Monday, January 13, 2020

The Evolution of Exchange Rate Markets

Back in 1848, John Stuart Mill made a classic argument that money was insignificant to the essential nature of an economy, because it was only a facilitator for what really matters--the actual transactions. Mill wrote (Principles of Political Economy, Book III, Ch. VII):
There cannot, in short, be intrinsically a more insignificant thing, in the economy of society, than money; except in the character of a contrivance for sparing time and labour. It is a machine for doing quickly and commodiously, what would be done, though less quickly and commodiously, without it: and like many other kinds of machinery, it only exerts a distinct and independent influence of its own when it gets out of order.
In a globalized economy, one might similarly argue that the exchange rate market is an insignificant thing. What really matters, one might claim, is the real flows of imports and exports, or the patterns of international financial investments. However, the exchange rate market involves trades totaling  $6.6 trillion per day. This is vastly more than needed to finance exports and imports, or to finance foreign direct investment and portfolio investment. Instead, the foreign exchange market is clearly being driven by financial transactions: specifically, those who are hedging against shifts in exchange rates, those who are trying to make a profit by trading in exchange rate markets, or both. It cannot be viewed as, in Mill's language, an intrinsically insignificant thing.

The go-to source for information about exchange rate markets is the Triennial Survey conducted by the Bank for International Settlements (an international organization run by the central banks and monetary authorities of 60 different countries).  The BIS Quarterly Review for December 2019 offers a five-paper symposium with details on the size and operation of exchange rate markets. Here, I'll mention some of the highlights from the overview paper by  Philip Wooldridge, "FX and OTC derivatives markets through the lens of the Triennial Survey."  The five papers that follow in the issue are:
A basic question in the issue is how to account for the fact that the size of exchange rate markets expanded by roughly 30% from $5.1 trillion per day in the April 2016 survey to $6.6 trillion per day in the April 2019 survey. Again, this rise cannot be explained by a rise in exports and imports, or by a rise in international foreign direct investment and portfolio investment, which aren't nearly large enough to be explain a foreign exchange market of this size.

One shift is that exchange rate trading is happening with shorter-term financial instruments. As a result, they need to be traded more often during a calendar year. Wooldridge writes:
The trading of short-term instruments grew faster than that of long-term instruments. This mechanically increased reported turnover because such contracts need to be replaced more often. Schrimpf and Sushko (2019a) emphasise that the trading of FX swaps, which is concentrated in maturities of less than a week, rose from $2.4 trillion in April 2016 to $3.2 trillion in April 2019 and accounted for most of the overall increase in FX trading.
Another shift is that exchange market trades involving currencies of emerging market countries is on the rise:
While globally trading continued to be dominated by the major currencies, in particular the US dollar and the euro, in FX markets the trading of emerging market currencies grew faster than that of major currencies. As discussed by Patel and Xia (2019), the share of emerging market currencies in global FX turnover rose to 23% in April 2019 from 19% in 2016 and 15% in 2013.
In my reading, the biggest underlying changes relate to what Wooldridge calls "electronification," which is the pattern that more exchange rate transactions are happening through electronic or automated trading. The cost of exchange rate transactions has fallen, but the cost of the information technology infrastructure for carrying out those transactions has risen. 

This shift helps to explain the pattern just mentioned, that exchange rates markets have become more likely to operate through a series of short-term transactions. In addition, more of the exchange rate market is happening in a few major financial centers. Wooldridge writes: 
"In FX markets, London, New York, Singapore and Hong Kong SAR increased their collective share of global trading to 75% in April 2019, up from 71% in 2016 and 65% in 2010. Trading in OTC interest rate derivatives markets was also increasingly concentrated in a few financial centres, especially London. Schrimpf and Sushko (2019a) attribute this geographical concentration to network externalities. For example, it is more cost-effective to centralise counterparty and credit relationships, or technical and legal infrastructures, in a handful of hubs than to spread them across many countries. The faster pace of trading also increased the advantages of locating traders' IT systems physically close to those of the platforms on which they trade."
In addition, electronification of exchange rate markets has made it possible for investors who want to do high-frequency automated trading to participate, including hedge funds and what are called "platform-traded funds" (which operate in a way similar to exchange-traded funds). Of course, this change fits with the other patterns in exchange rate markets, like more short-term trades and a greater concentration of this trading in big financial centers. 

For those of us who will always bear the emotional scars from the meltdowns of financial markets during the Great Recession, the rapid growth of exchange rate market raises natural concerns over whether this rapid rise in exchange rate markets should raise concerns about financial risks that could in theory spill over into the rest of the global economy. At least so far, these concerns seem fairly muted. 

Behind the financial scenes, exchange rate transactions are ultimately handled by "dealers," of whom there are about 75 in the world at present. What if some of the major dealers become involved in a pattern of trading where they are exposed to risk, and end up going broke? However, a large share of exchange rate transactions are now carried out through central "clearinghouse" financial institutions.  The clearinghouse helps to match up buyers and sellers for transactions in exchange rate markets. The result is that while the number of exchange market transactions has risen, the amount of money truly at risk (once offsetting transactions are taken into account, has actually declined. Wooldridge writes: 
The marked pickup in the trading of FX and OTC derivatives between the 2016 and 2019 surveys did not lead to an increase in outstanding exposures. To be sure, since 2015 the notional principal of outstanding OTC derivatives has trended upwards, and at end-June 2019 it reached its highest level since 2014. However, their gross market value - a more meaningful measure of amounts at risk than notional principal - has trended downward since 2012. 
Just to be clear, I'm not saying that trying to trying to make money in foreign exchange markets or trying to hedge against movements in foreign exchange markets is low-risk. Foreign exchange markets are well-known for making sharp and unexpected movements in the short-term and medium-term, and for sticking at levels that seem "too low" or "too high" for unexpectedly long periods of time. Indeed, these features explain why the size of exchange rate markets is so large, as investors are trying either to hedge against these movements or to make a profit by anticipating them. But the rise of central clearninghouses for these markets seems to have reduced the risk that a meltdown originating in failures of the main global exchange rate dealiers will bleed into the rest of the global economy.