Introduction to Financial Services: The International Foreign Exchange Market
Updated November 1, 2019
Introduction to Financial Services: The International Foreign
Exchange Market
Overview
time in the future and at a pre-arranged rate of exchange
The international foreign exchange market is a vast,
(forward transactions). A swap is a contract to exchange
complex assortment of globally dispersed actors and
currencies and to pay or receive interest payments over the
transactions that comprise millions of transactions daily,
duration of the contract. An option is a flexible forward
valued at trillions of dollars. On a daily basis, the value of
transaction that allows the owner of the option to buy or sell
global foreign exchange transactions eclipses the total
a specific amount of foreign currency at a certain price
global value of economic output and the value of all traded
before the pre-determined expiration date of the option
stocks and bonds. These markets are highly liquid as a
contract. Over-the-counter foreign exchange derivative
result of extensive global communications systems and
market transactions consist largely of interest rate contracts
electronic trading venues that operate on a 24-hour basis.
(primarily interest rate swaps and forward rate agreements
Foreign exchange markets respond rapidly to political and
in a single currency that are designed to manage exposure
economic events and instantaneously transmit market
to changes in interest rates over the duration of the swap).
signals across national borders. Governments are adopting
or considering regulations to curtail some aspects of the
Foreign Exchange Market
foreign exchange derivatives market and are examining
Market Activity. According to a triennial survey of the
challenges posed by digital currencies.
world’s leading 53 central banks and monetary authorities
conducted by the Bank for International Settlements (BIS)
Unexpected or abrupt disruptions in the foreign exchange
in April 2019, spot transactions and foreign exchange
market, and the global economy more broadly, can roil
swaps dominate the traditional foreign exchange markets,
financial markets and economies around the globe with
as indicated in Table 1. Daily turnover in these foreign
broad implications for economic activity. For instance, in
exchange markets totaled more than $6.6 trillion in the
January 2015, Switzerland removed the cap it had placed on
survey, while daily turnover in the OTC market totaled
the foreign exchange value of its currency; in August 2015,
$6.5 trillion, primarily in interest rate instruments (swaps).
China depreciated its currency; and in June 2016, British
In total, daily foreign exchange turnover was $13.1 trillion,
voters endorsed a referendum to pull the United Kingdom
nearly double the value of daily transactions recorded in the
out of the European Union. In 2018 and 2019, swings in
previous survey in April 2016.
financial markets reflected concerns over on-again, off-
again trade talks between the United States and China. In
Table 1. Foreign Exchange Market Turnover
each case, global financial markets experienced large shifts
(daily averages in April of the year indicated, tril ions of US
in positions over a short period of time.
dol ars)
Foreign Exchange Transactions
Year
2013
2016
2019
Foreign exchange (FX) markets facilitate international
Spot transactions
2.0
1.7
2.0
commerce by making it possible for firms to exchange
currencies for exporting and importing goods and services.
Outright forwards
0.7
0.6
0.5
The markets also supply currencies for foreign investment,
Foreign exchange swaps
2.2
2.4
3.2
for purchases of financial instruments, and to currency
traders attempting to gain profits from short-term
Options
0.3
0.2
0.3
fluctuations in exchange rates. Some governments also hold
Total “traditional”
5.4
5.1
6.6
foreign currencies as reserves to protect against fluctuations
in currency exchange rates.
Interest rate instruments
2.3
2.7
6.5
Trading in the foreign exchange market occurs in both
Total Market Turnover
7.7
7.8
13.1
traditional markets with organized exchanges and
United States
standardized products and in the over-the-counter (OTC)
market that is informal with uniquely crafted products.
Foreign exchange turnover
1.3
1.3
0.8
Through international efforts, governments are attempting
OTC derivatives
0.7
1.4
3.3
to standardize reporting and transactions in the OTC
market. Traditional foreign exchange transactions consist of
Total U.S. turnover
2.0
2.6
4.1
four kinds: spot transactions, forward transactions, swaps,
Source: Bank for International Settlements, and Federal Reserve
and options. Spot and forward transactions are agreements
Bank of New York.
that involve trading currencies immediately at the market
exchange rate (spot transactions) or at some pre-arranged
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Introduction to Financial Services: The International Foreign Exchange Market
The BIS indicated that the sharp increase in the daily OTC
Serving as an invoicing currency to fund commercial
turnover in interest rate derivative contracts in 2019
activities in international trade, even among countries
compared with 2016 reflects increased hedging and shifting
that do not use the dollar as their national currency.
of positions associated with concerns over monetary policy
and global economic growth prospects, more
Accounting for two-thirds of global central bank
comprehensive reporting, and the increased use of shorter-
reserves, which central banks can use to intervene at
term contracts.
times to protect their currencies from the spillover
effects of global crises.
In the United States in April 2019, the outstanding daily
turnover in notional amount of traditional foreign exchange
Accounting for more than half of non-U.S. banks’
contracts totaled $800 billion, while the comparable daily
foreign currency deposits.
turnover in interest rate contracts totaled $3.3 trillion. The
combined U.S. daily foreign exchange market turnover
Accounting for almost two-thirds of non-U.S. corporate
activity amounted to $4.1 trillion, about one-third the total
borrowings from banks and the corporate bond market.
daily global foreign exchange market turnover activity.
Notably, the total daily foreign exchange turnover in the
Regulatory reforms that require financial institutions to
U.S. market was more than double the annual amount of
hold safe and liquid assets as a buffer against adverse
U.S. exports of goods and services. Similarly, the daily
financial shocks have added to the global demand for
global foreign exchange market turnover was more than
dollars.
five times the annual amount of U.S. exports of goods and
services.
Figure 2. Currency Distribution of Global Foreign
Exchange Market Turnover
Markets by Geographic Region. Foreign exchange
trading activity is dominated by a few geographic locations,
as indicated in Figure 1. London is the largest trading
center, accounting for 41% of global volume. This share,
however, may change as a result of Brexit (the British exit
from the European Union), The United States (New York)
accounts for less than half the U.K. share, or 17% of global
trading. The next six countries—Singapore (7.6%), Hong
Kong (7.6%), Japan (4.5%), Switzerland (3.3%), and
France (2.0%)—combined with the U.K. and U.S. shares—
account for about 85% of all daily foreign exchange market
turnover.
Source: Bank for International Settlements, September 2019.
Figure 1. Geographical Distribution of Global Foreign
Issues for Congress
Exchange Market Turnover
Through the Dodd-Frank Wall Street Reform and
Consumer Protection Act (P.L. 111-203), Congress moved
to regulate parts of the foreign exchange derivatives (swap)
markets by: (1) registering and regulating swap dealers and
major swap participants; (2) implementing clearing and
trade execution requirements for certain foreign exchange
swaps; and (3) establishing record keeping and reporting
requirements. Congress may choose to use its oversight role
to ensure that the new requirements promote transparency
and greater stability in the foreign exchange derivatives
market and to determine if new laws or regulations are
necessary. The emergence of digital currencies and the
Source: Bank for International Settlements, September 2019.
increased role in international markets of currencies such as
the Chinese renminbi may pose challenges for the dollar
The Role of the Dollar. The U.S. dollar is the most heavily
over the long run as the global economy’s dominant reserve
traded currency in FX markets, as indicated in Figure 2. It
currency. Also, Brexit may shift some foreign exchange
accounts for 88% of daily foreign exchange market
trading from London to other locations in Europe, but may
turnover. (Because two currencies are involved in each
affect trading activity in New York. Congress may choose
transaction, the sum of the percentage shares of individual
to assess and evaluate the continuing role of the dollar as
currencies totals 200% instead of 100%.) In comparison,
the dominant global reserve currency and possible
the euro accounts for 32% of trades, the Japanese yen
implications for U.S. economic and financial policies.
accounts for 17%, and the British pound accounts for 13%.
Other currencies account for smaller shares: Australian
dollar (7.0%), Canadian dollar (5.0%), Swiss franc (5.0%),
James K. Jackson, Specialist in International Trade and
and Chinese renminbi (4.3%).
Finance
IF10112
As the dominant global reserve currency, the dollar is used
to fund an array of financial transactions, including:
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Introduction to Financial Services: The International Foreign Exchange Market
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https://crsreports.congress.gov | IF10112 · VERSION 6 · UPDATED