is discussed at length in Chapter 9.
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Currency OverlayFX Customer
FX CustomerFX Customer
Bank 1Dealingroom
Bank 2Dealingroom
FX Customer
Bank 3Dealingroom
InterbanknetworkBank 6Dealingroom
Bank 5Dealingroom
FX Customer
FX Customer
Bank 4DealingroomFX Customer
FX Customer
Figure 4.1 FX market structure
4.2.1 Market sizeBecause the market is informal, with no central clearing or exchange, market-wide data hasbeen in short supply. However, in March 1986 four major foreign exchange centres weresurveyed for the ﬁrst time by their central banks under the auspices of the BIS6 in an effort toredress this balance. It was decided to establish a regular triennial survey, and the number offoreign exchange centres surveyed has grown dramatically. In April 1989, 21 countries weresurveyed; in the latest BIS Survey preliminary results, published in 2002 but referring to April2001, 48 countries were surveyed. In summary, the volume of FX dealing in April 2001 was$1.2 trillion per day.The ﬁrst thing to remark about this number is how high the transaction volume is. Contrastdaily London Stock Exchange (c. $10bn) or NYSE (c. $50bn) ﬁgures to see how high. Thesecond thing to note is that although the survey compilers have tried to eliminate straightdouble counting (i.e. buyer and seller both reporting the same transaction), the nature of theforeign exchange market means that customer orders ‘echo’ through the interbank system toﬁnd a counterparty customer. The survey reports that non-ﬁnancial customer deals account foronly 13% of the total turnover, with ﬁnancial sector customers another 28%. We will return tothis point later.While the BIS survey tells us much about the size of the market and the nature of thetransactions, it tells us nothing of the motivation and goals of the participants.6
The Bank for International Settlements in Basle.
Foreign Exchange Market – History and Structure
Box 4.3
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Netting
‘Netting’ is a process established between counterparties in the FX market to reduce the riskfrom FX deals. There are commonly two types of netting: settlement netting and forwardcontract netting.Settlement nettingIn active foreign exchange dealing organisations, there may be multiple deals with givencounterparties that mature on the same day. For example, Bank A may have many outstanding deals to sell dollars (versus a number of currencies) with Counterparty B, andwhich require the delivery in total of, say, $100m. However, they may also have severaloutstanding deals with Counterparty B to buy dollars which imply the receipt, in total, of$200m. Under netting arrangements, these two payments will not be made: instead onepayment of $100m from Counterparty B to Bank A will be made. The same calculation ismade for all currencies, with net payments only being exchanged. This netting is bilateral –multilateral netting is now the province of the CLS Bank (see Box 4.5).Forward contract nettingMany of the maturing obligations of Bank A and Counterparty B on the day in questionabove would have been the result of forward deals conducted many months earlier. Someof these forward deals may have the same currency pairs, and the same amount of onecurrency, but one purchase and one sale. This is typically described as one deal followed bya ‘reversing’ deal. In contract netting, the gross exposure of either party to deliver currenciesto one another is eliminated, and replaced by one contract for the payment of the differenceaccount (i.e. proﬁt and loss). This is also called ‘netting by novation’, implying that theobligation to only deliver the difference is ‘new’ (novation), and not simply the two olddeals put together.The risk that netting is designed to eliminate is theoretical rather than practical – thepossibility that a receiver of an insolvent counterparty ‘cherry picks’ the contracts that arefavourable to the receiver, and reneges on the unfavourable.
4.2.2 Banks – the market-makersAt the market’s core are the banking sector’s foreign exchange dealing rooms. Their key roleis to make prices. For this service, the sector is paid, and the payment comes in the form ofspreads: quoting a lower price for buying than selling. This is the only source of FX earningsfor the bank; as mentioned above, there are no commissions in the wholesale FX market. Whileit is true that an individual bank may not make money on a single customer transaction, thebanking system, taking the generality of deals, will.4.2.3 CustomersCustomers are, by the conventional deﬁnition of foreign exchange dealing rooms, those counterparties who are not expected to make prices, only take them. In layman’s terms, customers
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Currency Overlay
Box 4.4
Market-makers
The currency market is not based in one geographical location or in any legal entity. It iscomposed of a network of market-making banks linked to customers via both the telephonedirect, and also via a range of intermediaries. A common price is established and maintainedby means of continuous price-screen information. This global network deals only in themain traded currencies (see Box 5.7); smaller and controlled currencies fall outside thismarket.The primary market-makers in the currency market are the ‘money centre’ banks whichform the core of the global foreign exchange network. They are market-makers in the sensethat they deploy risk capital to allow them to run unmatched currency positions within theworking day. With this ability, they make ‘two-way’ prices, that is transparent pricing atwhich they will either buy (lower price) or sell (higher price) a currency. These are calledbid/offer spreads (see Box 3.3).Unlike market-makers in many other markets, banks do not have to hold an ‘inventory’of currency, or ‘borrow’ it from existing holders at premium rates. The depth and liquidityof the cash markets and their associated derivatives (forward currency market) mean thatthe mechanics of market-making are symmetrical whether long or short.Market-makers in currency need two-way volume to make consistent proﬁts. Since currencies are zero-sum instruments in the hands of the private sector, there is no net returnto expertise for the market-making other than bid/offer spreads. Competition between themain global money centre banks has forced bid/offer spreads to be the lowest in any market.Within the market-maker banks, speciﬁc individuals are assigned to ‘run the book’ inspeciﬁc currency pairs. While there is an extensive folklore in the scalp-hunting exploitsof these individuals (‘I knew he was coming, so I tipped it a bit left, and when he tookthe bait I stuffed him with half a bar I bought 20 points cheaper’ – a ‘bar’ being marketslang for a billion), the evidence is that the consistently proﬁtable market-makers are thosewith the best distribution (branch networks, wholesale customers, captive customers likeinvestment custody), and that market-making itself is a clearing function which could (andprobably will) be automated.ring bank dealers and ask them to do a deal, not the other way round. Customers are in practicea very varied collection of organisations. They include: ﬁnancial institutions like (smaller)banks and insurance companies; the other divisions of the bank market-makers themselves(i.e. retail banking, credit cards, investment banking, FX option writers); active investmenttrading houses like hedge funds and proprietary traders; industrial and commercial companies(ICCs); oil and commodity dealers and merchants; central banks; and investment managersand currency overlay managers acting for their (mainly) pension fund clients. The reader canprobably think of more categories not explicitly identiﬁed here.‘Trade’, as generally understood by the man in the street, is only conducted by two of thesecounterparty sectors (ICCs and oil and commodity merchants). And the total amount of ‘trade’conducted per year (i.e. world imports and exports) could be accommodated in four or ﬁvedays of foreign exchange trading annually. The remaining sectors are more or less trading oncapital account, and their motives range from outright defensiveness (a pension fund hedging100% of a foreign bond purchase) to outright speculation (a hedge fund taking a forward shortposition in a currency seen as vulnerable).
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The next section analyses customer behaviour in some detail. In summary, a very largeproportion of the players in the FX market are not proﬁt-seeking and/or not price-sensitive.Box 4.5
CLS Bank
The CLS Bank began operation in 2002, after many years in gestation. The idea behindit is to reduce the foreign exchange market’s exposure to daylight settlement risk. In anutshell, all currency transactions, which are bilateral and privately arranged, require thesimultaneous transmission of money by both parties to the other. Because both cannot waituntil the other has paid (because then no money would ever ﬂow!), payments are made withno security that the counterbalancing receipt will arrive on time, or at all. This puts eachparty at risk of the potential default by the other. It is called ‘daylight’ risk, because theamount at risk is the amount paid out during a working day which is not yet settled with apayment in during that day.CLS Bank is a co-operative bank set up by the banking industry to centralise the settlementprocess. In a nutshell, individual CLS settlement members (large commercial/FX bankswho are also shareholders) will pool all their commitments to pay other CLS settlementmembers. These funds will be paid to CLS, who will release them on receipt of the fundsof all the other settlement members. This is known as a Payment-versus-Payment (PVP)system, and the whole CLS ‘system’ is a Continuous Linked Settlement (CLS) system.The system works by linking the real-time gross payments systems of the seven central banks of the currencies to which this system initially applies (US, ECB, UK, Japan,Switzerland, Australia and Canada). It operates on a daily cycle, with a 5-hour commonwindow for settlement, 7am to noon Central European Time. During this period CLS gathers funds from its settlement members (via the central banks), and then subject to receiptof funds, pays out funds to settlement members. All settlement members maintain sufﬁcient liquidity at CLS to cover failed trades and other contingencies. However, the volumeof gross settlements that are made via CLS will be 80–90% smaller than the equivalentsettlements made in the conventional bilateral settlements procedures.This opens up the opportunity for a small group of players with the necessary characteristicsto exploit the constraints of the majority for gain.Since the only medium through which this can happen is the FX price through time, we willtry to discover whether the structural characteristics of the FX market indeed feed through to‘inefﬁcient’ price behaviour.4.2.4 Clearing mechanismIn contrast to ‘customer’ behaviour, which is enormously varied, unpredictable and highlydisaggregated, foreign exchange dealer behaviour – the remaining 59%7 of turnover – mostlyrepresents the ‘clearing’ of deals through the FX market. Let’s give an example. A customerrings a bank and buys $10m vs. yen forward for six months, a typical wholesale customer deal.To avoid running overnight risk, which is risky and regulatorily expensive, the bank will needto unwind its short dollar/long yen position before the end of the day, if possible at a proﬁt. The7
59% is the residual from the 13% + 28% of customer deals in the BIS Survey above.
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Currency Overlay
methods by which it does this are two-fold – it can either hope that a customer or customerswill ring and ask to buy yen/sell dollars on their quoted prices, or it can go to other banks askingfor prices to sell yen/buy dollars. In a multi-dealer system, the likelihood of the right customercoming to that speciﬁc bank at the right time by chance is slim – but in the countless thousands(probably millions) of wholesale deals done each day, there will be customers around theworld taking the positions that our bank desires to square its book. The 59% of interbank dealstherefore represent the ‘clearing system’ for exposure to ‘ﬁnd’ another customer.4.2.5 Turnover excluding ‘clearing’If there were only one global bank (but still the same number of customer deals) there wouldbe no clearing, since it would be done by the global bank’s internal system. Reported foreignexchange volume would therefore fall by over half, although in reality nothing would havechanged. Interbank dealing does not ‘make’ or ‘lose’ money. For the banking sector as awhole, it is, by deﬁnition, a non-proﬁt activity. Conducting foreign deals in a closed loopcannot generate net income inside the loop. Therefore customer deals (41% of turnover, or$485bn per day8 ) pay all the costs of the market.
4.3 CUSTOMER TYPESIn this section I look at the customer participants in the foreign exchange market, their behaviour, and the constraints under which they operate. In attempting to describe the behaviourof hundreds of thousands of different entities (taking all participating organisations together),or hundreds of millions of individuals (taking individual decision-making into account), I aminevitably forced to make broad generalisations which may not in every case be defensible.The reader will have to forgive me for this.4.3.1 Industrial and commercial companies (ICCs)4.3.1.1 Proﬁt-seekingThere are a number of types of market behaviour subsumed within this category. Most obvious is the treasury department given leeway to take positions in forward currency contracts,derivatives, capital instruments or cash. These decisions could be model-driven (technical,fundamental, option replication, hybrid); they could be the result of a ‘currency committee’deciding to extend or reduce coverage of key variables (import/export exposure); they could bea capital event (bond issue, swap, foreign asset purchase) which is explicitly or implicitly chosen to be hedged, partially hedged or unhedged; or they could be the discretionary undertakingof ﬁnancial contracts or derivatives9 which open, close or modify currency exposure.This is a very large category of decision-making processes, but they are all characterisedby a lack of systematic nature, by fundamentally differing perspectives (importer/exporter,dollar-based/euro-based/yen-based/sterling-based), and almost universally by a lack of clearbenchmark against which to measure success. They are also carried out by employees of ICCs8
See BIS Press Release, 9 October 2001, Table 2.Some of these can be surprising. Some years ago I was an expert witness in a case of ‘mis-selling’ of an unusual derivative to aEuropean food processor. The client thought that it was a $50m deposit contract. In fact, the contract was the sale by the client of acurrency option with a principal value of more than $1.6bn. The loss in dispute was over $100m.9
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71
with no general access to close or inside information on the FX market, and with less analyticalresources than professionals in ﬁnancial organisations.4.3.1.2 Non-proﬁt-seekingIn contrast to the above behaviour, which is proﬁt-seeking, much of the day-to-day transactionsof ICCs are simply automatic responses to contracts, deliveries, invoices or other underlyingbusiness events. A typical example of this category is where (say) an importer takes delivery ofsome goods from a foreign supplier, and is presented with an invoice for payment of a foreigncurrency amount due on a particular day. Just prior to the payment date, the importer ringshis bank, and undertakes a spot FX deal to buy the required amount of foreign currency. Theimporter is almost completely impervious to movements in the spot rate or the rate achieved;he has to do the deal, so he does.The behaviour can apply to forward rates just as much as to spot rates. On placing a ﬁrm,ﬁxed price order for (say) a consignment of oil, the customer may execute a forward contractto ‘lock’ in the cost in his home currency. The customer will have no leeway over whether ornot to execute the deal, it will be done if the overall package of the foreign currency and thespot rate at the time is acceptable.4.3.2 Oil and commodity dealers and merchantsThis sector is very active in the FX market because of the nature of their business. Even quitemodest merchants can conduct very large and frequent FX deals, as each supplier and customercontract is risk-matched in every aspect. The vast bulk of this volume is not proﬁt-seeking;the answer from a merchant as to why he bought $100m for sterling this morning will almostalways be ‘because I was simultaneously selling a crude contract to a UK customer priced insterling and covering it on the Rotterdam market’, or similar. It will not be because he thinksthe dollar will on balance go up.There will be smaller net amounts of proﬁt-seeking behaviour, say from the well capitalisedmerchants, and this can be categorised in exactly the same way as the equivalent behaviourfrom the ICC sector.4.3.3 Financial institutions (banks and insurance companies)These two entities are rather different: banks will usually be acting as intermediaries for an underlying customer order or request, and in effect are part of the clearing network. They will earna fee by charging their customers a wider bid/offer spread than they are charged by the FX market. They are put in the ‘customer’ rather than the ‘market-maker’ category because generallythey take the prices that are given to them by the FX market, and pass them on to their customerswithout taking price risk on their own account. To the extent that they make ﬁxed prices totheir customers prior to covering their risk, they slide over into the market-maker category.Insurance companies are very different. On the one hand, non-life insurance companieshave a plethora of cross-border transactions arising from premium, underwriting and claimpayments. In this they will behave like ICCs. On the other hand, life companies are pools ofcapital, and will generally behave in a similar way to investment managers (see below), subjectto the following exceptions.Many insurance companies have ﬁxed liabilities (say annuities), and little room for manoeuvre in their asset allocation, which will be largely domestic ﬁxed income. The pool of unitised
72
Currency Overlay
or ‘with proﬁt’ (UK only) assets which tend to attract an equity allocation also tend to belargely domestic to the country concerned. Where either insurance companies or banks act asgatherers of deﬁned contribution funds (personal and stakeholder pensions in the UK; 401(k)in the US), the extent to which the managers of these funds can take currency positions forproﬁt will be largely determined by their prospectuses. A brief survey of these reveals almostnone that offer fully currency-hedged products, or claim to be able to add value by taking betsin currency. FX market evidence also shows that this sector generates relatively small volume.4.3.4 FX option writersThis is a little understood, but quite important, category. There is now a well-developed FXoption market, and the technology and software exists for uncovered option writers to hedgetheir resultant currency exposure in the cash (spot and forward) markets. This technology isnow pretty standard, and it requires option writers to vary the proportion of their forward coverin a process called delta hedging. Any regulated bank that holds a balance of uncovered ‘delta’will be active in this category, not least because their regulator will demand it.It is very difﬁcult to categorise this behaviour into either the non-proﬁt-seeking or proﬁtseeking pot. It is proﬁt-seeking in that the bank involved will seek to make a proﬁt out ofthe totality of the options book (i.e. premiums charged) and the related hedge. However, theimmediate behaviour in the market is largely mechanistic. This sector increases its delta as acurrency strengthens and reduces it when a currency weakens; this means buying currenciesas they go up, or having what an economist would describe as an ‘upward sloping’ or perverse,demand curve. Such a demand curve is destabilising to markets in the short-term.At particular times, delta hedgers can become quite dominant in the market. That was true in1985, when high currency volatility and a period of rapid growth and new technology in the FXoption market meant that they generated large and destabilising FX volumes. This effect wasself-correcting as the high option premiums, and losses incurred by the delta hedgers, quicklyremoved both option demand and option writing capacity from the market. Exactly the samephenomenon was seen again in 1992 in the successful speculative attack on sterling. It is likelythat the sum of the net sales of sterling by delta hedgers in the run-up to the ERM exit was muchgreater than the legendary $10bn bet by George Soros (see below). Ironically, however, optionwriters over this period would have lost signiﬁcant amounts of money (despite the fact thattheir hedges made money), as they would have sold options at low ‘implied volatilities’,10 andhedged them in the very volatile subsequent market behaviour. This is borne out by statementsmade by the major FX option-writing banks in the aftermath. There was also a similar periodin October 1998 in the yen exchange rate crisis (see below).4.3.5 Investment pool traders in FX (hedge funds, proprietary traders)This category is the only category whose involvement in the FX market is almost whollyproﬁt-seeking. The typical customer description is of a hedge fund. Such a fund may have anabsolute return target, with very wide discretion as to the instruments and markets that the fundcan invest in.10An ‘implied volatility’ is the standard deviation of annualised changes in the underlying FX market that is implied by the Black–Scholes (or similar) option pricing formula from the option premium traded in the option market. This rather complicated concept isvery important in all option markets. Indeed, many option traders will claim that they ‘trade implied volatilities’.
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These players’ entry into (and exit from) the FX market has developed into a pattern overthe years, and two distinct styles can be distinguished. One is the attack on artiﬁcial pricesmaintained by central banks or their governments. These attacks can only take place when arate is being defended, and also only tend to take place in a herd manner at particular times ofstress. The most famous attack was by George Soros on the UK pound in September 1992. Thiswas successful, and by repute Mr Soros’s Quantum hedge fund made £1bn out of the trade.The success of the attack was predicated on two key elements: weak political will and a largeherd attack. It is likely that the weight of ‘speculative’ attack was an order of magnitude largerthan the $10bn principal value that Soros reputedly put at risk. Much of this will have beenessentially defensive in nature (see Sections 4.3.4 and 4.3.6). It is worth noting that speculativeattacks are not always successful. A sustained and large attack on HK$/US$ parity at 7.80 wasmounted in 1998, and the Hong Kong government, clearly demonstrating the will to defendthis level, mounted a successful campaign of interest rate rises together with some physicalintervention to maintain the parity level. The cost to the unsuccessful attackers (which includeda signiﬁcant number of hedge funds) was high – a US/HK adverse 1m interest rate differentialwhich rose to 11% p.a., paid by the attackers.The other style is the ‘macro’ style, which does not require defensive levels to attack. Hedgefunds also tend to hunt in packs in this approach, but they usually have an ‘obvious’ playwhich becomes popular. The most notorious of these was the so-called ‘carry’ trade of 1998against the yen. In the popular language of the time, speculators were being ‘paid’ to ‘short’ theyen, since borrowing yen short-term cost about 0.5% p.a., and lending US dollars paid about5.5%. This thinking, combined with a long period of yen weakness which had started in 1995following a period of yen strength, led hedge funds to believe that there was a free lunch. Forseveral months in 1998 there was. Then in October 1998, a rally in the yen prompted the hedgefund sector to reduce their short positions. The scale of these was such that it created a sharpupward price movement of the yen, which prompted more buying to cover remaining shortyen positions. The outcome was an exceptionally large movement in the yen/$ exchange rate(around 11% depending on the time reference of consecutive days), the largest one/two-daymovement seen in any of the major traded currency rates in 30 years. This experience (whichwas very painful for the hedge funds, and which invalidated many of their risk models) largelyremoved the macro hedge funds from the FX markets, and there is little evidence of their returnat the time of writing (2003).4.3.6 Investment managers and currency overlay managersThis group is roughly homogeneous in structure, in that they manage on a more or less discretionary basis the assets (and in this context cross-border assets) of the world’s funded pensionschemes. These are principally schemes located in the US, UK, Switzerland, Netherlands andJapan. From national estimates,11 these pension systems account for about 95% of the roughly$8.6 trillion of global funded DB pension assets. From the same estimates, about $1.2 trillionof assets is held cross-border. This creates a pool of $1.2 trillion in the hands of this groupof investment managers and currency overlay managers which can be moved across the exchanges, or hedged using forward contracts, either for proﬁt or as a result of non-currency-ledpolicy decisions.11Source: Watson Wyatt and OECD, Sep 00 (updated to Dec 02 with market valuation changes). Note that Germany and Francehave very small funded pension sectors.
74
Currency Overlay
The behaviour of this group in the FX markets is better documented than most of the customer groups in the FX market. Most cross-border (or ‘international’) ﬁxed income mandatesare established with a fully hedged benchmark. This means that no economic exposure generally ﬂows across currencies – when foreign bonds are purchased, the currency exposure issimultaneously sold forward. This sector (which is small compared to internationally heldequities) is therefore characterised by small and selective proﬁt-seeking bets, often more orless loosely based on the ‘forward rate bias’ theory,12 or on opportunistic ‘plays’.In international equity mandates, our research indicates that between $80bn and $130bnof international equities have fully or partially hedged benchmarks or have active currencymandates associated with them. Of this total, probably around $80bn have active currencymanagement mandates. Active currency mandates will generate variable hedge ratios (generally but not universally between 0% and 100%), and these variations will be entirely proﬁtseeking.Currency overlay managers, as distinct from investment managers, generally have moresystematic or model-driven approaches. Investment managers (whose principal responsibilityis to manage the underlying assets) tend to undertake more opportunistic ‘bets’ on currency.Many (but not all) currency overlay managers, but few investment managers, exploit a wellknown inefﬁciency in the currency market – that of ‘trends’. Without going into details, thisexploitation tends to make the currency overlay sector as a whole a perverse trader just likeoption hedgers – they buy when currencies are going up and sell when currencies are goingdown. While this behaviour is destabilising, the effect on the market (if any) clearly dependson the relative scale involved. Other management styles tend to be more heterogeneous (andtherefore harder to summarise), although the forward rate bias, technical indicators13 andfundamental forecasting all play a part.4.3.7 Central banksCentral banks have a strategic position in the currency markets, and over the years have had asigniﬁcant effect on it. Their principal role is that of executor of government foreign exchangepolicy. Over time their policy environment changes, and therefore their behaviour changesalong with it. Their behaviour can be categorised into three types.(1) Declared target exchange rate defence. This is the Hong Kong model, and the ERM priorto 1992/3. In this behaviour, the central bank has an absolute requirement to ensure that the spotexchange rate trades within more or less narrow bands. In earlier environments (say BrettonWoods 1948–71), this effort scarcely involved domestic interest rates, direct use of foreignexchange reserves was enough. However, with the scale of private capital stock and ﬂowshugely outgunning the relatively modest ofﬁcial foreign exchange reserves, exchange-ratedefending central banks, particularly the successful ones, have marshalled domestic interestrates to the defensive armoury. This involves using domestic-monetary-policy muscle to raisedomestic interest rates when the currency is under external attack. The downside of this policy12The forward rate bias theory stipulates that the average mean appreciation of the low interest currency in a currency pair is lessthan the full interest rate differential. It obviously applies vice versa to high interest rate currencies.13Technical trading is a long-established approach designed to capture movements generated by ‘market dynamics’ (often therelative behaviour of differing horizon moving averages). I place Chartism (where the shape of time series price charts is seen to beimportant) as a subsection of technical trading. Like all active approaches, there is an underlying assumption that markets are notrandom-walk.
Foreign Exchange Market – History and Structure
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is that unless Euro-interest rates14 are separated from domestic rates by exchange controls (asthey were in France in 198215 ), then the domestic economy is put through the mill for the sakeof the defence of an arbitrary external exchange rate.(2) Tactical intervention. Many OECD countries, while not maintaining a ﬁxed exchangerate policy, have not abandoned their ability to intervene in their own and others’ exchangerates to further economic or political policy. The timing, size and stated reason for interventionsof this type are very widely varied, from a smoothing operation to calm the market (perhaps inthe wake of an external shock), to an organised and concerted attempt to move the equilibriummarket exchange rate or trend. Examples of this are numerous in the recent history of the yen,and also in the failed attempt by the ECB to stem the fall of the euro in autumn 1999 throughthe psychologically important level of 1.00 dollar/euro.(3) Rejection of FX intervention. The UK has largely pursued this policy in the last 10 years,as has the US. Both governments regard the external value of the exchange rate as a matter forthe markets.The overriding common characteristic of the behaviour of central banks, whatever theirpolicy framework, is that they are not proﬁt-seeking. Generally, although not universally, theyare designed to act in a ‘smoothing’ capacity, and tend to buy weaker currencies and sellstronger currencies.All of the above is designed to demonstrate that the structure and participants in the FXmarket are very different from other markets, are unique to this market, and mean that proﬁtseeking behaviour is a relatively small proportion of the overall volumes in the market.
4.4 PHYSICAL AND REGULATORY ISSUESAs mentioned above, the foreign exchange market is physically highly disaggregated. Unlikemany regulated markets (stock and futures markets, for example), there is no ‘place’ that itcan be said that the foreign exchange market resides. This disaggregation has led to a numberof notable effects unique to the foreign exchange market.4.4.1 Exchange controlsThe foreign exchange market is not one market in the physical sense, nor is it one market in theconceptual sense. In the physical sense its networked multi-centre basis means that differentcentres, which operate under different political and legal frameworks, are treated differently bytheir governments. In the conceptual sense, there is one global market, and many local markets,which are largely or totally disconnected from the global market. Currency overlay inhabits theformer almost exclusively, but an understanding of the latter is useful for a complete pictureof the foreign exchange world.The key to understanding those foreign exchange markets outside the global market isunderstanding what governments do, and why.14