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Foreign-Exchange Trading and the Dollar

The Bank for International Settlements released its triennial snapshot of the foreign-exchange market in December. Two trends emerge from the survey's wealth of information: Technology is changing the market, and the dollar still dominates trading, despite continued talk of its imminent demise.

Every day across the globe, $4 trillion worth of foreign exchange changes hands. That figure is up 20 percent since 2007, despite the worldwide recession and a serious drop in global trade. Much of the growth in foreign-exchange turnover stems from a relatively new quarter. Past surveys showed that trades among the large traditional foreign-exchange dealers (reporting dealers) and trades between this group and their nonfinancial customers dominated the market. Indeed, they still do, accounting for slightly over half of all foreign-exchange transactions. Nevertheless, their share is shrinking. Since 2001, trades between this traditional group and a set of nontraditional (or other) financial institutions, including small banks, money-market funds, pension funds, and hedge funds have grown rapidly. These nontraditional counterparties now account for nearly half of all foreign-exchange turnover, whereas in 2001, they accounted for less than one-fifth of all activity.

Fostering this growth has been the continued development of electronic methods of executing trades. Increasingly, for example, computer programs place trades automatically in response to small price changes. Electronic trading reduces the costs of transacting in the foreign-exchange market, which encourages greater—more diverse—participation and increases liquidity in the market.

Much of this trading activity reflects currency speculation, price arbitrage, or hedging operations. Foreign-exchange trading is many times larger than economic activity—as measured by either output or international trade—and has grown faster than these measures of economic activity in recent years.

The BIS survey also shows that the U.S. dollar is still the predominant international currency, with 85 percent of all daily foreign-exchange transactions involving dollars. The dollar has lost some ground to the euro in recent years, but with half as many trades as the dollar, the euro remains a distant second. The widespread use of the dollar is not likely to change quickly. The sheer size, sophistication, and relative stability of the U.S. economy render the costs of holding and transacting in dollars lower than doing so in other currencies that do not share these characteristics.

Figure 1. World Trade

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