11 November 2021, 6.30 pm
Structural change in the foreign exchange market: implications for the SNB
Money Market Event
Andréa M. Maechler and Thomas Moser*
Member of the Governing Board / Alternate Member of the Governing Board Swiss National Bank
Geneva, 11 November 2021
© Swiss National Bank (speech given in French)
The speakers would like to thank Linda Kirschner and Carolin Reiss for their support in drafting this speech. They also thank Benjamin Anderegg, Irma Cruz, Lukas Frei, Alain Kouo, Mico Loretan, Thomas Maag and Alexander Wehrli for their valuable comments as well as SNB Language Services for the translations of the text.
Ladies and gentlemen
It gives me great pleasure to welcome you all - both online and in person - to this year's Swiss National Bank Money Market Event in Geneva.
The past two decades have been marked by dramatic changes in the economic landscape. These changes include a series of crises such as the global financial crisis, the European sovereign debt crisis and, most recently, the coronavirus pandemic. Structural change is occurring at multiple levels, and the pace of this change is picking up significantly due to the ongoing digital revolution. Financial markets are particularly affected by these developments.
In recent years, new technologies, new players and new tools have substantially altered not only the outward appearance of these markets but also their inner workings, their underlying dynamics. Market participants and central banks must therefore confront the following questions: Where can innovations be exploited, what opportunities will they create, and how should any risks be managed? Where is 'mere' technological progress in play, and where do the ongoing changes have more far-reaching, fundamental consequences?
Today, we wish to focus on the structural change - indeed the transformation - taking place on the foreign exchange (FX) market. The developments and challenges are particularly evident in the FX market, where trading activity has accelerated markedly in recent years. The FX market is now a so-called'fast-paced electronic market' - high-frequency, electronic and complex.
These developments are particularly relevant for the SNB, as the exchange value of the Swiss franc, and hence the FX market, are of great importance to us. Even though the exchange rate is not a target of monetary policy, it is relevant because it significantly influences monetary conditions and thus our ability to fulfil our mandate to ensure price stability while taking due account of economic developments. In a small open economy such as Switzerland, changes in the exchange rate materially affect domestic prices and economic activity and must therefore be taken into account when designing monetary policy. If the SNB adjusts its policy rate or intervenes in the FX market, this in turn has an impact on the exchange rate. The dynamics of the Swiss franc are complicated by the fact that its exchange value tends to appreciate in uncertain times due to the currency's status as an international safe haven.
In addition to the important role the Swiss franc plays in influencing monetary conditions in Switzerland, the FX market also matters because it affects the implementation of our monetary and investment policies. As a central bank, the SNB is interested in ensuring that the FX market functions smoothly at all times, enabling an efficient price discovery process which supports the transmission of monetary policy. Furthermore, as a direct participant in the FX market, we have a responsibility to act as efficiently and effectively as possible. For instance, in the context of monetary policy implementation, we seek to achieve maximum impact when deploying our instruments. By contrast, when it comes to our investment policy and managing our currency reserves (these make up the bulk of our balance sheet, which is worth over CHF 1,000 billion), we seek to minimise our impact.
My colleague Thomas Moser and I will outline today the changes we are observing in the FX market, the challenges associated with them, and what this means for the SNB.
The key message of our presentation is as follows: Rapid structural change, driven by the ongoing digital revolution, is affecting all financial markets today, and it could accelerate further in the years ahead. As a central bank, we must have a solid grasp of the developments and changes taking place in the markets - at both a macroeconomic and a market microstructure level - and be able to identify their fundamental implications at an early stage. When core variables, including the structure and functioning of the market, price discovery processes and market dynamics, change, central banks must be able to spot such changes and react to them where necessary.
Using the example of the FX market, we will demonstrate that, in addition to new data, new technologies and new skills, central banks will require a completely new data and analysis infrastructure if their market monitoring and analysis are to remain state-of-the-art in the face of the profound transformation taking place. It will likely not surprise you to learn that central banks have been exploring this issue for some time and are joining forces in this area.
The remainder of our presentation is divided into three sections. First, we will examine the nature of the structural change that has been underway in the FX market for some years. Second, we will discuss various operational and policy-related challenges that result from this structural change. And third, we will outline how the SNB is responding to these challenges as a market participant and market observer and what role the FX Global Code plays in this context.
Digital innovation is bringing about structural change in the FX market
With daily trading volume averaging USD 6.6 trillion, the FX market is the world's largest financial market. Notably, the FX market is not centralised - it has a decentralised, fragmented structure (cf. chart 1). One of the fundamental features of this market is that the bulk of the trading takes place over-the-counter; that is to say, it is transacted bilaterally between individual parties, usually via an array of different electronic trading platforms. Because the market is fragmented and liquidity is distributed across many so-called 'pools', there is neither one marketplace nor one price for foreign exchange. One should therefore always bear in mind that a decentralised, fragmented market structure means that quotes on any given trading platform will only ever offer a partial view - but never a complete picture - of the market.
The FX market has been experiencing a dramatic transformation for several years now due to digital innovation. Exponential improvements in computing power, the ever-increasing speed of data exchange, and the declining costs of data storage have caused the share of trades that are executed electronically by both parties to a transaction to swell continuously. In 2019, 75% of spot transaction volume was already being traded electronically. Not only have transaction volumes grown significantly, but the market has also become much faster and more complex; it has genuinely evolved into a 'fast-paced electronic market'.
In the wake of this transformation, two major structural changes have occurred in this market, which we will discuss next.
First, fragmentation is increasing in the FX market and the importance of the primary markets is decreasing. For decades, the so-called 'primary markets' - the interbank trading platforms EBS and Refinitiv - set the tone for trading and price discovery in the decentralised FX market. The prices displayed in the primary markets are widely available and binding ('firm'), i.e. once the trading interest has been communicated, prices can no longer be withdrawn or adjusted by the quote provider (no 'last look'). This has made them an important anchor in certain currency pairs, especially during periods of heightened volatility. Secondary trading platforms, on the other hand, often provide 'non-firm liquidity', i.e. the prices shown are merely indicative quotes. Access to these secondary platforms and the prices shown on them is also more limited due to their less prominent position in markets.
In recent years, competition for trading volume has increased significantly and the market has become even more fragmented. In the early stages of the electronification of trading, it was technically very difficult and resource-intensive to set up a new trading platform. However, owing to sharp drops in the cost of the associated technologies, these barriers to entry for alternative trading platforms have fallen steadily; this has led to an increase in the number of secondary trading venues. In addition, for several years now, new players have been pushing into the market which has traditionally been dominated by banks, and they are taking over the classic intermediary function the latter used to perform.
Within this increasingly fragmented market, trading activity has been migrating from primary markets to secondary markets. While the market share of traditional primary markets is declining, secondary trading platforms are gaining market share. On the left-hand side of chart 2 we show the estimated primary market share for all currencies. Note that this share has more than halved over the last 10 years. And the Swiss franc is no exception here. On the right-hand side of the chart, we can see that the market share of the Swiss franc currency pairs has also decreased considerably and is currently stuck at a low level.
This migration of trading activity is due, among other things, to the fact that the new trading platform operators entering the market are offering technological improvements and attractive conditions in an effort to court volume. As a consequence, liquidity providers are choosing to distribute their quotes across multiple platforms. Thus, not only is the market becoming more fragmented, liquidity itself is as well.
Second, the trend towards internalisation is gaining momentum, making trading activity in the FX market less transparent. Internalisation is a less transparent form of trade execution. When executing transactions, professional market participants typically have a choice between more transparent and less transparent trading options. In other words, they can place their orders directly on widely accessible trading platforms (the primary and secondary platforms), or they can transact outside of this system, for example by using 'dark pools' or internalisation via intermediaries. We will discuss some of the implications of these less transparent forms of trading in the panel discussion that will follow after this talk. With internalisation, client
transactions within a financial institution are no longer traded on the interbank market. Instead, the financial institution, in its role as intermediary, offsets trade orders from client transactions internally against its own book of trade orders. The degree of internalisation may be geared to meet specific requirements - trading may take place entirely outside of the primary and secondary platforms, or a hybrid approach may be adopted that draws partly on an internal intermediary's liquidity and partly on the liquidity of primary or secondary platforms. The informational content of these transactions thus remains more or less within a financial institution and is therefore more or less beyond the reach of price discovery on the primary market platforms. Which type of trade execution is chosen ultimately depends on the objective of the market participants, i.e. whether the goal is to reduce market risk, minimise transaction costs, or maximise the probability of a transaction being fully executed.
In recent years, the trend towards internalisation has gathered pace. Due to the growing volume of internalised trades, there is less and less need for dealers to execute transactions on widely accessible interbank trading platforms (cf. chart 3).
From an individual perspective, internalisation can be beneficial for both clients and intermediaries. Intermediaries that provide internalisation can avoid paying bid-ask spreads as well as other transaction and settlement costs associated with external platforms; this allows them to offer better prices to clients. For their part, clients hope that by avoiding widely accessible platforms they can reduce 'information leakage', and with it the price impact of their trades.
At the same time, however, this approach reduces transparency on the FX market as a whole, since fewer transactions take place on widely available platforms. This is because the more market participants conclude their transactions outside of the regular trading platforms, the less information about actual trading activity is reflected in posted prices. What can seem advantageous from an individual trader's perspective may, from a certain point onwards, be detrimental from an aggregate market perspective.
Overall, prices on the FX market have become more competitive due to the greater number of players, while trading activity has simultaneously become more fragmented and less transparent. You are probably asking yourselves whether this development is positive or negative. We can already see some clear changes emerging as a result of the structural change. While these are not yet problematic from the point of view of market dynamics and market functioning, it is important to have a sound understanding of the impact of these developments. We will now discuss some of the challenges presented by these structural changes in the FX market.
The increasing fragmentation of the market potentially affects the relevance and reliability of reference prices, which in turn can affect the efficiency and robustness of the market. In a decentralised market such as the FX market, so-called 'reference prices' play a key role. They simplify the price discovery process, and they are used both as a real-time reference for
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