Wednesday, September 26, 2007

The Foreign Currency Markets Have Grown Significantly in the Last Few Years - The BIS

Excerpts below from the WSJ states that according to the Bank of International Settlements (BIS), the foreign exchange markets have grown significantly since 2004. The ties in well with an earlier post discussing the changing role of the US economy amongst the world economies. Let's face for those brought up in a period where the US economically dominated the world, it looks like "we" are going to have to change our thinking and make some room on the bench for other players.

. . . . a report by the Bank for International Settlements in Basel, Switzerland, adds some hard numbers to that picture. Global markets are exploding in size, scope and complexity.

The BIS, which offers services to central banks, provides a reality check on financial globalization by tracking the size of foreign-exchange markets.

In April, daily turnover in currency markets rose to $3.2 trillion, the bank said yesterday. That's more in value than the annual economic output of Germany or China, changing hands in currency markets every day around the world. It's also up 71% from the BIS's last survey in 2004, the largest jump in volume since the institution began conducting its benchmark survey in 1989.

The currency market is "the world's biggest fruit and vegetable stall," says Jim O'Neill, global head of economic research at Goldman Sachs Group Inc. "There are so many participants in it, and it adjusts very quickly to new information."

The study touches on many types of financial transactions, from hedge funds making complex financial bets, to companies transacting money to source parts in China, to Americans loading up on yen or euros before a trip abroad.

The BIS figure tracks garden-variety currency interactions: on-the-spot transactions to convert two currencies, forward contracts purchased by individuals or institutions to buy currencies at a future date, and swaps that involve the exchange of two currencies at two points in time.

Economists have long hailed the benefits of globalization. When two countries trade, it allows each to focus on producing what it is most efficient at doing. Financial globalization helps banks and investors spread out their risks and absorb unexpected shocks.

The downside of the increasing financial globalization was apparent in the turmoil that gripped world markets in July and August. The crisis demonstrated how financial risk -- once concentrated in lending by banks -- can appear far away in expected ways, possibly leading to contagions. That's a big challenge for central banks and regulators as they attempt to monitor the health of the global financial system.

The BIS said technology played a key role in fostering the explosion of currency trading, with automated trading models allowing investors to continually chase small moves in currencies. "A significant expansion in the activity of investor groups including hedge funds" as well as individual investors also contributed to the increase, it said.

The report showed that players in the currency market are increasingly relying on complex instruments to make bets or reduce their exposure to risk. Trading in financial derivatives linked to currencies soared to $2.1 trillion a day, the report said, a rise of more than 70% since 2004. Large companies are also taking a more active and sophisticated approach to managing currency exposure.

The most dramatic rise came in cross-currency swaps, in which two parties agree to exchange streams of interest payments in different currencies for a certain period. Those daily volumes grew by 281% between 2004 and 2007, possibly because investors were seeking to hedge rising investments in foreign currency bonds.

Emerging-market currencies were involved in almost 20% of all transactions in April. The share of the Chinese yuan in the total currency turnover increased, although it remains very small. The currency is isolated by Chinese government capital controls. It remained behind currencies like the Korean won and the Polish zloty.

Contrary to some expectations, the dollar didn't fall much out of favor as the world's pre-eminent currency. The dollar was on one side of more than four-fifths of all daily currency transactions, a slight decrease from 2004, though up from 1995. That was mostly due to the currency's depreciation in the past three years.

The share of the Japanese yen in total turnover also decreased. Currencies that are playing a larger role on the global stage include the Australian dollar and the New Zealand dollar, according to the report, thanks to a rush of investors seeking out the high interest rates in those countries.

The survey, carried out once every three years, polled 54 central banks and monetary authorities. Industry insiders said the figure for daily turnover of $3.2 trillion, while bigger than many had expected, could underestimate the true size of the industry.

Hedge funds, for example, can now trade directly with each other, and this kind of flow isn't captured by the survey.

The report's conclusions echo the experience of players in the currency markets, who say they've seen a growing interest on the part of companies and investors in trading currencies.

The BIS report said that the United Kingdom and the U.S. remain by far the largest currency-trading centers, together accounting for just over half of the total. Switzerland, meanwhile, overtook Japan as the third-largest trading center.

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