Historical Development and Modern Structure of Foreign Exchange

The Historical Development and Modern Structure of Foreign Exchange

While the history of foreign exchange is almost as long as civilization itself, one need only go back as far as 1944 to unearth the foundation of the modern structure of foreign exchange. Having witnessed the Great Depression and two world wars, global leaders were naturally anxious to bring about stability, and the creation of a new economic and financial system was an important step toward that goal.

With that in mind, the Bretton Woods Accord was drafted and signed by all 44 members of the Allied Nations. (It was later acceded to by Japan, Germany, and the rest of the defeated Axis Powers.) As the United States had already begun to establish itself as the world’s preeminent economic power, it was decided that the US dollar would become the backbone of the new system of foreign exchange. The dollar was pegged to gold (at an initial price of $35/ounce), and all other currencies were in turn pegged to the US dollar. The world’s central banks were then tasked with buying and selling dollars so as to limit their respective currencies from fluctuating by more than 1% in either direction.

In order to foster cooperation and stability, the Bretton Woods Accord also mandated the creation of the International Monetary Fund (IMF) and the precursor to the World Bank. The IMF was charged directly with carrying out a radical new financial system. Basically, members of the IMF were required to make subscription payments (in the form of gold and domestic currency) in proportion to their economic size. In return, they were granted voting rights, also in proportion to the size of their economies. As exchange rates naturally fluctuate in accordance with changing patterns in trade and economic growth, the IMF was endowed with the power to make loans to central banks, for the purpose of maintaining exchange rate stability. The World Bank, meanwhile, was charged with making loans to countries that were struggling economically and using its capital base to promote reconstruction and development in the wake of the devastation caused by the Second World War.

Bretton Woods II

Alas, the Bretton Woods system proved to be untenable. Due to an economic rebalancing (namely, the rapid post-war recovery of Germany and Japan), it became increasingly difficult to maintain the exchange rate pegs to the US dollar. This was further complicated by differing rates of inflation, and the swinging of the US trade balance from surplus to deficit. In 1968, the IMF tried to head off the impending crisis by creating so-called Special Drawing Rights (SDRs), a supranational currency that would be denominated in gold and a basket of constituent currencies. Member countries were automatically allocated SDRs in proportion to their subscriptions to the IMF, and could use them to stabilize their currencies in lieu of buying and selling US dollars.

Only a few years later, however, it was already apparent that this system had failed to address the massive imbalances, at the heart of which was the overvaluation of the US dollar relative to the price of gold. Then-President Richard Nixon responded by raising the price of gold (devaluing the US dollar) and imposing import controls designed to prevent further capital flight. Most importantly, he limited its convertibility, so that US dollars could no longer be exchanged directly for gold. This was a major historical development, as there was now nothing more than faith in the US government and a written declaration on the currency bills that guaranteed the worth of the US dollar.

As President Nixon did little to rein in spending on the Vietnam War and domestic social programs, however, the glut of dollars continued to expand inexorably. It soon became impossible to maintain a currency peg at any level. In 1973, the original Bretton Woods system was officially terminated, and was replaced by the so-called Bretton Woods II system. In this new system, currencies fluctuate freely against one another in accordance with market forces. Within a few years, all major currencies were nominally floating (not explicitly pegged to the US dollar). This marked the beginning of the fiat currency era, as well as a bold experiment that some commentators argue has not yet run its course!

That’s not to say that informal currency pegging has died out completely. The Bank of England continued fixing the British pound to the deutsche mark until 1992, when speculators, led by hedge fund investor George Soros, famously “broke the bank” and forced it to dismantle the peg. Meanwhile, oil-exporting countries have persisted in pegging their currencies to the US dollar to this day, since the price of oil is also denominated in US dollars. Countries throughout the developing world—namely China —also fix their currencies to the dollar and/or euro. And speaking of the euro, it is both the best-known and most recent example of currency pegging.

Overall, however, the fiat currency system remains the order of the day, despite the fact that, generally speaking, it hasn’t really engendered stability. On the contrary, the last four decades have seen their share of collapse. More than 100 countries—mostly in Africa and Latin America—have defaulted on their sovereign debt obligations.  The most famous cases involved Argentina, Brazil, Mexico, and Russia, all of which were accompanied by (separate) currency crises. There was stagflation in the 1970s, brought about by rising oil prices and an economic recession, and a proportional devaluation of the US dollar. The late 1990s saw the Southeast Asian financial crisis and the consequent collapse of half a dozen regional economies, their financial markets, and their currencies. The financial crisis that lasted roughly from 2008 to 2011, meanwhile, witnessed similar instability and some of the largest forex fluctuations ever recorded. Iceland defaulted on its debt, and the Icelandic krona collapsed. And in almost every case, the IMF has been there to mop up the mess with (often controversial) counsel and loans, with the effect that most currency crises have been short-lived.

In the aftermath of every crisis comes the inevitable debate over whether the former economic system should be revived, and the financial crisis of 2008–2011 has been no exception to that rule. Economic conservatives argue that the US dollar will be ruined by the high level of US debt, and they proffer the reinstatement of the gold peg as the only real solution. Fiat currencies have given unlimited power to government and no check on their ability to print unlimited amounts of money. Critics of the euro, meanwhile, insist that the currency union never made sense and that fiscal and economic discrepancies will soon render it extinct.

In addition, the record spikes in volatility that accompanied the financial crisis of 2008 to 2011 have triggered the predictable calls for a cap on speculation. Policymakers have invoked the so-called Tobin Tax, which would levy a nominal fee on all forex trades, and use the proceeds to help central banks fend off speculative attacks on their currencies.

The IMF has most recently begun to encourage the use of capital controls as a tool to prevent wild oscillations in exchange rates. SDRs have also been expanded (to more than $300 billion) and redistributed (in accordance with Figure 1-1), but their use remains subject to practical complications. Besides, given that they are still denominated in other currencies, the role of SDRs is as much political as it is financial.

It should come as no surprise that its biggest proponents are those countries that in general have strained relations with the United States.

FIGURE 1.1 Allocation of IMF Special drawing Rights (SDRs)

In short, the so-called Bretton Woods II system will probably remain in effect for the continued future. There may be further currency consolidation (within Asia and/or Africa), but no country is likely to unilaterally reinstate the gold standard. Barring any unforeseen developments, currencies will continue to fluctuate against each other in accordance with market forces.

Market Structure

In its modern form, the forex market closely resembles many of the other financial markets, with a few critical exceptions. Unlike the markets for other securities, forex trading is geographically decentralized. According to the Bank for International Settlements (BIS), the United Kingdom, United States, and Japan are the three largest trading centers, followed by Switzerland, Singapore, Hong Kong, Australia, France, Denmark and Germany. Together, these ten countries account for more than 90% of forex volume. Ironically, the rise in electronic trading (which would seem to render geography irrelevant) has spurred the creation of tight trading clusters. This has caused volume to become ever more concentrated in a handful of cities, namely London and New York City (Figure 1-2).

Figure 1-2  : Geographical distribution of Forex trading

While countries should enjoy a natural monopoly (or a comparative advantage) in the exchange of their own currencies, trades are typically routed to the nearest liquid trading center in order to optimize the speed of execution. In other words, while it takes less than a second for an order to be transmitted electronically from San Francisco to New York, it takes even less time for an order to be transmitted from 49th Street to 42nd Street in New York. For certain traders, shaving one millisecond off of their execution time can mean the difference between profit and loss.

Over-the-Counter Market

The second distinction between the forex market and other financial markets is that there is no centralized exchange through which all currencies are traded. (There is an exception to this rule, in the form of certain forex derivatives, which will be examined in greater detail in Chapter 2.) Instead, currencies are exchanged over-the-counter (OTC), which is to say that transactions are executed directly between two parties. These two parties, for example, might be an individual and a bank, or two individuals, or two banks. When one party wants to place a trade, it must contact a broker or a dealer. The former serves its customers by matching up buyers and sellers, while the latter will fill orders by taking the opposite side of a trade. (This distinction is not mutually exclusive, as some firms will switch roles as it suits them.)

Since currencies are always bought in pairs (one currency against one other currency) they must always be sold in pairs. In other words, the buyer and seller must necessarily be interested in taking opposing positions. For example, if a seller is interested in closing out a long position in the US dollar relative to the euro, the buyer must be interested in opening a long position in the euro against the US dollar. As with any type of financial securities trade, it is the job of the broker to sort through all of these nuances. The broker must amalgamate quotes from multiple sources and combine the best bid (the price at which currency can be sold) with the best ask (the price at which currency can be bought), and present the resulting spread to customers (Table 1-1).

Table 1-1 Broker Amalgamation of Bid/Ask Spreads

Having received the separate quotes in Table 1-1, the broker would present the 1.3502 ($25 million) - 1.3504 ($7 million) to the customer, which represents a combination of the best bid and ask prices. (These days, this job is mostly done automatically by computers, but the principle is the same as if it were being done by hand.) Ultimately, if the seller is willing to accept a price at or below the buyer’s offer, the trade will clear. The broker will earn a profit by charging a transaction fee (expressed as a percentage of the transaction value).

If the seller demands a price that is too high and/or the buyer’s offer is too low, the trade cannot be executed. Given the size of the market and the continuous volume of transactions, this is not usually an issue. The main exceptions are for unusually large orders and during moments of uncertainty, such as major news developments. During these times, the market will temporarily shrink, and spreads will widen. Those that insist on placing a trade anyway may have to accept a less favorable execution price.

In practice, a forex dealer performs the same role for his clients by helping them execute trades. Unlike a broker, however, the forex dealer will actually serve as the counterparty for clients’ trades and aim to profit from favorable exchange rate movements and also by capturing the spread. Let’s consider the example above, to further elucidate this distinction. With a spread of 1.3502-1.3504, the broker will merely connect its clients with either the bid or the ask party, depending on whether they wish to buy or sell. The dealer, in contrast, will actually provide its own bid/ask spread and will fill the trade itself. It may aim to buy at 1.3502 and instantly sell at 1.3504, or it may wish to hold the position until it can earn a more substantial gain. Either way, the dealer must assume some exchange rate risk.

The business model of a broker is then quite different from a dealer. Despite the conflicts of interest that the dealer model would seem to engender, however, it is not automatically clear which one is better for clients.

Tiered System

The forex market is divided into different tiers, access to which depends on size. The top tier is known as the interbank market (or interdealer market), where trading takes place directly between broker-dealers and other large-scale liquidity providers. While interbank trading accounts for less than 20% or so of overall forex volume (Figure 1-3), it nonetheless represents the backbone of the market. Access is limited to the world’s largest banks, liquidity is nothing short of complete, and spreads are ludicrously small (less than one PIP for major currencies).

FIGURE 1.3 : Breakdown of Forex market tiers

These days, interdealer trading takes place almost entirely (90% plus) through electronic portals, such as Electronic Communication Networks (ECNs) that include Thomson Reuters Dealing 3000, ICAP EBS, and, to a lesser extent, Bloomberg Terminal and Citigroup LAVA.  Qualifying banks and broker-dealers pay subscription fees to the platform providers, and in exchange, are granted access to certain price data. The best prices are naturally extended to those with the best credit relationships. The ECNs do not themselves serve as brokers, but merely facilitate trading by participants. Toward this end, the ECNs offer trading overlays so that participants can move seamlessly from requesting quotes to executing trades.

Interbank trades are settled by the Continuous Linked Settlement Bank (CLS). Through a complex system of credit lines and payment protocols, this bank is able to limit one of the most basic risks of forex: counterparty risk. This risk is present in any financial transaction and basically represents the possibility that one party to a financial transaction (in this case, a currency exchange) will not honor its obligation to the other. CLS processes trades for 17 major currencies and on behalf of 69 financial institutions, comprising more than half of all global forex activity. Since CLS settles trades daily and ensures that everyone gets paid, participants can effectively conduct a limitless number of forex trades. Without CLS, forex liquidity/volume would be significantly smaller.

On behalf of their clients, brokers manually and electronically facilitate yet another level of trading. You can see from Figure 1-3 that telephone transactions (also known as voice broker) still account for a large portion of overall volume. For illiquid instruments and currency pairs, nonstandard contract sizes, unusual dates, and other circumstances, there is evidently still an important advantage to being able to speak with a broker. Phone execution also carries the added benefit of anonymity, which is important to some fund managers.

The majority of broker executions (especially on the spot market) are conducted electronically. Since 2005, brokers have begun to grant indirect access to the interbank market to favored clients. So-called prime brokerage account holders are able to place trades on the interbank market via their brokers. Trades are settled in the name of the broker-dealer, not in the name of the client that places the trade.

As seen in Figure 1-3, the interdealer market has suffered slightly, due to a rise in competition from platforms that facilitate trading directly between dealers and clients. In the United States, so-called customer direct trading represents a whopping 40% of overall volume.

Most of this trading takes place on proprietary trading systems that have been developed by broker-dealers. Due to the explosion in volume over the last decade, a handful of the top broker-dealers account for more than $100 billion in daily volume. (See Figure 1¬5.) As a result, it’s no longer necessary for large banks to rely completely on the interbank market. Instead, they have started to process trades internally, by directly matching their own customers’ buy and sell orders. Evidence suggests that only the largest and most complex orders (representing perhaps 20% of the total) are now funneled into the interbank market.

Multi-dealer trading systems currently represent the smallest corner of the forex market. This category is poised to capture a growing chunk of volume over the upcoming decade, however, due to its growing attraction to hedge funds, commodity trading advisers (CTAs), and other high-frequency traders. The market is dominated by FX Connect (State Street), FX All, Currenex (State Street), and HotSpot FX (Knight Capital), with about a dozen others accounting for less than 30% of multi-dealer activity.

Multi-dealer platforms are attractive to clients not only because of the liquidity, range of instruments, and currency pairs they offer, but also because of the sophistication of their software and the breadth of services that they perform. Many platforms are basically one-stop shops for institutional currency traders, offering automatic trading reconciliation, multi-asset trading, trading statistics, streaming quotes, and even credit guarantees. They earn money by assessing nominal fees ($10-20 per million traded) on every transaction.

Retail represents the bottom tier of foreign exchange. The majority of retail forex volume is processed by a handful of retail aggregators. These aggregators work the same way as interbank broker-dealers. Sometimes they provide quotes from various brokers and “liquidity providers” and merely execute trades on behalf of their customers. Brokers that operate this way will profit by presenting their customers with a slightly wider spread (i.e., higher price for the buyer and a lower price for the seller) than with which their supplying interbank brokers originally presented them.

Other retail aggregators execute trades internally by either matching up buyers with sellers or by taking the opposite side of the trade themselves. This type of aggregator is known as a dealing desk. As you can probably imagine, this latter approach is somewhat controversial. Given that the majority of retail traders lose money, it is profitable for the broker. As explained in Chapter 8, however, neither system can claim outright superiority.

Of course there are also small transactions that are conducted at community banks, foreign exchange kiosks, money transfer companies, and other locations. Due to high transaction costs (i.e., spreads) and other constraints, these institutions facilitate non- speculative currency con-versions, overseas remittances, etc. They account for only a small portion of overall volume.

It should finally be pointed out that these tiers don’t exist in separate vacuums. While trading amounts generally fall and spreads widen the lower one goes on the totem pole, the market at the retail level should nonetheless closely resemble the market at the wholesale level. Possibilities for arbitrage (taking advantage of price discrepancies on different markets to generate risk-free profits) should ensure that prices are consistent across all levels of the market.