The Foreign-Exchange Market for Danish Kroner

Kim Abildgren, Economics

INTRODUCTION AND SUMMARY

In terms of turnover, the foreign-exchange market is one of the world's largest markets. Global trade in foreign exchange amounts to around2 trillion dollars per banking day. Trade in foreign exchange is essential to a well-functioning international economy. This not only applies to foreign-exchange transactions derived from trade in goods across national borders since pension funds' investments in foreign securities, direct investments in business enterprises across national borders and corporate borrowing in the international financial markets all entail trade in foreign exchange. Many foreign-exchange transactions are the result of financial and non-financial enterprises' need to manage foreign-exchange exposures on assets and debt, as well as revenue and expenditure denominated in foreign exchange. In addition, market participants take foreign-exchange positions in the expectation of gains on the future development in exchange rates (speculation). Finally, market participants buy and sell foreign exchange in order to eliminate price differences between the same currency pair in different marketplaces (arbitrage). This contributes to liquidity^[1] and efficient price formation in the foreign-exchange market.

The foreign-exchange market for Danish kroner is the market for purchase and sale of foreign exchange against Danish kroner. The krone market is fundamental to Danish monetary and foreign-exchange policy. This is where the exchange rate of the krone is formed, and where Danmarks Nationalbank intervenes by purchasing and selling foreign exchange in order to stabilise the krone. This article describes the institutional structure of the krone market and the development trends in recent years.^[2] The turnover of foreign exchange against kroner in the global foreign-exchange markets is more than kr. 100 billion per banking day. Denmark's fixed-exchange-rate policy entails that the fluctuations in the exchange rate of the krone vis-à-vis the euro are very small. Consequently, the spreads between the largest participants' bid and ask prices are narrower in the krone market than in a number of other foreign-exchange markets.

DEFINITION OF FOREIGN EXCHANGE

Foreign exchange is money denominated in the currency of another country, and the exchange rate is normally calculated as the price of a unit of the other country's currency expressed in the domestic currency.

Defining the foreign-exchange market requires the same considerations as when defining the terms "money" and "money supply". In principle, only the exchange rates for banknotes and coins of different countries are "pure" exchange rates. However, this type of foreign exchange is only traded in the market for foreign exchange for travel purposes, etc. In monetary terms, it is by and large equivalent to M0.^[3]

The majority of foreign-exchange transactions relate to trade in bank deposits denominated in different currencies, since foreign-exchange transactions are settled by transferring demand deposits from one account to another. Consequently, a definition of foreign exchange comprises not only cash foreign exchange, but also the assets used to settle foreign-exchange transactions, i.e. bank deposits on demand denominated in foreign exchange. In monetary terms this is roughly equivalent to M1.

However, the definition of foreign exchange always depends on the specific context. Besides demand deposits with banks, Danmarks Nationalbank's foreign-exchange reserve thus also includes liquid bonds that can quickly be sold or collateralised if Danmarks Nationalbank needs foreign exchange for intervention purposes.^[4] This is foreign exchange in a broader sense, equivalent to broader monetary aggregates than M0 and M1.

THE FOREIGN-EXCHANGE MARKET FOR DANISH KRONER – DEFINITION, SIZE AND PRODUCTS

The foreign-exchange market for Danish kroner is the market for purchase and sale of foreign exchange against Danish kroner. All transactions entailing transfer of a position in Danish kroner against foreign exchange from one player to another are in principle part of the foreign-exchange market for Danish kroner.

The krone market has no geographical or physical limits. Purchase and sale of foreign exchange against Danish kroner between two non-residents (e.g. a krone transaction between a German bank and a German investor in Danish bonds, or a krone transaction between a German bank and a Germany company importing goods from Denmark) is also part of the foreign-exchange market for Danish kroner. On the other hand, purchase and sale of dollars against euro between two Danish banks is not part of the foreign-exchange market for Danish kroner.

Every three years, the Bank for International Settlements, BIS, coordinates the compilation of international statistics on turnover in the global foreign-exchange markets, cf. Box 1. The most recent survey relates to April 2004. Using data from this survey, a distinction can be drawn between the "Danish foreign-exchange market for Danish kroner" and the "global foreign-exchange market for Danish kroner". The former comprises foreign-exchange transactions in Danish kroner involving a bank located in Denmark. The "global" market, on the other hand, comprises foreign-exchange transactions in Danish kroner involving a bank located either in Denmark or abroad.

The average daily turnover in the Danish foreign-exchange market for Danish kroner was kr. 72 billion in April 2004, while turnover in the global foreign-exchange market for Danish kroner was kr. 104 billion per banking day, cf. Table 1. This means that around 30 per cent of the turnover of kroner in the foreign-exchange market does not pass through banks located in Denmark. Part of the global turnover of kroner takes place between the foreign units of, respectively, Danish banks and Danish business enterprises. However, it is also customary for large Danish enterprises and institutional investors to trade foreign exchange against kroner with large international banks with which they already conduct other financial transactions, e.g. trade in foreign securities.

The foreign-exchange market for Danish kroner primarily comprises spot and forward contracts. In addition, FX swaps, currency swaps and foreign-exchange options are traded. The products in the foreign-exchange market for Danish kroner are outlined in Box 1.

Turnover in the individual products in the foreign-exchange market for Danish kroner is also shown in Table 1. Foreign-exchange swaps (FX swaps) account for around 70-75 per cent of turnover. However, FX swaps with one leg in kroner should be seen as a money-market product rather than a foreign-exchange-market product since the purpose is often to raise or lend krone-denominated liquidity for a short period against foreign exchange, typically dollars, as collateral. The rest of the turnover primarily comprises spot transactions (around 15-20 per cent) and to a lesser extent forward contracts (around 5-10 per cent). The krone-denominated turnover in currency swaps and foreign-exchange options is very modest in view of the small fluctuations in the krone vis-à-vis the euro.

Table 2 shows the distribution by maturities of forward contracts and FX swaps in the foreign-exchange market for Danish kroner. Many FX swaps have maturities of less than 7 days, while forward contracts mainly have maturities exceeding 7 days. This reflects that FX swaps are often used as a short-term money-market product, while forward contracts are used to hedge exchange-rate exposure over longer periods.

For the Danish section of the foreign-exchange market for Danish kroner, trading in the individual products can be broken down by currencies, cf. Table 3. Around 80 per cent of the spot trades are kroner against euro. This reflects the extensive trade with the euro area, and that interbank spot trading takes place via euro. When a bank e.g. trades kroner for dollars with a customer, the bank often hedges the exchange-rate risk on the transaction via, respectively, euro-dollar and krone-euro trades in the interbank market.

For forward contracts, euro account for only around one third of turnover. In view of Denmark's fixed-exchange-rate policy, forward contracts are primarily used to hedge the development in the exchange rates of other currencies than the euro. The high proportion of dollar transactions, around 40 per cent, furthermore reflects that banks trade kroner forward against other currencies via dollars.

DEVELOPMENT IN TURNOVER IN THE FOREIGN-EXCHANGE MARKET FOR DANISH KRONER SINCE 1992

It is possible to illustrate the development in turnover in the Danish section of the foreign-exchange market for Danish kroner since 1992, cf. Chart 1. In absolute terms, turnover has risen from kr. 30 billion per banking day in 1992 to kr. 72 billion per banking day in 2004. In terms of "classic foreign-exchange turnover" alone, i.e. spot and forward contracts, turnover in the last 10 years has fluctuated around a level of kr. 14-18 billion per banking day. When assessing the development in turnover over time, it is important to bear in mind that payment transactions between Denmark and abroad have increased substantially in the last decade.^[5] The krone-denominated turnover in Denmark in relation to the total volume of goods and capital payments between Denmark and abroad shows a declining trend. The relatively stable daily turnover volume in spot and forward contracts in billion kroner since 1992, even though the volume of payments is rising, should be viewed against the background of the reduced fluctuation of the krone vis-à-vis the euro and, prior to 1999, the D-mark.

Data for the global turnover in the foreign-exchange market for Danish kroner is only available from 2001 onwards. Turnover fell from kr. 123 billion per banking day in April 2001 to kr. 104 billion in April 2004. Once again, most of the development is attributable to FX swaps. Only a slight decline was seen in the turnover in spot and forward contracts, which fell from kr. 32.4 billion per banking day in April 2001 to kr. 29.7 billion in April 2004.^[6]

As stated in Box 1, the data for turnover of kroner relates only to April of the years in question and may therefore to some extent be influenced by random factors, e.g. large foreign-exchange transactions in connection with mergers and acquisitions. The high global turnover in the foreign-exchange market for Danish kroner in April 2001 compared to April 2004 should also be viewed against the background of a somewhat higher yield spread between Denmark and the euro area in 2001 compared with 2004. Viewed in isolation, the volume of intervention by Danmarks Nationalbank, which also influences turnover, has the opposite effect. Intervention in April 2004 totalled around kr. 7.5 billion, while there was no intervention in April 2001.

THE PARTICIPANTS IN THE FOREIGN-EXCHANGE MARKET FOR DANISH KRONER

The participants in the foreign-exchange market for Danish kroner can generally be divided into customers, foreign-exchange dealers and brokers – and Danmarks Nationalbank.

Customers are typically private enterprises that need to buy and sell foreign exchange in connection with payments to and from abroad, or institutional investors purchasing and selling securities across national borders. Local authorities and public enterprises may also have a number of large payments to and from abroad. Private individuals normally only use the foreign-exchange market in connection with the purchase and sale of foreign exchange for travel purposes, card payments via the Internet, or direct purchase and sale of foreign securities.

Foreign-exchange dealers are banks that either purchase and sell foreign exchange for their customers, hedge their own positions or participate in currency arbitrage^[7]. A number of banks have concluded agreements to act as market makers in the foreign-exchange market for Danish kroner. Market makers have an obligation to quote binding two-way prices vis-à-vis each other within fixed maximum bid/ask spreads and for certain amounts.

Foreign-exchange dealers normally have relatively large transactions in the foreign-exchange market for Danish kroner, e.g. in the range of 10-30 million euro per transaction. In recent years, foreign-exchange dealers have mutually traded kroner against euro with a bid/ask spread for spot transactions of kr. 0.03-0.05 per 100 euro, i.e. "3-5 pips" – equivalent to 0.004-0.007 per cent, cf. Table 4. In the Swedish and Norwegian professional foreign-exchange markets, the bid/ask spreads are around 5-10 times as wide as in the foreign-exchange market for Danish kroner. This especially reflects the greater volatility of the Norwegian krone and the Swedish krona vis-à-vis the euro, but there may also be variations in liquidity in the three markets. Trading spreads in the foreign-exchange market for Danish kroner have narrowed in the last 10-15 years. In connection with the currency crises in the 1st half of the 1990s, considerable bid/ask spreads could be seen for kroner against D-mark.

Besides the direct participants in the foreign-exchange market there are also brokers who act as intermediaries between buyers and sellers without themselves being a party to the transactions. Intermediation is subject to a product-specific fee, which may be negotiable. There is one local broker in the Danish foreign-exchange market for Danish kroner, but Danish kroner can also be traded with foreign brokers in e.g. Frankfurt, London and Luxembourg.

Danmarks Nationalbank's key function in the foreign-exchange market for Danish kroner is purchase and sale of foreign exchange in connection with intervention to stabilise the krone vis-à-vis the euro, cf. Box 2. Danmarks Nationalbank also purchases and sells kroner against foreign exchange since it is banker to the central government and in this capacity undertakes payments relating to government debt and other central-government transactions in foreign exchange. Finally, Danmarks Nationalbank on a daily basis publishes information on the exchange rate of the krone against a number of other currencies. These exchange rates are for information purposes only.^[8] Currency cannot be bought from or sold to Danmarks Nationalbank at the published exchange rates. Danmarks Nationalbank's exchange rates are used in numerous contexts, e.g. in many contracts, and in the banks' cash foreign-exchange transactions with customers, etc. where there is a wish to use an independent source.

DANMARKS NATIONALBANK'S INTERVENTION IN THE FOREIGN-EXCHANGE MARKET FOR DANISH KRONER	Box 2
In the short term, Danmarks Nationalbank can stabilise the exchange rate of the krone against the euro by intervention purchase or sale of foreign exchange against kroner. When Danmarks Nationalbank sells foreign exchange and purchases kroner, the krone tends to strengthen. When Danmarks Nationalbank purchases foreignexchange and sells kroner, the krone tends to weaken, cf. the Chart.
INTERVENTION 1999-2005
Source: Danmarks Nationalbank.
If Danmarks Nationalbank has regularly sold foreign exchange and purchased kroner for a prolonged period, this indicates that the interest-rate spread between Denmark and the euro area is too low. In that case Danmarks Nationalbank must raise its interest rates relative to those of the ECB. On the other hand, Danmarks Nationalbank lowers its interest rates relative to the ECB if foreign exchange has been purchased and kroner sold for a prolonged period. When management of interest rates is used as a monetary-policy instrument, as is the case in Denmark, intervention is normally said to be sterilised if the transaction does not in itself affect the short-term interest rate. If the short-term interest rate is affected, the intervention is non-sterilised. In periods when the foreign-exchange market is stable, Danmarks Nationalbank's intervention is best described as sterilised, while it is non-sterilised in periods of turbulence in the foreign-exchange market, cf. Abildgren (2005). A survey of Danmarks Nationalbank's intervention in the foreign-exchange market for Danish kroner in 1999-2004 shows that intervention is a suitable instrument for stabilising the exchange rate in the short term. Based on experience from this period, average purchase or sale of foreign exchange for around kr. 7.5 billion was required to adjust the exchange rate by kr. 0.10 per 100 euro, cf. Andersen (2005). In the same period, capital flows related to portfolio investments have had an impact of the same magnitude on the exchange rate of the krone, cf. Hansen and Storgaard (2005).

TRADING IN THE FOREIGN-EXCHANGE MARKET FOR DANISH KRONER^[9]

Trading in the foreign-exchange market for Danish kroner takes place in several ways, cf. the overview in Form 1. The overview draws a broad distinction between stock-exchange trading and OTC trading outside stock exchanges. In contrast to certain large US stock exchanges, foreign-exchange-market products are not traded on the stock exchange in Denmark. Trading in the foreign-exchange market for Danish kroner solely takes place OTC, either in the interbank or the customer market. The interbank market comprises internal trading among foreign-exchange dealers, while the customer market comprises the foreign-exchange dealers' transactions with customers, i.e. business enterprises, institutional investors, etc.

Part of the interbank trading in the foreign-exchange market for Danish kroner is bilateral. The background may be a need to fully identify the counterparty to a transaction. This facilitates management of settlement and credit risks against each individual counterparty. Other factors include saving brokerage commission or trading costs in connection with centralised electronic trading systems . In view of the modest number of participants in large parts of the foreign-exchange market for Danish kroner, it is also relatively easy for buyers and sellers to make contact, even without a centralised marketplace. Bilateral interbank trading takes place directly by telephone, but also via trade-supporting systems that give direct access to conclude electronic agreements on foreign-exchange transactions between counterparties.

Centralised interbank trading takes place via voice brokers and electronic brokers. In connection with centralised trading it is not possible, or only to some extent possible, to decide who the other party to the transaction should be.

In practice, trading via a voice broker entails that the market participants supply a broker with prices and amounts. On an ongoing basis, the broker states the best bid/ask prices and amounts in the market via a voice system. A market participant can accept a trade by submitting a reply to the broker, who will then establish contact between the parties.

Trading via an electronic broker is a fully automated transaction which merely requires a click on the screen to execute a trade. The transaction takes place at the best price quoted in the system among the banks accepted as potential counterparties.

Bilateral customer trading takes place by telephone, but also via electronic single-dealer platforms. In the latter case, a single bank has a platform where its customers can electronically trade foreign exchange with the bank as the counterparty.

Some customer trading takes place on a centralised basis via electronic multi-dealer trading platforms. In this case, the customer can request bid and ask prices from 2-5 banks simultaneously and can then execute a fully automated transaction by clicking the preferred price.

In April 2004, trading via electronic systems in the Danish interbank market constituted 47 per cent of all spot transactions, cf. Drejer and Hove (2004). This figure covers all foreign-exchange transactions, not only those where one leg is in Danish kroner. No statistical data is available concerning the percentage of the turnover in the foreign-exchange market for Danish kroner that is electronic.

SETTLEMENT OF FOREIGN-EXCHANGE TRANSACTIONS IN DANISH KRONER

As a main rule, settlement of transactions in the foreign-exchange market for Danish kroner takes place two banking days after the trade date.^[10] Settlement in the foreign-exchange market takes place via correspondent banks or via CLS^[11] (Continuous Linked Settlement), an international settlement system for foreign-exchange transactions.

On settlement via a correspondent bank, the foreign exchange traded is normally transferred via a bank in the home country of the currencies in question. For example, krone-euro transactions are settled via banks in Denmark and the euro area. All foreign-exchange dealers have a network of correspondent banks with foreign-exchange accounts in various countries. In practice, the parties independently submit payment instructions to their correspondent banks, requesting them to transfer the amount in question to the counterparty's account with its correspondent bank.

In recent years there has been focus on correspondent bank settlement, which entails certain risks since a party cannot be completely sure that the counterparty submits its payment instruction and executes payment.^[12] In September 2002, CLS was established. In this system, foreign-exchange transactions are settled on a payment-versus-payment basis, whereby it is ensured that both parties to a transaction have effected payment to CLS before the payments are exchanged. At present 15 different currencies are traded via CLS, including Danish kroner, which joined CLS in September 2003. The use of CLS reduces the settlement risk in international foreign-exchange trading.^[13]

In March 2005, the volume of foreign-exchange transactions in Danish kroner via CLS was equivalent to around two thirds of the global turnover of Danish kroner in April 2004, cf. CLS (2005). The high percentage of krone transactions settled via CLS reflects that a large share of the foreign-exchange market for Danish kroner is concentrated on a small number of banks, which are all linked to CLS. Large "market shares" for settlement via CLS are also seen for other small currencies, e.g. New Zealand dollars, while the percentage is somewhat lower for large currencies such as the pound sterling.

LITERATURE

Abildgren, Kim (2005), Sterilised and Non-Sterilised Intervention in the Foreign-Exchange Market, Danmarks Nationalbank, Monetary Review, 1st Quarter.

Andersen, Allan B. (2005), Exchange-Rate Impact of Danmarks Nationalbank's Interventions in the Foreign-Exchange Market, Danmarks Nationalbank, Monetary Review, 1st Quarter.

BIS (2005), Triennial Central Bank Survey. Foreign exchange and derivatives market activity in 2004, Basel.

CLS (2005), CLS Brief, Issue 09, June.

Danmarks Nationalbank (2003a), Monetary Policy in Denmark.

Danmarks Nationalbank (2003b), CLS and Payment System Stability, Financial Stability.

Danmarks Nationalbank (2004a), Financial Management at Danmarks Nationalbank.

Danmarks Nationalbank (2004b), Survey of the Danish foreign-exchange and derivatives market turnover in April 2004, Financial statistics. Special report, 28 September.

Danmarks Nationalbank (2005), Payment Systems in Denmark.

Drejer, Peter Askjær and Vibeke Buur Hove (2004), Turnover in the Foreign-Exchange and Derivatives Markets in April 2004, Danmarks Nationalbank, Monetary Review, 4th Quarter.

Hansen, Jakob Lage and Peter Ejler Storgaard (2005), Capital Flows and the Exchange Rate of the Krone, Danmarks Nationalbank, Monetary Review, 2nd Quarter.

Jensen, Peter Kjær (1999), The Foreign-Exchange Reserve, Danmarks Nationalbank, Monetary Review, 1st Quarter.

Krabbe, Henrik S. and Lisbeth S. Pedersen (1998), The Danish Foreign-Exchange Market, Danmarks Nationalbank, Monetary Review, 1st Quarter.

Sarno, Lucio and Mark P. Taylor (2002), The economics of exchange rates, Cambridge University Press.

Rime, Dagfinn (2003), New Electronic Trading Systems in Foreign Exchange Markets, Chapter 21 of: Jones, Derec C. (ed.) (2003), New Economy Handbook, Academic Press.