Foreign-Exchange and Derivatives Markets in 2007

Rune Egstrup and Birgitte Damm Fischer, Statistics

INTRODUCTION AND SUMMARY

Activity in the global OTC derivatives markets^[1] has also increased significantly, with some foreign-exchange and interest-rate instruments achieving 3-year growth rates of around 100 per cent. The Danish OTC market for foreign-exchange and interest-rate derivatives is very modest seen in an international context.

These results are presented in an international survey of turnover in the foreign-exchange and OTC derivatives markets. Danmarks Nationalbank conducted the Danish part of the survey^[2], which is coordinated by the Bank for International Settlements (BIS)^[3]. Details of the survey are provided in Box 1.

THE FOREIGN-EXCHANGE MARKET

The global survey and the Danish part of the survey both show that in 2007 growth in turnover in the foreign-exchange market was higher than at any time since the start of the survey. Average daily foreign-exchange turnover in Denmark rose by 111 per cent from 2004 to 2007, while the corresponding global growth was 71 per cent, cf. Chart 1.

Higher interbank trading in FX swaps in Denmark
Turnover in the traditional foreign-exchange market in Denmark by way of spot and forward transactions and FX swaps averaged 86 billion dollars per banking day in April 2007. The equivalent global turnover was 3,210 billion dollars.

All three instruments have contributed to the rising turnover in the Danish foreign-exchange market. In value terms, FX swaps make up by far the largest part of the market, and this is also the instrument that has seen the greatest absolute increase. A similar pattern is observed in the global foreign-exchange market, cf. Table 1.

Most of the increase in turnover in the Danish market relates to trading between reporting dealers, clearly reflecting the counterparty distribution in the Danish foreign-exchange market. Interbank trading among domestic and foreign reporting dealers accounts for as much as 78 per cent of the aggregate foreign-exchange turnover in the Danish survey, while the segments other financial institutions (e.g. pension and insurance companies, investment banks and hedge funds) and non-financial customers each account for 11 per cent of turnover, cf. Chart 2.

The relatively high share of interbank trading between reporting dealers in the Danish foreign-exchange market is primarily related to FX swaps. These often have short maturities, sometimes only one day, which is a contributing factor to the high turnover of this instrument in the Danish market. In Denmark, FX swaps are the banks' preferred money-market instrument for managing krone-denominated liquidity, partly because FX swaps are easier to administer for banks than other types of collateralised money-market instruments such as repos.

The sharp rise in turnover in FX swaps between reporting dealers should also be viewed in the light of the more widespread use of CLS (Continuous Linked Settlement)^[4], cf. Chart 3, for settlement of foreign-exchange transactions. Settlement via CLS limits the risk on foreign-exchange transactions because the two legs can be settled simultaneously in the system, and this may have contributed to the rise in interbank trading in FX swaps in Denmark.

The change is partly technically driven
A substantial part of the increase in total turnover in the foreign-exchange markets is a result of a higher share of foreign-exchange instruments with relatively short maturities. When contracts are renewed more often, this contributes to increasing turnover. Even a small reduction of the average maturity can generate considerable growth in turnover. The maturity of traditional foreign-exchange transactions was generally lower in the 2007 survey than in the two preceding surveys. Chart 4 shows the maturity distribution for FX swaps, which account for the largest share in value terms of turnover in the Danish foreign-exchange market. As the Chart shows, there has been a shift towards FX swaps with shorter maturities^[5].

This shift coincides with a steepening of the yield curve, cf. Chart 5. Larger yield spreads between maturities may have contributed to higher turnover in short-term transactions. Fluctuations in the volatility in the foreign-exchange market and credit-line issues may also have affected the choice of maturity.

A small part of the increase in turnover in the foreign-exchange markets may also be attributable to the weakening of the dollar in the period 2004-07, as turnover is stated in dollars. However, even after adjustment for the development in the dollar rate, growth rates are still considerable, at 96 per cent in Denmark and 65 per cent globally.

A sustained overall upswing and increased internationalisation also play a role
The strong growth in turnover in the foreign-exchange markets should also be viewed against the backdrop of a sustained overall upswing in the global economy in recent years with high GDP growth, increasing international trade and rising stock markets. Foreign-exchange trading may also have been boosted by technological advances and new players such as hedge funds, as well as relatively low interest rate levels, which have made leveraged buyouts attractive.

Increasing globalisation also affects turnover in the foreign-exchange markets. In Denmark's case, external assets and liabilities have increased substantially in recent years, both in absolute terms and as a ratio of GDP, cf. Chart 6.

The development in Denmark's external assets and liabilities reflects, among other things, increasing cross-border investments. Business enterprises seek to gain an advantage by setting up in export markets or to reduce their costs by relocating some of their activities abroad. This is reflected in direct investments. Danish outward direct investments and direct investments into Denmark have both risen considerably over the last three years. Danish outward direct investments as a ratio of GDP rose from just over 30 per cent at the end of 2003 to around 45 per cent at the end of 2006. A similar trend has been registered in direct investments into Denmark.^[6]

International diversification is also seen within portfolio investments. According to BIS (2007), large institutional investors with long investment horizons tend to invest in more internationally diversified portfolios, which may have contributed to the rise in global foreign-exchange trading.

To some extent, this also applies to Danish institutional investors, since they have increased their aggregate portfolios of external assets from approximately kr. 770 billion at end-2004 to almost kr. 1,180 billion in the 1st quarter of 2007. This development is primarily attributable to investment associations^[7], but in recent years the Danish insurance and pension sector has also increased its portfolios of securities denominated in foreign currency^[8].

Currency breakdown of foreign-exchange turnover
A currency breakdown of the Danish foreign-exchange market shows that it is increasingly dominated by the euro. In the 2007 survey, 46 per cent of turnover in the Danish foreign-exchange market had one leg in euro, compared with 38 per cent in 2004^[9]. At the global level, the euro's share remains unchanged at around 37 per cent, cf. Table 2. The rising importance of the euro in the Danish foreign-exchange market is e.g. attributable to confidence in Denmark's fixed-exchange-rate policy and the fact that the fluctuations of the krone around its central rate have diminished since the 2004 survey. This may have affected the business enterprises' choice of invoicing currency. Furthermore, investment associations, among others, have restructured their portfolios in favour of euro-denominated securities^[10]. Market participants also point to portfolio restructuring in the pension sector as a factor behind the rising share of the euro in the Danish foreign-exchange market.

In spite of the increasing importance of the euro in the Danish market, the dollar remains the dominant currency, in Denmark and globally. The dollar's share of total foreign-exchange turnover has been declining, but globally 86 per cent of all foreign-exchange transactions still had one leg in dollars in April 2007, while the equivalent figure for Denmark was 75 per cent. The dominance of the dollar in the foreign-exchange market reflects the fact that many currency pairs are traded with the dollar as an intermediary currency.

In the Danish market, 28 per cent of the foreign-exchange turnover in April 2007 had one leg in kroner. This was unchanged compared with 2004.

THE OTC MARKET FOR FOREIGN-EXCHANGE AND INTEREST-RATE DERIVATIVES

Foreign-exchange derivatives
Average daily turnover in the Danish OTC foreign-exchange derivatives market (currency swaps and options) has risen by 75 per cent in relation to 2004, cf. Table 3, and thus somewhat less than the traditional foreign-exchange market. With average daily turnover of 2.1 billion dollars per banking day, the market remains very limited in size. Globally, the foreign-exchange derivatives market has increased by 111 per cent in terms of average daily turnover, i.e. a higher growth rate than the traditional foreign-exchange market.

In both the Danish and the global survey, currency options account for three quarters of the foreign-exchange derivatives market, but the highest growth rates are seen for currency swaps, which have more than trebled since 2004. According to BIS (2007), the high global growth is partly attributable to hedging in connection with bond issuance in foreign currency^[11]. Similar conditions may apply in the Danish market, where issuance abroad by Danish residents more or less doubled from the 1st quarter of 2004 to the 1st quarter of 2007^[12]. Danish market participants also indicate that currency swaps are increasingly used by banks for long-term financing in foreign exchange, which is in line with the fact that growth in currency swaps in Denmark is primarily attributable to reporting dealers and to a lesser extent to other financial institutions. Non-financial customers, on the other hand, constitute a negligible share.

For currency options, the entire increase is attributable to other financial institutions and non-financial customers, while trading between reporting dealers has declined. According to the market participants, this reflects the increasing use of foreign-exchange derivatives in risk management and portfolio management.

Interest-rate derivatives
At 10 billion dollars per banking day, OTC trade in interest-rate derivatives by way of forward rate agreements (FRAs), interest-rate swaps and interest-rate options in the Danish market is by and large unchanged compared with 2004. These figures mask opposite trends for the various instruments, since turnover in FRAs and interest-rate options has risen while a decline has been registered for interest-rate swaps. The latter decline – primarily in trading between reporting dealers – is to a small extent attributable to geographical relocation of a reporting dealer's trading desk so that part of its trade is no longer registered as turnover in Denmark. Otherwise, the development should presumably mainly be viewed in the light of unusually high growth in turnover in the 2004 survey. Non-financial customers account for the largest share of the increasing turnover in the other two interest-rate derivative instruments.

The global survey shows higher turnover in interest-rate derivatives for all three counterparty categories. Total turnover in interest-rate derivatives averaged 1,686 billion dollars per banking day in April 2007, an increase of 64 per cent over 2004.

GEOGRAPHICAL DISTRIBUTION OF TURNOVER IN FOREIGN EXCHANGE AND DERIVATIVES

As the preceding surveys also showed, trade in foreign-exchange and OTC derivatives is still concentrated in the UK. Turnover in the UK accounts for 34 per cent of total turnover in the foreign-exchange market and 42 per cent of turnover in the OTC derivatives market, cf. Table 4. The USA and the euro area are the second and third largest markets.

Denmark's share of the global foreign-exchange market increased from 1.7 per cent in 2004 to 2.2 per cent in 2007. The Danish market for OTC derivatives is, however, more limited, particularly when it is taken into account that other countries often have a substantial organised derivatives market alongside the OTC market. The limited size of the Danish OTC derivatives market may, for example, reflect that large institutional investors trade derivatives with foreign banks, so that their turnover is excluded from the Danish part of the survey.

LITERATURE

BIS (2007), Triennial Central Bank Survey of Foreign Exchange and Derivatives Market Activity in April 2007, September.

Danmarks Nationalbank (2007), Survey of the Danish foreign-exchange and derivatives market turnover in April 2007, Financial statistics, Special statement, 25 September.

Natorp, Lone, and Tina Skotte Sørensen (2006), Settlement of Foreign-Exchange Transactions, Danmarks Nationalbank, Monetary Review, 4th Quarter.

OECD (2007), Trends and recent developments in foreign direct investment, June.