchange for the Bank of England.

Automation of the FX market, which began with EBS (now owned by ICAP) and Reuters Dealing (now part of Thomson Reuters) and evolved into ECN-style platforms and exchange-based trading, has contributed to the accelerated growth. Also, algorithmic trading has recently been embraced by the FX market, says Pickering, adding to trading volumes.

Not every country is ready for full-steamahead FX trading of its currency, however.

Gustavo Franco, former president of the Central Bank of Brazil, says it is important to keep in mind that for Brazil - in comparison with Canada, the United Kingdom or the United States - FX is new to the market. "Foreign exchange for us has been, over the years, a sort of a public service conceded in the private sector. Not a market." He notes that the Brazilian real is a relatively new currency and its credibility is dependent upon the government's reserves. "We cannot afford the luxury of not having international reserves and having a fully unconstrained flexible exchange rate. It's too early in the game for us," says Franco.

EMERGING ASSET CLASS

The emergence of FX as an asset class and the rising popularity of electronic trading have brought new participants into the market and fueled market growth in recent years. The result is a global market with $3.2 trillion in daily turnover, according to the Bank for International Settlements' 2007 Triennial Survey of Foreign Exchange. Former Federal Reserve System Chairman Paul Volcker says this amount cannot be accounted for with legitimate hedging of trading transactions, technological change and mathematical algorithms. "The fact is, you've got thousands of hedge funds and others who are trading in this market because they want to make a little money," he says.

Franco says that Brazil is almost a "lab experiment" in this regard: "The moment we stabilized the Brazilian economy, we started to see the interbank volumes in foreign exchange multiply by a factor of three or four, becoming more like six times the spot transacting in foreign exchange." Added to this were derivatives, which took volumes up to 20 times that of spot. All of this has caused debate within the country about speculators driving the currency price. "The price discovery moved into the derivatives space, and the sensation was that we lost control of the price-fixing mechanism," says Franco.

Fisher says that a certain amount of speculative activity is necessary to make the market work. "If you look back over history with the benefit of hindsight, in most situations where there have been very large exchange rate movements, it was almost always economic policy, which fundamentally was the problem," he says. Pickering says that Canada's floating exchange rate provides the country with fl exibility to allow economic adjustment: "It allows the exchange rate to do its job when commodity prices are moving around quite a bit, for example."

FX AND MARKET TURMOIL

As of September, the central bankers agreed that the FX trading ecosystem appears to have held up well during the credit crisis. However, Fisher notes that there were some worrying moments related to sharp currency movements, when the FX swaps market "appeared to seize up." This situation was rectifi ed quickly, and overall, Fisher says the FX infrastructure - including CME Group, the CLS Bank and SWIFT – has worked well over the past 12 months.

Pickering adds the dominant role of the U.S. dollar could be changing. "I think that speaks to the expansion of global trade, the emergence of huge economies like India and China that would, over time, lead to growth of volumes… and diversify the number of currencies going forward."

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