Exchange Rate Economics: Theories and Evidence

4 Introduction
(orders to buy/sell a specified quantity of foreign exchange at a specified price)
from which she,in turn,will quote the best bid/ask rates to market makers. The
latter are referred to as the broker’s ‘inside spread’. The broker earns a profit by
charging a fee for her service of bringing buyers and sellers together. The foreign
exchange market is therefore multiple dealer in nature.
More recently,automated brokerage trading systems have become popular in
the foreign exchange market and perhaps the best known is the Reuters 2000–2
automated electronic trading system. This dealing system allows a bank dealer to
enter buy and/or sell prices directly into the system thereby avoiding the need
for a human,voice based,broker (and it is therefore seen as more cost effective).
The D2000-2 records the touch,which is the highest bid and lowest ask price. This
differs importantly from so-called indicative foreign exchange pages which show
the latest update of the bid and ask entered by a single identified bank. The system
also shows the quantity that the bank was willing to deal in,which is shown in
integers of $1 million. The limit orders are also stored in these systems but are not
revealed. A member of the trading system (i.e. another bank) can hit either the
bid or ask price via his own computer terminal. The trading system then checks
if the deal is prudential to both parties and if it is the deal goes ahead,with the
transaction price being posted on the screen. Associated with the price is the change
in quantity of the bid (ask) and also in the price offered if the size of the deal exhausts
the quantity offered at the previous price. These concepts are discussed in more
detail in Chapter 14.
1.3 A snapshot of the global foreign exchange
market in 2001
The Bank for International Settlements (BIS) produces a triennial global survey
of turnover in the foreign exchange market gathered from data collected by its 48
participating central banks. These surveys have been conducted since 1989 and
the latest available at the time of writing was the 2001 survey (see BIS 2001). This
showed that average daily turnover in ‘traditional’ foreign exchange markets – spot
transactions,outright forwards and foreign exchange swaps – in 2001 was $1.2 trillion,compared
with $1.49 trillion in April 1998,a 19% fall in volume at current
exchange rates (a 14% fall at constant exchange rates). The breakdown is shown
in Table 1.1,which shows that the biggest hit occurred in terms of spot transactions
and foreign exchange swaps,with outright forward contracts increasing
slightly.
As the BIS notes,this decline in foreign exchange market turnover does not
reflect a change in the pattern of exchange rate volatility (see Table 1.2),but
rather the introduction of the euro,the growing share of electronic brokering in
the spot interbank market,consolidation in the banking industry and international
concentration in the corporate sector (see Galati 2001 for a further discussion).
The share of interbank trading in total turnover in 2001 was 58%,a decline
of 5% over the previous survey,a decline attributed to the increased role of
electronic brokering,which implied that foreign exchange dealers needed to trade