The Danish Foreign-Exchange Market

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1 33 The Danish Foreign-Exchange Market by Henrik Smed Krabbe, Market Operations Department and Lisbeth Stausholm Pedersen, Economics Department The foreign-exchange market is a market for purchase and sale of foreign exchange against Danish kroner. Capital flows and foreign trade are the principal factors creating the need for this market, in which exchange-rate risks are hedged and conversion between kroner and foreign currency takes place. Since the krone rate is formed in the foreign-exhange market the latter plays a central role in the monetary and foreign-exchange policy. The development in the market over the last 5-6 years shows that both price quotation and the turnover depend on the stability of the krone. During the foreign-exchange unrest in trading with in particular nonresidents rose significantly, and the spread between bid and offer rates widened. In recent years the krone rate has been extremely stable, especially in 1997, and the turnover has been somewhat lower than in the period of unrest. Furthermore, price quotation has been very efficient, so that among professional market participants the margin between bid and offer rates is very small. The development in the banks' foreign-exchange positions shows an equally clear tendency. Since the foreign-exchange unrest in the banks have rarely held large positions in individual currencies, in contrast to the tendency before the period of unrest. As on other Danish financial markets the degree of concentration among market participants is relatively high. This article describes the Danish foreign-exchange market and its development in recent years. A similar description has previously been given of the development in the Danish money market. 1) Definition of the Danish foreign-exchange market The Danish foreign-exchange market is defined as purchase and sale of foreign exchange against kroner. All transactions involving the transfer from one participant to another of a position in kroner against foreign exchange are part of the Danish market. The market has no geographical delimitation, i.e. the purchase and sale of foreign exchange against kroner solely between non-residents are also part of the Danish market. The lift- 1) Palle Duvier Mehlbye and Jacob Topp "Money Market Development", Danmarks Nationalbank, Monetary Review, August 1996.

2 34 Chart 1 Diagram showing resident foreign-exchange dealers' fellow players in the foreign-exchange market Other resident foreign-exchange dealers Resident and nonresident customers Domestic bank (foreign-exchange dealer) Danmarks Nationalbank Non-resident foreign-exchange dealer ing of the last foreign-exchange restrictions in 1988 achieved the full liberalization of currency trading. The purchase and sale of foreign exchange against kroner comprise a broad range of transactions and participants. The definition for example includes purchase and sale of foreign exchange for travel purposes. This article solely concerns the professional foreign-exchange market, i.e. transactions between foreign-exchange dealers (banks), customers (typically business enterprises), non-resident customers and foreign-exchange dealers, and the Nationalbank. Chart 1 shows the participants in the Danish foreign-exchange market. 1) The participants can generally be divided into two main categories: customers and foreign-exchange dealers. Customers are typically private business enterprises with a need to purchase and sell foreign exchange in connection with payments to and from abroad. Local governments and public enterprises which also have a number of large payments to and from abroad are also included. Finally, small banks which do not have very much business involving foreign-exchange transactions will place their foreign-exchange orders with larger banks, thus playing the role of customer in the foreign-exchange market. Foreign-exchange dealers are banks which buy and sell foreign exchange in order to fulfil their customers' requirements, as well as to hedge 1) In the Danish foreign-exchange market the Nationalbank trades with resident foreign-exchange dealers, i.e. by trading foreign exchange against kroner. The Nationalbank also trades with non-resident foreign-exchange dealers, but only by trading currency against currency (in connection with management of the foreignexchange reserve). Since the latter is not part of the Danish foreign-exchange market, it is not included in the illustration.

3 35 Box 1 Foreign-exchange trading - practice and conventions Foreign-exchange trading almost exclusively comprises conversions between immediately encashable bank deposits denominated in kroner and foreign exchange. In practice these transactions take place by setting bid and offer rates, either directly by telephone, via a broker or via electronic systems such as Reuters Dealing or Electronic Broking Service (EBS). A foreign-exchange dealer e.g. wishing to trade D-marks for a certain amount will call a counterparty or a broker and request twoway prices for that amount. In principle the procedure is the same via the electronic systems where price quotation is via the computer screen. Today, a large and increasing proportion of transactions take place via electronic systems. This eliminates the brokerage. It also means that a dealer can contact even more counterparties simultaneously, and ensures anonymity until the transaction is completed. Moreover, the electronic trading systems can match transactions with due consideration of any inter-bank trading limits and even also provide information on the depth of the market and on whether buying or selling interest is greatest. For trading via the electronic systems a small "system cost" per transaction is paid. The Danish foreign-exchange market is far smaller than the foreign-exchange markets in major countries such as the USA, the UK and Germany. In practice, direct prices are thus only quoted for very few currencies, whereas prices against minor currencies are fixed indirectly via cross-rates. When the banks offer prices for FRF against DKK, the price will always be calculated on the basis of the DEM cross-rates DEM/FRF and DEM/DKK. Settlement/validation in the foreign-exchange market is usually two banking days after the trading day (T+2). One or more closing days in a country means that all of the cross-rates in which the currency of that country is included are settled one or more days later. However, a closing day in the USA always means that all crossrates are settled one day later. Normally the traded currencies are transferred via a bank in the "home country" of the relevant currencies. For example, DEM is settled via a bank in Germany which is not necessarily a German bank, but might just as well be a foreign bank's branch in Germany. So all foreign-exchange-market participants have a network of correspondent banks with foreign-exchange accounts in various countries. In practice transactions are settled by the parties independently sending payment instructions to their respective correspondent banks for transfer of the sold amount to the account held by the counterparty with its correspondent bank. There has been considerable focus on this settlement method in recent years because it entails certain risks, for example less than full assurance that the counterparty will send payment instructions. In general, the development in the international foreign-exchange markets is moving towards the use of clearing centres (such as ECHO) or netting systems (e.g. FX Net) where such risks can be partly reduced. However, as yet only a modest proportion of krone-denominated transactions is settled in this way. Settlement risks in the foreign-exchange market and new measures in the area are described in a previous article by Lars G. Sørensen entitled "Settlement Risk in Foreign Exchange Trading" (in Danish only), Monetary Review, August 1996.

4 36 their own positions and to make a profit on the margin between bid and offer rates. Previously a bank was required to be an authorized foreignexchange dealer in order to trade in foreign exchange, but today's market is fully liberalized and all banks have direct access to trade foreign exchange in the market. However, to be a foreign-exchange dealer a network of correspondent banks is required, cf. Box 1. The Nationalbank may also be termed a foreign-exchange dealer. Like other foreign-exchange dealers the Nationalbank carries out payments on behalf of its customers, i.e. the external payments of the central government and the Kingdom of Denmark Mortgage Bank. As a general rule the Nationalbank hedges these payments in the foreign-exchange market via the Danish banks. The Nationalbank's central role in the foreign-exchange market is to buy and sell foreign exchange in connection with intervention to stabilize the krone. The Nationalbank thus buys and sells foreign exchange against kroner in order to stabilize the krone rate vis-à-vis the currencies of the core EMS countries. In recent years the Nationalbank has intervened more actively in order to limit the day-to-day fluctuations in the exchange rate. The Nationalbank's willingness to absorb kroner or foreign exchange from the market plays a large role in stabilizing the market. The fluctuations in the krone rate have been extremely small during the last 12 months in particular. The Nationalbank is thus an important indirect player in the foreign-exchange market by using interest-rate adjustments or intervention to signal the continued anchoring of the krone to the core currencies. The last function of the Nationalbank in relation to the foreign-exchange market is to publish indicative exchange rates. These exchange rates are calculated on the basis of the current market rates at 11:30 a.m. every day. The exchange rates are indicative and are not necessarily based on actual trading. The Nationalbank's indicative exchange rates are used for many different purposes (e.g. in many contracts, in the banks' cash foreignexchange transactions with customers, etc.), which may be due to the need for an independent source. Previously, the Nationalbank published exchange rates which were subject to fixing/listing on the basis of actual trading. This practice was discontinued as from October 1, Apart from the direct participants, the foreign-exchange market also includes brokers who establish contact between buyer and seller without being a party to the transaction themselves. Two foreign-exchange brokers operate on the Danish foreign-exchange market, but they account for only a small proportion of trading in the market.

5 37 Box 2 Turnover and positions in the Danish foreign-exchange market - statistics The only published statistics for turnover in the Danish foreign-exchange market is an international survey by the Bank for International Settlements, BIS, Central Bank Survey of Foreign Exchange and Derivatives Market Activity, May The Nationalbank conducted the Danish element of the survey. In 1989, 1992 and most recently in 1995 the Nationalbank collected data for the daily turnover in one single month in respect of the various transaction categories as well as the various currencies. The turnover statistics comprise trading in foreign exchange against kroner as well as trading in foreign exchange against foreign exchange, so that the statistics are not limited to the Danish foreign-exchange market. The most recent survey is described in the Monetary Review, February In addition to the published survey the Nationalbank also collects statistics concerning both trading volume and positions from Danish banks as an element of the Nationalbank's supervision of the foreign-exchange market. Eight of the largest Danish banks thus submit daily reports to the Nationalbank on their foreignexchange purchase and sale transactions with respectively resident customers and foreign-exchange dealers, non-resident customers and foreign-exchange dealers, and the Nationalbank. These statistics are estimated to cover around per cent of the total trading volume. The banks' net foreign-exchange position is also apparent from these reports and is calculated on the basis of the net foreign-exchange position on the previous day. The banks also report their monthly balance sheets to the Danish Financial Supervisory Authority. The balance sheets show the banks' foreign-exchange positions distributed by currency at the close of the month. The purpose of the reports is to monitor the banks' foreign-exchange exposure. They also give details of the banks' outstanding foreign-exchange-denominated spot and forward contracts at the close of the month. There are no statistics for the entire turnover in the Danish foreignexchange market. The existing statistical sources are described in Box 2, while Chart 1 illustrates the transactions covered by the statistics, i.e. the reporting foreign-exchange dealers' transactions with the other four categories of participant. The concepts of turnover and foreign-exchange position apply to the statistics described in Box 2. By turnover in the Danish foreign-exchange market is meant the total spot and forward purchases and sales of foreign exchange against kroner of the reporting bank (parent bank) vis-à-vis resident and non-resident customers and foreignexchange dealers and the Nationalbank. 1) Swap transactions are not included. The foreign-exchange position is a compilation of the reporting bank's net accounts in foreign exchange, where the bank itself bears the ex- 1) The trading-volume statistics in this article are subject to adjustment for duplicate registration of transactions with other resident foreign-exchange dealers.

6 38 change-rate risk. All net spot, net forward and net option positions are included. The concept of position thus quantifies the foreign-exchange exposure of the reporting banks. Products traded in the Danish foreign-exchange market The Danish foreign-exchange market features only a small number of standardized products. These products are primarily spot and forward transactions. In addition, there are foreign-exchange options. A spot transaction is the most simple product and is used for simple conversion between kroner and foreign exchange. For example, an export company with revenues in dollars and expenditure in kroner may wish to sell its dollar revenues in return for kroner. The exchange rate on the trading day, i.e. the spot rate, is the conversion rate for a spot transaction. Settlement normally takes place two days later. Forward transactions are often used by companies to hedge the exchange-rate risk associated with their transactions. If an export company knows it will receive dollars in 6 months' time it can sell this future dollar revenue forward in order to fix its value in kroner in advance. The company can thus immunize itself against fluctuations in the exchange rate. Likewise, non-residents holding krone-denominated bonds can hedge their position by forward sale of their future krone-denominated income on the bonds. Foreign-exchange options are also used to hedge the exchange-rate risk. An export company which will receive dollars in e.g. 6 months' time can buy an option entailing the right, but not the obligation, to sell the dollars at a fixed exchange rate in 6 months' time. The company is thus guaranteed a minimum exchange rate for its dollar-denominated income, should the dollar depreciate against the krone. The premium paid by the company for this right depends on several factors, primarily maturity, volatility and the minimum exchange rate required. The extent of the use of the individual instruments in relative terms was previously investigated in 1989, 1992 and 1995 as part of an international survey coordinated by BIS, cf. Box 2. The Table below presents the key statistics from the survey. Besides transactions between kroner and foreign exchange the turnover figures also include transactions between two foreign currencies in which a Danish foreign-exchange dealer participated. Turnover is thus not delineated as the Danish foreign-exchange market, but defined as overall foreign-exchange trading involving Danish participants. Nevertheless, the statistics do provide an indication of the breakdown of trading by transaction category.

7 39 Turnover in the foreign-exchange market by transaction type, April USD billion per banking day Percentage distribution Spot transactions Forward transactions Options Total The Table shows that spot transactions make up by far the largest proportion of trading in the foreign-exchange market. One reason is that spot transactions have the shortest maturity. In terms of contracts outstanding on any given day forward transactions constitute by far the greatest share. Throughout the period foreign-exchange options accounted for a relatively insignificant share. The major market participants report that most trading in the Danish foreign-exchange market as spot transactions takes place in kroner against D-marks. This pattern is confirmed by the BIS survey. Transactions for kroner against dollars account for the largest share of the forward market. The foreign-exchange market is closely linked to several other financial markets, since foreign-exchange transactions are often concluded simultaneously with a money-market or bond transaction. The interaction with the money market is of particular significance, because the liquidity in kroner e.g. required for payment of a foreign-exchange purchase has to be raised in the money market. Foreign-exchange swaps, i.e. loans against foreign exchange as collateral, are also traded in the money market. These products are traded as spot and forward transactions in foreign exchange, but since there is no transfer of any foreign-exchange position from one participant to another this product is not part of the foreign-exchange market. The principal connection between the bond market and the foreignexchange market is via the hedging of the exchange-rate risk in connection with non-residents' purchase and sale of krone-denominated bonds. Market structure As stated, the direct participants in the professional foreign-exchange market are banks/foreign-exchange dealers. The group of directly participating banks is relatively small, since a number of smaller banks often pass on customers' foreign-exchange orders to larger banks due to the small banks' lack of a required network of correspondent banks or to the

8 40 limited volume of transactions. Trading in the foreign-exchange market is also concentrated on a very small number of participants, and the degree of concentration has intensified since Today, the four principal players have a market share of approximately 85 per cent of the turnover of the eight reporting banks. On the other hand, there is a large group of indirect participants (business enterprises and small banks). This is related to a general need for foreign-exchange transactions. For example, a number of large business enterprises with their own financial departments are significant indirect foreign-exchange-market participants. This applied especially to the period before the foreign-exchange unrest in This activity primarily reflected speculation in currency yield differentials. During the unrest activity was still high, but was attributable to other factors, viz. the hedging of commercial currency flows as well as speculation in expected exchangerate fluctuations. Since then business enterprises have reduced their level of activity in the foreign-exchange market. The banks' management of foreign-exchange funds on behalf of customers also contributed to activity in the foreign-exchange market, but today this activity has virtually disappeared. Development in the foreign-exchange market Turnover 1) in the foreign-exchange market fluctuates considerably. For example, the current turnover is only approximately half the volume during the foreign-exchange unrest in 1993, cf. Chart 2. However, this does not indicate that the present turnover in the foreign-exchange market is significantly lower than normal, but rather that the turnover was abnormally high during the unrest in The turnover as such does not give any indication of the efficiency of the market, but is in principle related solely to the hedging requirement/speculation motive. The Nationalbank's intervention in order to limit the day-to-day fluctuations in the krone rate has undoubtedly also contributed to the dampening of trading in the foreign-exchange market in recent years. The Nationalbank's active signalling of the intention to maintain a stable krone rate via its interest-rate policy and by intervention can be said to have reduced the need for hedging and the speculation motive. Chart 2 illustrates the Nationalbank's increased activity in the foreign-exchange market after mid It is shown that the Nationalbank accounts for a very consider- 1) The turnover solely comprises transactions concluded by the eight reporting banks. The turnoer has been adjusted for duplicate registration.

9 41 Chart 2 Kr. billion 14 The volume of eight foreign-exchange dealers' trading with various foreign-exchange-market participants Non-resident customers and foreign-exchange dealers Resident customers and foreign-exchange dealers Danmarks Nationalbank able proportion of trading on individual days, whereas average trading (the black line) with the Nationalbank is relatively limited. In general, the largest Danish foreign-exchange dealers have traded almost equally with residents and non-residents in the Danish foreignexchange market, cf. Chart 2. However, trading with non-residents is subject to greater volatility than with the domestic participants in the markets. Particularly on days with indications of unrest a short and sharp rise in trading can be observed, most notably for non-resident participants who are more likely to hedge their krone-denominated positions against the risk of unrest. The banks' practice in the market - price quotation and positions Several banks have entered into market-maker agreements in the foreign-exchange market along the same lines as the market-maker agreements for various segments of the money market. Market-maker agreements exist in the foreign-exchange market for spot transactions against D-marks and dollars and for forward transactions against dollars. These segments account for the largest turnover in the foreign-exchange market. The participants in the agreements - the market makers - agree to quote binding two-way prices against each other with a fixed maximum spread between the bid and offer rates for a certain amount. These agreements are

10 42 mostly "gentleman's agreements", but are generally fulfilled and appear to function. Agreements in the spot market are normally fixed for one year at a time and apply on days without any unrest. On turbulent days the market makers will typically conclude a new short-term agreement with a wider spread between bid and offer rates. The current participants in the marketmaker agreements for spot transactions are a number of major Danish banks and most recently also a foreign bank. The spread between the bid and offer rates which the market makers are willing to offer reflects the efficiency of price quotation in the market. Price quotation is normally more efficient when exchange rates are stable. For example, the current spread between the bid and offer rates is less than kr per 100 D-marks in the market-maker agreement for spot D-mark transactions, while it had reached kr in certain periods of the foreign-exchange unrest in Generally the price quotation against the D-mark is the most efficient. The reasons are that the D-mark is the currency most frequently traded against the krone in the spot market, as well as the stability of the krone vis-à-vis the D-mark. Today the spread between the bid and offer rates for the dollar is around kr The fact that price quotation in the foreign-exchange market has generally become more efficient is attributable to the greater stability in the market and probably also to the new electronic trading systems, cf. Box 1. The amounts to which the banks commit themselves in market-maker agreements can vary from bank to bank. For the last few years typical amounts have been a commitment of between 10 and 20 million D-marks and approximately 5 million dollars for each bank. With regard to forward transactions there are only market-maker agreements for dollar transactions between the banks, since the turnover of forward transactions against D-marks is extremely small. There is little demand to hedge the exchange-rate risk against the D-mark. Danish foreignexchange dealers and branches of foreign banks participate in the marketmaker agreement for dollar forward transactions. The agreements depend on both the maturity of the transaction and the stability of the market. In this case too the spread between bid and offer rates has narrowed considerably in recent years. During the foreign-exchange unrest in 1993 the spread on certain days far exceeded kr per 100 dollars for a 3-month transaction, whereas the current spread is around kr In general, the banks do not take large positions in foreign exchange against kroner. The banks have unrestricted access to take positions in

11 43 Chart 3 Kr. billion 6 The banks' net foreign-exchange positions, end of month Total D-mark foreign exchange, but such positions will usually entail an unwanted risk. The previous exchange-rate policy entailed currency-trading regulations which restricted the banks' foreign-exchange exposure. In the banks' total net foreign-exchange position normally fluctuated at between kr. +/- 4 billion. After the currency unrest during this period there was a shift in behaviour, and from 1994 the banks' total net foreign-exchange position was reduced. It changed to most of the time comprise net assets, varying between kr. 0 and 3 billion. This change was primarily a considerable reduction and virtual elimination as from the beginning of the unrest in mid-1992, cf. Chart 3, of the net liability positions in D-marks which were between kr. -5 and -12 billion prior to the foreignexchange unrest in August The unrest in foreign-exchange markets in thus changed the banks' perception of the rules of the game in the foreign-exchange market and since then no major positions have been taken in any currency, as either assets or liabilities. Reporting from the banks shows that no large positions have been taken in the other currencies, nor have any major shifts occurred.

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