The main participants in the foreign exchange market include foreign exchange dealers, financial and non-financial customers, central banks and brokers.
Participant # 1. Foreign Exchange Dealers:
Most commercial banks in the United States customarily have bought and sold foreign exchange for their customers as one of their standard financial services. But beginning at a very early stage in the development of the over-the-counter market, a small number of large commercial banks operating in New York and other U.S. money centers took on foreign exchange trading as a major business activity. They operated for corporate and other customers, serving as intermediaries and market makers.
In this capacity, they transacted business as correspondents for many other commercial banks throughout the country, while also buying and selling foreign exchange for their own accounts. These major dealer banks found it useful to trade with each other frequently, as they sought to find buyers and sellers and to manage their positions. This group developed into an inter-bank market for foreign exchange.
During the past 25 years, some investment banking firms and other financial institutions have become emulators and direct competitors of the commercial banks as dealers in the over-the-counter market. They now also serve as major dealers, executing transactions that previously would have been handled only by the large commercial banks, and providing foreign exchange services to a variety of customers in competition with the dealer banks.
They are now part of the network of foreign exchange dealers that constitutes the U.S. segment of the foreign exchange market. Although it is still called the “inter-bank” market in foreign exchange, it is more accurately an “inter dealer” market.
Of the 93 reporting dealers in 1998, 82 were commercial banks, and 11 were investment banks or insurance firms. All of the large U.S. money center banks are active dealers. Most of the 93 institutions are located in New York, but a number of them are based in Boston, Chicago, San Francisco, and other U.S. financial centers. Many of the dealer institutions have outlets in other countries as well as in the United States.
Included in the group are a substantial number of U.S. branches and subsidiaries of major foreign banks —banks from Japan, the United Kingdom, Germany, France, Switzerland, and elsewhere. Many of these branches and agencies specialize in dealing in the home currency of their parent bank. A substantial share of the foreign exchange activity of the dealers in the United States is done by these U.S. branches and subsidiaries of foreign banks.
Participant # 2. Financial and Non-Financial Customers:
According to the 1998 survey, 49 percent of the foreign exchange trading activity in the over-the-counter market represented “inter dealer” transactions, of the remaining 51 percent of total foreign exchange transactions, financial (non-dealer) customers accounted for 31 percent, and non-financial customers 20 percent.
The range of financial and non-financial customers includes such counterparties as- smaller commercial banks and investment banks that do not act as major dealers, firms and corporations that are buying or selling foreign exchange because they are in the process of buying or selling something else (a product, a service, or a financial asset), managers of money funds, mutual funds, hedge funds, and pension funds; and even high net worth individuals. For such intermediaries and end-users, the foreign exchange transaction is part of the payments process —that is, a means of completing some commercial, investment, speculative, or hedging activity.
Institutional investors, insurance companies, pension funds, mutual funds, hedge funds, and other investment funds have, in recent years, become major participants in the foreign exchange markets. Many of these investors have begun to take a more global approach to portfolio management. Even though these institutions in the aggregate still hold only a relatively small proportion (5 to 10 percent) of their investments in foreign currency denominated assets, the amounts these institutions control are so large that they have become key players in the foreign exchange market.
In the United States, for example, mutual funds have grown to more than $5 trillion in total assets, pension funds are close to $3 trillion, and insurance companies about $21/2 trillion. The hedge funds, though far smaller in total assets, also are able to play an important role, given their frequent use of high leverage and, in many cases, their investors’ financial strength and higher tolerance for risk.
Given the large magnitudes of these institutions’ assets, even a modest shift in emphasis toward foreign investment can mean large increases in foreign exchange transactions. In addition, there has been a tendency among many funds managers worldwide to manage their investments much more actively, and with greater focus on short-term results. Rapid growth in derivatives and the development of new financial instruments also have fostered international investment.
Reflecting these developments, portfolio investment has come to play a very prominent role in the foreign exchange market and accounts for a large share of foreign exchange market activity. The role of portfolio investment may continue to grow rapidly, as fund managers and investors increase the level of funds invested abroad.
Participant # 3. Central Banks:
All central banks participate in their nations’ foreign exchange markets to some degree, and their operations can be of great importance to those markets. But central banks differ, not only in the extent of their participation, but also in the manner and purposes of their involvement.
Intervention operations designed to influence foreign exchange market conditions or the exchange rate represent a critically important aspect of central banks’ foreign exchange transactions. However, the intervention practices of individual central banks differ greatly with respect to objectives, approaches, amounts, and tactics. Unlike the days of the Bretton Woods par value system (before 1971), nations are now free, within broad rules of the IMF, to choose the exchange rate regime they feel best suits their needs.
The United States and many other developed and developing nations have chosen an “independently floating” regime, providing for a considerable degree of flexibility in their exchange rates. But a large number of countries continue to peg their currencies, either to the U.S. dollar or some other currency, or to a currency basket or a currency composite, or have chosen some other regime to limit or manage flexibility of the home currency .The choice of exchange rate regime determines the basic framework within which each central bank carries out its intervention activities.
Foreign exchange market intervention is not the only reason central banks buy and sell foreign currencies. Many central banks serve as their government’s principal international banker, and handle most, and in some cases all, foreign exchange transactions for the government as well as for other public sector enterprises, such as the post office, electric power utilities, and nationalized airline or railroad.
Consequently, even without its own intervention operations, a central bank may be operating in the foreign exchange market in order to acquire or dispose’ of foreign currencies for some government procurement or investment purpose.
A central bank also may seek to accumulate, reallocate among currencies, or reduce its foreign exchange reserve balances. It may be in the market as agent for another central bank, using that other central bank’s resources to assist it in influencing that nation’s exchange rate. Alternatively, it might be assisting another central bank in acquiring foreign currencies needed for the other central bank’s activities or business expenditures.
Thus, for example, the Foreign Exchange Desk of the Federal Reserve Bank of New York engages in intervention operations only occasionally. But it usually is in the market every day, buying and selling foreign currencies, often in modest amounts, for its “customers” (i.e., other central banks, some U.S. agencies, and international institutions). This “customer” business provides a useful service to other central banks or agencies, while also enabling the Desk to stay in close touch with the market for the currencies being traded.
Participant # 4. Brokers:
In the Over-the-Counter Market:
The role of a broker in the OTC market is to bring together a buyer and a seller in return for a fee or commission. Whereas a “dealer” acts as principal in a transaction and may take one side of a trade for his firm’s account, thus committing the firm’s capital, a “broker” is an intermediary who acts as agent for one or both parties in the transaction and, in principle, does not commit capital. The dealer hopes to find the- other side to the transaction and earn a spread by closing out the position in a subsequent trade with another party, while the broker relies on the commission received for the service provided (i.e. ,bringing the buyer and seller together).
Brokers do not take positions or face the risk of holding an inventory of currency balances subject to exchange rate fluctuations. In over-the- counter trading, the activity of brokers is confined to the dealers market. Brokers, including “voice” brokers located in the United States and abroad, as well as electronic brokerage systems, handle about one quarter of all U.S. foreign exchange transactions in the OTC market. The remaining three-quarters take the form of “direct dealing” between dealers and other institutions in the market.
The share of business going through brokers varies in different national markets, because of differences in market structure and tradition. Earlier surveys showed brokers’ share averages as low as 10-15 percent in some markets (Switzerland and South Africa) and as high as 45-50 percent in others (France, Netherlands, and Ireland).
Foreign exchange brokerage is a highly competitive field and the brokers must provide service of high quality in order to make a profit. Although some tend to specialize in particular currencies, they are all rivals for the same business in the inter- dealer market. Not only do brokers compete among themselves for broker business — voice brokers against each other, against voice brokers located abroad, and against electronic broking systems—but the broker community as a whole competes against banks and other dealer institutions that have the option of dealing directly with each other, both in their local- markets and abroad, and avoiding the brokers and the brokers’ fees.
(a) Voice Brokers:
Skill in carrying out operations for customers and the degree of customers’ confidence determine a voice broker’s success. To perform their function, brokers must stay in close touch with a large number of dealers and know the rates at which market participants are prepared to buy and sell. With 93 active dealers in New York and a much larger number in London, that can be a formidable task, particularly at times of intense activity and volatile rate movements. Information is the essential ingredient of the foreign exchange market and the player with the latest, complete, and most reliable information holds the best cards.
As one channel, many voice brokers have open telephone lines to many trading desks, so that a bank trader dealing in, say, sterling, can hear over squawk boxes continuous oral reports of the activity of brokers in that currency, the condition of the market, the number of transactions occurring, and the rates at which trading is taking place, though traders do not hear the names of the two banks in the transaction or the specific amounts of the trade.
(b) Automated Order-Matching, or Electronic Broking Systems:
Until 1992, all brokered business in the U.S. OTC market was handled by voice brokers. But during the past few years, electronic broker systems (or automated order matching systems) have gained a significant share of the market for spot transactions. The two electronic broking systems currently operating in the United States are Electronic Brokerage Systems, or EBS, and Reuters 2000-2. In the 1998 survey, electronic broking accounted for 13 percent of total market volume in the United States, more than double its market share three years earlier.
In the brokers market, 57 percent of turnover is now conducted through order-matching systems, compared with 18 percent in 1995. With these electronic systems, traders can see on their screens the bid and offer rates that are being quoted by potential counterparties acceptable to that trader’s institution (as well as quotes available in the market more broadly), match an order, and make the deal electronically ,with back offices receiving proper notification.
The electronic broking systems are regarded as fast and reliable. Like a voice broker, they offer a degree of anonymity. The counterparty is not known until the deal is struck, and then only to the other counterparty.
The fees charged for this computerized service are regarded as competitive. The automated systems are already widely used for certain standardized operations in the spot market, particularly for smaller-sized transactions in the most widely traded currency pairs. Many market observers expect these electronic broking or order matching systems to expand their activities much further and to develop systems to cover additional products, to the competitive disadvantage, in particular, of the voice brokers.
(c) In the Exchange-Traded Market:
In the exchange-traded segment of the market, which covers currency futures and exchange traded currency options, the institutional structure and the role of brokers are different from those in the OTC market.
In the exchanges, orders from customers are transmitted to a floor broker. The floor broker then tries to execute the order on the floor of the exchange (by open outcry), either with another floor broker or with one of the floor traders, also called “locals,” who are members of the exchange on the trading floor, executing trades or themselves.
Each completed deal is channeled through the clearing house of that particular exchange by a learning member firm. A participant that is not a clearing member firm must have its trades cleared by a clearing member.
The clearinghouse guarantees the performance of both parties, assuring that the long side of every short position will be met, and that the short side of every long position will be met. This requires (unlike in the OTC Market) payment of initial and maintenance margins to the clearinghouse (by buyers and sellers of futures and by writers, but not holders, of options). In addition, there is daily marking to market and settlement. Thus, frequent payments to (and receipts from) brokers and clearing members may be called for by customers to meet these daily settlements.