The foreign exchange (FX) market is the largest financial market by trading volume in the world, with average daily turnover of approximately $7.5 trillion. It has become increasingly complex over time, as its structure has undergone shifts in the types of market participants, the jurisdictions in which they transact, and the mix of instruments traded. The FX market also plays a critical role in supporting international trade, investment, and finance. With this in mind and in light of its role in monitoring and participating in the market, the Federal Reserve Bank of New York hosted the FX Market Structure Conference in November of last year.
The conference featured a keynote address by Michelle Neal, at the time head of the New York Fed’s Markets Group, remarks by Brent Neiman, then assistant secretary for international finance at the U.S. Treasury, a moderated discussion on the FX Global Code with Chair of the Global Foreign Exchange Committee Gerardo Garcia, and panel discussions on key topics.
In today’s article, we highlight the main themes raised throughout the day’s discussions.
Rapidly Evolving FX Market Landscape
A primary theme in each session was how the FX market landscape continues to evolve, with implications for price discovery, liquidity, and market functioning. Participants highlighted the trend of decentralization, with more transactions occurring across different platforms while primary venue usage declines. Despite this trend, they said that the primary venues remained critical sources for price discovery, particularly during times of elevated volatility, and reference rates for pricing derivative contracts. Panelists also raised that price discovery in spot FX is increasingly originating in the futures market, in part due to its broader participant base and typically faster pricing updates.
On innovation and modernization, panelists emphasized that advancements have occurred beyond spot FX markets. For example, electronic and algorithmic-based trading strategies are increasingly used in FX swaps and options. Internalization—where dealers offset client buy and sell orders—is becoming more common in trading algorithms and with derivatives. Blockchain technology is seen as increasingly beneficial, including for collateral management.
Participants frequently pointed to the growing presence of nonbank financial institutions (NBFIs) as a key shift in the FX market. While still largely dominated by banks, overall spot FX liquidity provision has expanded due to increased NBFI participation. That participation and resulting increased liquidity, according to panelists, are in large part due to the credit intermediation services that prime brokers offer NBFIs. The market-making activities by NBFIs led one buy-side panelist to stress the importance of diversifying their firm’s set of liquidity providers, becoming more reliant on NBFIs. Panelists emphasized, however, that bank dealers remain the predominant liquidity providers in the FX swap market.
Regarding FX settlement, panelists said that despite the industry’s focus on shortening settlement cycles through industry-mandated transitions and technological research, market participants tend to prefer improvements around settlement certainty and precision over speed, since quicker settlement cycles could potentially increase operational risks.
Variation Across FX Market Segments
Another theme was how the FX market is not one size fits all for its participants. For example, while FX liquidity is typically viewed as very robust, it can become more limited when trading currencies other than the U.S. dollar, euro, and Japanese yen. Panelists specifically pointed to wider spreads and shallower market depth when transacting in non-major currencies.
Furthermore, the market’s complexity and fragmentation have particularly affected smaller and more regionally focused dealers, who often face greater challenges around internalizing flows and investing in technology.
On pricing, buy-side participants and other liquidity consumers largely welcomed the spread compression—or when the difference between bid and ask prices narrows—seen across most trading venues, though dealers expressed the challenges this presents to their profitability.
Different segments of the FX market also have varied priorities when it comes to risk management. Some participants emphasized the importance of introducing trading infrastructures that allow for separation of counterparty credit risks from market and funding liquidity risks when trading FX swaps.
FX Global Code’s Influence on the Market
In addition to the moderated discussion on the importance of the FX Global Code (“Code”) to the integrity and functioning of the FX market, the global set of principles was frequently mentioned during other panels. Panelists said that broader adoption of the Code among market participants has helped improve transparency and resiliency in the FX market. They also said that they proactively confirm their counterparties’ adherence to the Code before establishing trading relationships, reflecting the market’s initiative in self-policing good practice. While Code adoption has been broad, panelists agreed that there is a need for greater adoption among certain buy-side segments, especially hedge funds.
The Chair of the Global Foreign Exchange Committee, which sponsors the Code, flagged the main themes of the Committee’s current review of the Code. The review happens every three years to ensure the Code remains fit for purpose and evolves with the market. In particular, the Committee is focused on improving transparency around delegated execution and data usage, including how platforms and liquidity providers use client trading information, and reducing settlement risk, primarily by encouraging the adoption of payment-versus-payment and netting services. Reflecting the importance of these topics, panelists touched on them throughout the day’s sessions.
Looking Ahead
Looking ahead, the structure of the FX market continues to rapidly evolve, and developments around transparency, innovation, and settlement risk will be of particular focus for industry participants. Ongoing collaboration and information sharing across the official and private sectors will be critical to effectively monitor the market structure’s evolution. The conference allowed participants to discuss several developments already underway and the effects they’re having in different corners of the FX market. Given the fruitful exchange of ideas and perspectives, the New York Fed looks forward to convening another conference later this year.
Dan Reichgott is an advisor in the New York Fed’s Markets Group.
Fabiola Ravazzolo is an advisor in the New York Fed’s Markets Group.
Lisa Chung is a director in the New York Fed’s Markets Group.
Alain Chaboud is an economist at the Federal Reserve Board of Governors.
The views expressed in this article are those of the contributing authors and do not necessarily reflect the position of the New York Fed or the Federal Reserve System.
