Foreign Exchange Markets

Structure
THE FOREIGN exchange market is, by most accounts, the oldest, largest, and
most extensive inancial market in the !orld" #nlike the utures exchange, !hich
brings buyers and sellers together in a central location, the forex market is not
centrally located" It is an over$the$counter market !here buyers and sellers
conduct business linked by tele%hones, com%uters, ax machines, and other
means o instant communications" &mong its %artici%ants are large cor%orations,
commercial banks, money centers, %ension unds and investment banking irms"
Foreign exchange involves trading one nation's currency or the currency o
another nation" &s individuals or com%anies rom one country trade across
borders, the need or oreign currency arises" For exam%le, !hen a (akistan
im%orter buys )alaysian (alm Oil, either the im%orter needs Ringgits to %ay the
)alaysian merchant or the )alaysian merchant must acce%t (ak Ru%ees and
convert them to Ringgits" & trading dierential develo%s and this is ho! %roits
are generated in the forex markets" This is ho! %roits are generated in the
forex markets"
In its most recent triennial survey o oreign exchange markets, the *ank or
International +ettlements ,*I+- estimated that average daily turnover in the
global oreign exchange market !as ./,/01 billion in &%ril /002" In com%arison,
average daily turnover during the same %eriod in the next largest inancial
market$$#+ government securities$$!as ./32 billion ,excluding re%urchase and
reverse re%urchase agreements-4 in the !orld's ten largest stock markets
together, it !as a mere .56 billion"
(layers in the )arket
Generally there are our levels o transactors or %artici%ants in a oreign exchange
market" The irst or the lo!est level com%rises o tourists, im%orters, ex%orters,
investors and the like !ho are the immediate user and su%%liers o oreign
currencies" The next or second level consists o commercial banks !hich act as
clearing houses bet!een users and earners o oreign exchange" The oreign
exchange brokers, through !hom the commercial banks even out their oreign
exchange inlo!s and" outlo!s among themselves are at the third level" The
ourth and the highest level is the one o central bank o a country, !hich acts as
the lender or buyer o last resort !hen the total oreign exchange earnings and
ex%enditures o the country are une7ual" The central bank then either dra!s
do!n its oreign exchange reserve or adds to them"
1. The State Bank of Pakistan:
+tate *ank o (akistan ,+*(- !hich is the 8entral *ank o the country has
been entrusted !ith the res%onsibility or an ongoing eective su%ervision o
the inancial sector" The relevant %rovisions o la! !hich vest %o!ers in +tate
*ank o (akistan ,+*(- to carry out ins%ection o banks are contained in the
*anking 8om%anies Ordinance, /096" *esides, +tate *ank o (akistan &ct,
/029 and the *ank:s Nationali;ation &ct, /035, The *anking 8om%anies
,Recovery o <oans, &dvances, 8redits = Finances- &ct, /003 ,&ct No" >? o
/003-, 8om%anies Ordinance, /0@5 and +tatutory Regulatory Orders ,+ROs-
are the relevant legislations !hich cover the activities concerning the inancial
sector"
The inancial sector in (akistan com%rises o commercial banks, non$banking
inancial institutions ,N*FIs-, leasing com%anies, modarabas, mutual unds,
stock exchange and insurance com%anies" #nder the %revalent legislative
structure the su%ervisory res%onsibilities in case o banks and non$banking
inancial institutions alls !ithin legal ambit o +tate *ank o (akistan !hile
the rest o the inancial institutions are monitored by other authorities such as
+ecurities and Exchange 8ommission and 8ontroller o Insurance"
#nder the ATO commitments the o%erational status o branch net!ork o
oreign banks o%erating in (akistan as on /6$/6$/003 has been %rotected and
ro;en" Ho!ever, existing oreign banks having less than B branches can have
branches to the extent o maximum number o B only" Ne! oreign banks
desirous o entering banking business in (akistan !ill no! be re7uired to
incor%orate as domestic bank under the local la!s"
E7uity %artici%ation o oreigners can be u%to 50C in the total minimum
ca%ital o #+ . //"2 million, subDect to the %rinci%le o reci%rocity" The
branches o oreign banks o%erating in (akistan can also be converted into a
local commercial bank by incor%orating under the local la!s and subDect to a
minimum %aid u% ca%ital o Rs" 211 million %rovided oreign share holding is
restricted to a maximum o 50C"
O(ENING OF FOREIGN 8#RREN8E &88O#NT+ AITH *&NF+ IN
(&FI+T&N #NGER NEA +8HE)E
#nder the existing instructions, the &uthori;ed Gealers ,*anks authori;ed
to deal in oreign exchange- !ithout the %rior a%%roval o the +tate *ank,
o%en oreign currency accounts in (akistan o (akistan national resident
in o outside (akistan including those having dual nationality" These
accounts can also be o%ened in the Doint names o residents and non$
residents, Residents Firms and resident com%anies including investment
banks and the com%anies incor%orated in (akistan !ith oreign share
holding are also eligible to o%en and maintain oreign currency accounts"
8haritable Trusts, Foundations ctc" !hich are exem%t rom %ayment o
income tax can also o%en oreign currency accounts in (akistan" This
acility is also available to all oreign nationals residing abroad, all oreign
irmsHcor%orations other than banks incor%orated and o%erating abroad
%rovided these are o!ned by %ersons !ho are other!ise eligible to o%en
oreign currency accounts" Foreign nationals residing in (akistan and
oreign irms and com%anies registered abroad and o%erating in (akistan
can also o%en and maintain oreign currency accounts !ith the &uthorised
Gealers %rovided the oreign exchange credited to such accounts does not
re%resent their earnings abroad in res%ect o business conducted in
(akistan or services rendered by such oreign national and
irmsHcom%anies !hile in (akistan" These accounts can be ed by
remittances received rom abroad as !ell as cash de%osits locally"
The &uthorised Gealers are ree to decide the rate o return on these
accounts %ayable to the de%ositors" They are also ree to recover
reasonable bank charges on handling cash transactions in oreign
currencies received into or %aid out o such accounts"
The non$residents are exem%ted rom %ayment o !ithholding tax and
com%ulsory deduction o Iakat" Aithdra!als rom these accounts in the
sha%e o cash currency notes is allo!ed and account holder is at liberty to
make remittances rom his account to the extent o his balance in his
account"
&88O#NT+ OF GI(<O)&TI8 )I++ION+ &NG INTERN&TION&<
ORG&NI+&TION+ ET8"
The Gi%lomatic )issions: sta in (akistan, their Gi%lomatic Oicers and
home based members o the )issions: sta in (akistan, as also all
international organi;ations in (akistan and their ex%atriate em%loyees are
allo!ed to o%en s%ecial oreign currency accounts outside the sco%e o
Foreign 8urrency &ccounts +cheme or the %ur%ose o receiving unds
rom abroad"
The di%lomatic oicers and home based members o the mission:s sta in
(akistan and the ex%atriate em%loyees o International Organi;ations can
!ithdra! in the sha%e o oreign currency notes rom their oreign
currency accounts !ithout any restrictions" Ho!ever, !ithdra!al in the
sha%e o cash is not allo!ed rom the oicial accounts o di%lomatic
missions and International Organi;ations"
E>8H&NGE R&TE )&N&GE)ENT
&NG *&<&N8E OF (&E)ENT+
One o the maDor res%onsibilities o the +tate *ank is the maintenance o
external value o the currency" In this regard, the *ank is re7uired, among
other measures taken by it, to regulate oreign exchange reserves o the
country in line !ith the sti%ulations o the Foreign Exchange &ct /053" &s
an agent to the Government, the *ank has been authorised to %urchase
and sale gold, silver or a%%roved oreign exchange and transactions o
+%ecial Gra!ing Rights !ith the International )onetary Fund under sub$
sections /B,a- and /B,- o +ection /3 o the +tate *ank o (akistan &ct,
/029"
The *ank is res%onsible to kee% the exchange rate o the ru%ee at an
a%%ro%riate level and %revent it rom !ide luctuations in order to
maintain com%etitiveness o our ex%orts and maintain stability in the
oreign exchange market" To achieve the obDective, various exchange
%olicies have been ado%ted rom time to time kee%ing in vie! the
%revailing circumstances" (ak$ru%ee remained linked to (ound +terling till
+e%tember, /03/ and subse7uently to #"+" Gollar" Ho!ever, it !as decided
to ado%t the managed loating exchange rate system !"e"" January @, /0@6
under !hich the value o the ru%ee !as determined on daily basis, !ith
reerence to a basket o currencies o (akistan:s maDor trading %artners
and com%etitors" &dDustments !ere made in its value as and !hen the
circumstances so !arranted" Guring the course o time, an im%ortant
develo%ment took %lace !hen (akistan acce%ted obligations o &rticle$
?III, +ection 6, B and 5 o the I)F &rticles o &greement, thereby making
the (ak$ru%ee convertible or current international transactions !ith eect
rom July /, /005"
&ter nuclear detonation by (akistan in /00@, a t!o$tier exchange rate
system !as introduced !"e"" 66nd July /00@, !ith a vie! to reduce the
%ressure on oicial reserves and %revent the economy to some extent rom
adverse im%lications o sanctions im%osed on (akistan" Ho!ever, eective
/0th )ay /000, the exchange rate has been uniied, !ith the introduction
o market$based loating exchange rate system, under !hich the exchange
rate is determined by the demand and su%%ly %ositions in the oreign
exchange market" The surrender re7uirement o oreign exchange recei%ts
on account o ex%orts and services, %reviously re7uired to be made to +tate
*ank through authori;ed dealers, has no! been done a!ay !ith and the
commercial banks and other authorised dealers have been made ree to
hold and undertake transaction in oreign currencies"
&s the custodian o country:s external reserves, the +tate *ank is also
res%onsible or the management o the oreign exchange reserves" The task
is being %erormed by an Investment 8ommittee !hich, ater taking into
consideration the overall level o reserves, maturities and %ayment
obligations, takes decision to make investment o sur%lus unds in such a
manner that ensures li7uidity o unds as !ell as maximises the earnings"
These reserves are also being used or intervention in the oreign exchange
market" For this %ur%ose, a Foreign Exchange Gealing Room has been set
u% at the 8entral Girectorate o +tate *ank o (akistan and services o a
KForex Ex%ert: have been ac7uired"
Instruments o )onetary (olicy
*eore the inancial sector reorms, monetary %olicy !as conducted
through administrative controls and 7uantitative restrictions on money
and credit aggregates" &ter the introduction o inancial sector reorms in
the beginning o/001s, a number o undamental changes !ere made in
the conduct o monetary and credit management, !hich essentially
marked a de%arture rom administrative controls and 7uantitative credit
restrictions to market$based monetary and credit management" The
system o bank$s%eciic credit ceilings as an instrument o money and
credit control !as gradually abolished in +e%tember, /002"
*uilding on the introduction o an auction system or government
securities, +*( no! manages domestic li7uidity, to a large extent, by
intervening in the secondary market through O%en )arket O%erations
,O)Os-" O)Os involve %urchase or sale o government securities by the
+*( in order to su%%ly or absorb bank reserves" +tate *ank conducts O)O
in the intervening %eriod bet!een %ublic debt auctions" It buys and sells
Government securities both outright and under re%urchase agreements"
INTROG#8TION TO (&FI+T&N:+ *&<&N8E OF (&E)ENT+
The credit entry or merchandise in (akistan:s *alance o (ayments is
based mainly on %roceeds o ex%orts recorded by the Foreign Exchange
Ge%artment" The money value against shi%ments o goods abroad is
either realised in oreign exchange or in non$resident ru%ees" *oth orms
o settlement tend to im%rove the country:s international %ositionL the
ormer by increasing its reserves and the latter by decreasing its liabilities
to oreigners"
The banks ,i"e", the authori;ed dealers in oreign exchange- re%ort each
transaction in the currency o settlement" For %ur%oses o aggregation, the
amounts received in oreign currencies have been converted to (akistan
Ru%ees at the rates %revailing during the res%ective %eriods"
8onse7uent u%on delinking o (akistan Ru%ee rom #"+"Gollar !"e"" @th
February, /0@6 transactions have been converted at mid%oint o buying
and selling rates"
The timing o transactions is related to the transer o o!nershi% o money
and not the movement o goods across (akistan:s international border"
For exam%le, i a oreign buyer makes an advance %ayment or %urchase o
cotton ahead o the normal ex%ort season, the Foreign Exchange
Ge%artment !ill record it a recei%t rom ex%orts as soon as a bank account
is credited although the actual shi%ment or shi%ments may take %lace a
e! months later" +imilarly, i (akistan enters into a deerred %ayments
agreement !ith a oreign country, the shi%ment o goods !ill %recede the
recei%t o their money value" Here again, the sale %roceeds !ill be
recorded at the time !hen the money is received" *et!een these t!o
extremes, the maDority o transactions is inanced by usance bills o 01$/61
days maturity and accordingly the ex%ort %roceeds lag behind the %hysical
movement o commodities" This also holds good or merchandise sold on
consignment basis"
For %ur%oses o exchange record, the valuation de%ends on the terms o
contract" )ost o the deals are on "o"b" basis but in some cases goods are
shi%%ed on c" = " contracts" The recorded %roceeds are, thereore, on a
mixed basis" The balance o %ayments entry is arrived at a uniorm "o"b"
valuation by deducting the element o reight and adDustment o coverage
and timing rom the total recorded igures o ex%orts" This so%histication
is, ho!ever, not %ossible or individual commodities and as such the
igures %resented here are on a mixed basis"
#%to June, /092 the *ank com%iled and released igures o ex%ort
%roceeds or eight commodities vi;"4 8otton, 8otton )anuactures, Jute,
Jute )anuactures, Hides and +kins, Tea, Aool and )iscellaneous"
In July, /092, the list !as elaborated to include @9 commodities" From
July, /093, t!elve more commodities !ere added to the list !hich !as
urther enlarged to cover /5/ commodities rom July, /031"
From July, /036, three digit commodity codes based on the (akistan
+tandard Trade 8lassiication ,(+T8- !ere introduced and the %revious
grou% classiication, i"e" %rimary %roducts, semi$manuactured
commodities and manuactured goods !as re%laced by the ten sections o
(+T8 as underL$
/" Foods = <ive &nimals
6" *everages = Tobacco
B" 8rude )aterials
5" )ineral Fuels
2" Oils = Fats
9" 8hemicals
3" )anuactured Goods
@" )achinery
0" )isc" )anuactures
10. Misc. Commodities
2. Commercial Banks
8ommercial banks in (akistan have been authori;ed to engage in one or
the ollo!ing !hich may includeL
The borro!ing, raising, or taking u% o money4 the lending or advancing o
money either u%on or !ithout security4 the drawing, making, accepting,
discounting, buying, selling, collecting and dealing in bills of exchange,
hundis, promissory notes, coupons, drafts, debenture certificates, scrips
and other instruments, and securities whether transferable or negotiable
or not; the granting and issuing of letters of credit; travelers cheques
and circular notes; the buying, selling and dealing in bullion and scrips;
the buying and selling of foreign exchange including foreign bank notes;
the acquiring, holding, issuing on commission, underwriting and dealing
in stock, funds, shares, debentures, debenture-stocks, bonds, obligations,
securities and investment of all kinds; the purchasing and selling of
bonds, scrips bills of lading, railway receipts, warrants, debentures, cer-
tificates, receipts (participation term certificates, term finance
certificates, musharika certificates, modarabah certificates and such
other instruments as may be approved by the State ank or other forms
of securities on behalf of constituents or others; the negotiating of loans
and advances; the receiving of all kinds of bonds scrips or valuables on
deposits or for safe custody or otherwise; the providing of safe deposit
vaults; the collecting and transmitting of money and securities;
The State of the Market
&lthough %artici%ants in the oreign exchange market are increasingly scattered
around the globe, most transactions still take %lace in <ondon, Ne! Eork, and
Tokyo" <ondon dominates the oreign exchange markets, !ith B1 %ercent o all
transactions4 Ne! Eork's share is /9 %ercent" Tokyo's share, no! /1 %ercent, has
been !hittled a!ay by the markets o +inga%ore and Hong Fong, !hich are ast
gaining %rominence" +inga%ore has become the !orld's ourth largest oreign
exchange market, and Hong Fong has overtaken +!it;erland to become the ith
largest" Even though 29 %ercent o the !orld's oreign exchange transactions are
executed in the three largest inancial centers, bet!een one$hal and three$
ourths o daily turnover is cross$border during the centers' business hours,
suggesting that one side o many transactions occurs outside o their business
hours"
)arket concentration
Nearly t!o$thirds o daily oreign exchange transactions take %lace bet!een bank
dealers" &bout /9 %ercent o transactions involve noninancial customers, an
increasingly diverse grou%" Originally, this grou% consisted %rimarily o
customers executing transactions related to trade4 it no! includes international
investors, s%eculators, and other ne! %layers" The remaining 61 %ercent o
transactions involve inancial institutions other than bank dealers, mostly
securities irms active in the international debt and e7uity markets that have
entered the oreign exchange market as intermediaries, %roviding one$sto%
sho%%ing or their customers"
Ges%ite the gro!ing diversity o customers, market concentration has increased
since /006, as the %ro%ortion o trading carried out by the to% banks continues to
rise" This trend is most evident in the smaller markets, !hich are being
abandoned by oreign banks seeking to consolidate their business in the maDor
centers, but it is also being seen in the maDor centers" *et!een /006 and /002, the
market share o the to% ten dealers in Tokyo rose rom 55 %ercent to 2/ %ercent,
in Ne! Eork rom 5/ %ercent to 53 %ercent, and in <ondon rom 5B %ercent to 55
%ercent" The to% 61 banks accounted or 31 %ercent o daily oreign exchange
transactions in Ne! Eork in /002, u% rom 91 %ercent in /006, and 9@ %ercent in
<ondon, u% rom 9B %ercent in /006" The %icture o the oreign exchange market
that emerges rom the /002 survey resembles the light ma% o a gro!ing airline,
in !hich the hubs are getting bigger and the s%okes more numerous$$and market
%artici%ants are increasingly interconnected"
<i7uidity
The oreign exchange market is highly li7uid$$transactions tend to be large and
are executed re7uently" & ty%ical dealing institution !rites bet!een B,111 and
5,111 trading tickets or oreign exchange transactions during an average 65$
hour day, and about 21 %ercent more than that on a busy day" Muoted %rices can
change 61 times a minute or maDor currencies, !ith the dollar$deutsche mark
rate changing u% to /@,111 times during a single day" Guring %eriods o extreme
stress, a single dealer may execute a trade every t!o to our minutes" +ingle
transactions !orth bet!een .611 million and .211 million are not uncommon in
the oreign exchange market and, at most times, do not aect %rices"
Ahile oten overshado!ed by the s%ot market, there is a gro!ing and vibrant
derivatives market based on oreign exchange" Over$the$counter ,OT8- derivative
contracts involving oreign exchange accounted or B3 %ercent o the estimated
.53"2 trillion in outstanding notional %rinci%al o derivatives contracts at the end
o )arch /002, as re%orted by the irst *I+ survey o derivatives" +ince notional
%rinci%al %rovides inormation only about the outstanding ace value o the
contracts being held and not about their economic value, the *I+ estimates their
gross market value as !ell" Foreign exchange contracts account or 95 %ercent o
the gross market value o .6"6 trillion, !hich itsel re%resents roughly 2 %ercent
o re%orted notional %rinci%al"
O total OT8 derivative contracts, 9 %ercent !ere oreign exchange o%tions
contracts" Ahile this is still a relatively small %ercentage, there is keen interest in
oreign exchange o%tions %roducts" The hedging strategies o many NexoticN and
N%lain vanillaN o%tions re7uire the continuous buying and selling o the
underlying currencies to maintain risk$ree hedges" Thus, they are oten !ritten
on the most li7uid oreign currencies, increasing the volumes traded in the s%ot
market"
Systemic Risks
FREE-FLOATING EXCHANGE RATES CREATE RISK:
Ahile all the above exam%les illustrate ho! currency exchange$rates can loat in
the forex market, ree$loating currency exchange$rates create risk" For
exam%le, !hen an &merican !ine merchant contracts to buy /,111 cases o
French !ine, the merchant may agree to %ay in French rancs, say 911 rancs %er
case, !hen the vintage is ready or shi%ment in t!o years" Ho!ever, over the
next t!o years, the value o the #"+" dollar could dro% rom 61 centsHranc to 51
centsHranc, raising the %rice o each case rom ./61 #"+" dollars to .651 #"+"
dollars" Thus, %ricing the !ine in rancs ex%oses the &merican !ine merchant to
a currency exchange$rate risk"
O course, i the !ine !as %riced in dollars ,./61 %er case- it !ould relieve the
&merican merchant rom the currency exchange$rate risk" *ut no! the French
!ine %roducer !ould suer, as the value o the dollar ell rom 61centsHranc to
51centsHranc" In this exam%le the French merchant !ould only receive hal as
much %er case ,i"e", B11rncs-"
*ecause o these risks, governments throughout history have intervened to ix
currency exchange$rates" In /055, or exam%le, !estern !orld leaders met in
*retton Aoods, Ne! Ham%shire, to create the International Monetary Fund
to co%e !ith !orld economic and inancial %roblems that occurred ollo!ing the
Great Ge%ression and Aorld Aar II" &s %art o the agreement, the value o the
#"+" dollar, the !orld's leading currency at the time, !as set at /HB2 o an ounce
o gold" &nd, !orld central banks !ere asked to kee% the exchange$rates o their
currencies %egged to the dollar's gold content, !ith variations limited to %lus or
minus /C"
+ince /055, there have been several instances !hen !orld leaders have met to
adDust the ixed currency exchange$rate4 but these rates have been abandoned
over the years, and volatility in the market continues" Firms ex%osed to currency$
exchange risk have turned to the forex market and currency utures markets to
manage these risks" In the forex market, transactions are customi;ed"
Firms ex%osed to currency$exchange risk have turned to the forex market and
currency utures markets to manage these risks" In the forex market,
transactions are customi;ed !here the rate o exchange and other terms are
agreed u%on by both %arties" (artici%ation in the forex market is generally
limited to very large customers"
It is %recisely or this reason that !e devote the energy re7uired to do the
home!ork to ensure that !e have an advantage over individuals or concerns !ho
count on luck or success" &s successul technicians !e are not Dust analy;ing and
orecasting the direction o currency exchange$rates, !e're also analy;ing and
orecasting the behavior o an assortment o %eo%le, cultures and nations, and
ho! the mixture o these elements !ill determine the direction o the exchange$
rates"
&s technicians, !e look behind every event that is traced out in our charts and
relate it to the market %artici%ants !hose interests !ere either im%acted or
beneited" Only ater the exchange$rate scenario in one event is understood, can
!e go on to the next exchange$rate change under examination"
)arkets behave se7uentially" There is a %rominent or an obscure thread o
continuity and causeHeect rationale that ties each moment o market behavior to
those that %receded it" Our task, as trading technicians, is to ind this thread"
Having ound it, !e then exert every eort to ollo! it through each ste% o its
meandering as it changes the value o a currency" Ae also look back over a e!
hours, days, or !eeks o %rice and trading volume to reach accurate conclusions
about a %articular currency's strengths and vulnerabilities" Through this exercise
!e can determine !hether a %osition should be established, increased, reduced or
oset com%letely"
&s technical traders, !e must vie! %rice as the cause and changes in trading
volume as the eect" (rice is both the trigger and the yardstick by !hich %roits
and losses are measured"
Settlement ri!
Ges%ite its vast li7uidity and geogra%hic breadth$$or %erha%s, in %art, because o
them$$the oreign exchange market has the ca%acity to bring modern global
inancial markets to their knees" Recogni;ing that the large and numerous cross$
border settlements that accom%any oreign exchange trading %ose a systemic
risk, the %ublic and %rivate sectors have %ro%osed various mechanisms or
managing this risk"
Transactions in the oreign exchange market take %lace at all hours o the day and
night and, more oten than not, involve institutions in dierent national
Durisdictions" It is this last eature$$the cross$border, cross$time$;one nature o
the transactions$$that %oses the greatest challenge or the eicient settlement o
the nearly .6"5 trillion t!o$!ay %ayments or the estimated 621,111 to B11,111
exchanges o currency every day" <arge settlements %ose at least t!o ty%es o risk"
!erstatt risk
The irst has been called Herstatt risk, ater *ankhaus Herstatt, !hich ailed to
deliver #+ dollars to counter%arties ater it !as ordered into li7uidation by the
German authorities in /035" *anks are ex%osed to large amounts o cross$border
settlement risk because irrevocable settlement o the se%arate legs o a oreign
exchange transaction may be made at dierent times" For exam%le, delivery o
yen to a Ne! Eork bank's Ja%anese corres%ondent bank in Tokyo occurs during
Tokyo business hours, !hile the corres%onding delivery o dollars by a Ne! Eork
bank to a Ja%anese counter%arty's #+ corres%ondent bank in Ne! Eork occurs
during Ne! Eork business hours" +ince the t!o national %ayment systems are
never o%en at the same time, there is the risk that ater the irst counter%arty has
delivered one side o the transaction, the other counter%arty may go bankru%t
and ail to deliver the osetting currency"
)ore than 61 years ater the colla%se o Herstatt, there is still no !idely acce%ted
method o 7uantiying settlement risk" The Foreign Exchange 8ommittee, a
%rivate sector grou% s%onsored by the Federal Reserve *ank o Ne! Eork, !as the
irst to survey oreign exchange dealers and %rovide a methodology or examining
settlement risk, as !ell as a set o recommended best %ractices, in its re%ort,
NReducing Foreign Exchange +ettlement Risk"N )ore recently, in )arch /009, the
8ommittee on (ayment and +ettlement +ystems o the Grou% o Ten ,the ten
industrial countries !ith the largest economies- released the &llso%% Re%ort,
!hich, building on the earlier methodology, analy;es existing arrangements and
sets out a strategy or reducing settlement risk"
The &llso%% Re%ort ound that oreign exchange settlement is not Dust an intraday
%henomenon and that %ayment lags can initially last at least one to t!o business
days4 another one to t!o business days may then ela%se beore a bank is assured
that it has received the re7uisite %ayments" The amount at risk at a bank could
exceed three days' !orth o trades, so that the ex%osure to even a single
counter%arty could exceed a bank's ca%ital" Ahile the risk is only beginning to be
recogni;ed and 7uantiied, recent oreign exchange %ayment deaults, including
those o the *ank o 8redit and 8ommerce International ,*88I- and *arings (lc,
demonstrate that the risk cannot be ignored"
"he liquidity risk
The second risk has to do !ith the %ossibility a counter%arty !ill deault because
o an o%erational or systems %roblem that leaves it !ith insuicient li7uidity to
make %ayment" In most cases, o%erational ailures can be resolved !ithin 65 to
5@ hours, and overnight unding can be obtained to cover a ailed delivery o
currency" It is not uncommon, ho!ever, to have more than .6 billion outstanding
bet!een banks overnight" & large o%erational ailure could sur%ass the ability o
even some o the best$ca%itali;ed institutions to access money markets, es%ecially
!hen notice o the ailure is received during o$hours in the institution's
domestic market or !hen the undelivered currency is not one in !hich the
ex%osed institution customarily borro!s" This is an es%ecially im%ortant issue in
emerging markets, !here the %hysical inrastructure or %ayment and settlement
may not be ade7uate to accommodate transactions that are increasing in si;e and
number"
#mpact on financial markets
& counter%arty that deaults because o either an insolvency or a li7uidity
%roblem could trigger a systemic %roblem" The most commonly articulated
scenario is one in !hich the ailure o one large bank causes a second bank to ail,
in turn causing a third bank to ail, and so on$$a Ndomino eect"N &nother
situation might arise in !hich a small number o institutions inde%endently ail
to deliver, causing other institutions to ail or to encounter li7uidity %roblems"
These scenarios are more likely to occur !hen institutions are highly
interde%endent" #sing actual gross settlement numbers rom a day in /005 !hen
the yen a%%reciated against the dollar by 2 %ercent, )ultinet, a multilateral
oreign exchange netting acility under develo%ment, sho!ed that the ailure o
the %artici%ant !ith the largest %osition !ithin its system could have caused a
number o other %artici%ants to ail"
Solutions to Reduce Risk
(ro%osals or managing settlement risk are based on t!o a%%roachesL ,/-
eliminating the delay bet!een the t!o legs o a transaction and ,6- reducing the
number and si;e o %ayments re7uiring settlement"
Simultaneity
The irst a%%roach is based on the belie that settlement risk could be eliminated,
or at least substantially reduced, i %ayments in the corres%onding currencies
!ere delivered and guaranteed simultaneously, thereby averting the %ossibility o
deault bet!een the time one %ayment is made and the other is received" This
a%%roach re7uires im%ortant changes in arrangements or international
%ayments" First, ga%s in the o%erating hours o the maDor !holesale domestic
%ayment systems !ould need to be closed" +econd, some ty%e o linked %ayment
systems or veriication o %ayments is re7uired to guarantee intraday Ninality o
%aymentN$$that is, the irrevocability o the %ayments and the ability o the
counter%arties to use their %ayments as soon as they are received"
The elimination o ga%s in o%erating hours is airly straightor!ard" Ahile there
is still much !ork to be done beore every country has a %ayment system ca%able
o %rocessing and settling large$value transactions in real time ,a Nreal$time gross
settlement,N or RTG+, system-, im%rovement or the maDor currencies is ex%ected
in /003 !hen the #nited +tates' RTG+ system, Fed!ire, !ill o%en at /6LB1 a"m"
local time" This !ill create an overla% bet!een %ayment systems in the #nited
+tates and Ja%an and increase the overla% bet!een the #+ and German %ayment
systems" )ore im%rovements should occur in /000, !hen the Trans$Euro%ean
&utomated Real$Time Gross +ettlement Ex%ress Transer ,T&RGET- system in
Euro%e !ill link the existing and ne! RTG+ systems o member countries in the
Euro%ean #nion"
The second change involves larger %ublic %olicy issues and is more %roblematic"
It is ty%ically assumed that only a central bank can guarantee inality o %ayment
in its o!n currency4 the achievement o simultaneous inality !ould thus re7uire
the coordination o oreign exchange$related %ayments among central banks"
&lthough it is technically easible to create cross$ border links !ithin the RTG+
systems run by the central banks so that, or exam%le, veriication that a yen
%ayment has been received in Tokyo is made beore the corres%onding dollar
%ayment is released in Ne! Eork, there are diicult %ractical and %olitical issues
that need to be resolved" For exam%le, one %otential side eect o linking national
RTG+ systems is that a disru%tion at one site !ould aect other sites" This !ould
be an es%ecially diicult situation i the ability to access o$hour money markets
!ere inhibited or the money markets !ere not dee% enough to %rovide ade7uate
li7uidity or the duration o the disru%tion" )ulti%le central banks running such
linked RTG+ systems may be re7uired to su%%ly central bank credit and li7uidity
acilities until the site !here the dislocation occurred is able to ada%t" Muestions
regarding !hich banks !ould su%%ly the credit, to !hom, and or ho! long, and
ho! excess unds !ould be Nmo%%ed u%N ater the event !ould all have to be
addressed" There !ould be a need or increased international coordination o
macro%rudential, su%ervisory, and lender$o$last$resort %olicies"
The central banks o the Grou% o Ten countries have thus ar been reluctant to
link their domestic %ayment systems and instead have %ressed the %rivate sector
or solutions to settlement %roblems" One !ay to reduce settlement risk !ould be
by altering or augmenting bank risk$management techni7ues" For exam%le,
credit risk control %rocesses could be ada%ted to identiy and control the oreign
exchange settlement ex%osures o counter%arties" Im%roved back oice %ayment
%rocessing, corres%ondent banking arrangements, and bilateral netting
ca%abilities may also reduce settlement risks" &ltering the timing o %ayments
and identiying inal or ailed recei%ts as soon as %ossible could also hel% banks
shorten the duration o settlement risks" These solutions re7uire no %ublic sector
involvement and could substantially reduce settlement ex%osures"
& more aggressive %rivate sector a%%roach being examined by 61 internationally
active banks kno!n as the Grou% o T!enty is to set u% a Nglobal clearing bankN$$
a %rivate sector institution that !ould act as the link bet!een national %ayment
systems, veriying %ayments so that simultaneity could be achieved" Ahile a
global clearing bank a%%ears to be, in %rinci%le, the most direct method or
managing Herstatt risk, there are remaining challenges"
First, the clearing bank's ability to guarantee inality o %ayment in each country
is uncertain" Finality !ould re7uire that the legal status o settlements be similar
in all %artici%ating countries, !hich, in turn, re7uires that the %artici%ants
address such issues as the clearing bank's location, cor%orate orm, and relation
to national settlement acilities" +econd, the o%eration o a global clearing bank
might have an im%act on li7uidity in short$term money markets and, thus, on
management o li7uidity by the central banks, and, %erha%s, on monetary %olicy
obDectives" I a global clearing bank re7uired its members to %ay large sums o
money into their accounts to cover large settlements, it might drain li7uidity rom
domestic money markets" The loss o li7uidity might oset the ability o a central
bank to control short$term interest rates and %rovision o intraday li7uidity to
domestic money markets" Furthermore, until the RTG+ systems involved in the
settlement o the maDor currencies are o%erating 65 hours a day, the clearing
bank's %rocedures may re7uire unds to be available to su%%ort settlement during
the short %eriods o overla%%ing hours bet!een the various national RTG+
systems" It is unclear !hether suicient li7uidity !ould develo% during these
%eriods to su%%ort the settlement o cross$border transactions" Finally, a single
system %ur%orting to settle the maDority o global oreign exchange %ayments
!ould be vulnerable to technological ailures4 several redundant systems !ould
%robably be re7uired to minimi;e this risk"
$educing settlements
In theory, a !ell$constructed global clearing bank could eliminate oreign
currency settlement risk" Ho!ever, the %roblems o harmoni;ing national la!s
and develo%ing %rocedures or ade7uate li7uidity %rovision, although not
insurmountable, are diicult and time consuming" *ecause the develo%ment o
such a bank is still in its early stages, %rivate sector bilateral and multilateral
netting arrangements are receiving increased attention" These arrangements are
based on the second a%%roach to managing settlement risk$$that o dramatically
lo!ering the si;e and number o %ayments"
Formal bilateral netting systems, available since /001, %eriodically aggregate the
amounts o!ed bet!een counter%arties and calculate one %ayment %er currency
or each %air o counter%arties$$there are no automatic %ayment acilities and the
systems do not assume oreign exchange ex%osures" ,Inormal bilateral
arrangements may be %rivately negotiated bet!een counter%arties at any time"-
*ilateral netting can reduce amounts at risk by an estimated 21 %ercent, on
average"
)ultilateral netting systems net the amounts o!ed among a grou% o
counter%arties through a clearinghouse arrangement, resulting in one %ayment
each day in a given currency to or rom the clearinghouse by each counter%arty"
Ahile )ultinet is still under develo%ment, another system, the Exchange
8learing House ,E8HO-, became available in &ugust /002" )ultilateral netting
can reduce settlement risk by 3B %ercent or a grou% o about 61 %artici%ants, and
by as much as 02 %ercent or a bigger grou%"
One o the %rimary diiculties aced by multilateral netting systems has been
making netted contracts legally enorceable" 8om%ared !ith other ty%es o
clearinghouses, a oreign exchange netting system cannot o%erate eectively
!ithout resolving the legal status o contracts in many dierent Durisdictions" The
clearinghouse itsel needs to be able to guarantee that the contracts it enters into
are legally binding, and institutions rom dierent legal Durisdictions need to
guarantee their ability to net and enter into contracts !ith the clearinghouse" In
addition, in situations o insolvency, the counter%arties and clearinghouse need
to assure themselves o access to collateral that may be held outside any o their
legal Durisdictions"
To attract members and satisy regulators, netting systems need to ensure that
the clearinghouse does not take on settlement ex%osures that cannot be covered
in the unlikely event o a ailed %ayment or the bankru%tcy o a user" &s a general
rule, netting systems are re7uired to meet the <amalussy minimum standards
established by the Grou% o Ten's central banks, !hich re7uire that the
multilateral netting system Nbe ca%able o ensuring timely com%letion o daily
settlements in the event o an inability to settle by the %artici%ant !ith the largest
single net debit %osition"N To meet this re7uirement, the multilateral netting
system relies on a combination o real$time ex%osure limits, the collection o
collateral or margin, and %recise o%erating %rocedures or limiting the duration o
settlement risks and or dealing !ith a deaulting member"
To avoid transerring a ailure to its other members, a multilateral netting system
needs to be able to ac7uire unding i %ayments are !ithheld and to continue
%ayments to other members" )ultilateral netting systems have broached the
unding issue either by holding collateral or by assuring themselves o outside
sources o li7uidity$$or exam%le, lines o credit and oreign exchange s!a%
acilities, mostly !ith member banks" Ho!ever, it is unclear !hether the systems
can rely on lines o credit !ith member banks, because these may also be aected
by a li7uidity %roblem during a %eriod o stress" #ltimately, then, central banks
!ould serve as the backsto% in a li7uidity crisis, Dust as they do !ithout %rivate
multilateral netting systems"
It is !orth em%hasi;ing that netting systems are not stand$alone methods or
eliminating settlement risk" &ter %ayments are netted, banks must still use a
%ayment system that guarantees inality o %ayments" Thus, once the netting has
been accom%lished, the system's o%erating %rocedures are critical in determining
the amount o time bet!een the settlement o the t!o legs o the transactions"
*oth netting systems have the ability to collect %ayments rom %artici%ants a e!
hours beore releasing their %ayments to the reci%ient %artici%ants or currencies
in !hich it is easible to access large$value RTG+ systems simultaneously,
shortening the ex%osure %eriod" *ut, unless there is simultaneous inality o
received %ayments, there remains some degree o Herstatt risk"
T!o multilateral netting systems may not be sustainable" The degree o risk
reduction is a unction o the number o linked counter%arties and is thereore
greatest !hen all the largest %artici%ants Doin the same system" It may not be
cost$eective or a single bank to become a member unless the other banks !ith
!hich it does business Doin the same netting system" Furthermore, a bank may
!ait to see !hat its counter%arties do, delaying reali;ation o the system's ull
%otential or risk reduction until enough banks Doin one netting system to make it
cost$eective or the others"
Aith the recent Grou% o T!enty initiative to develo% a global clearing bank, the
bilateral and multilateral netting systems ace urther challenges" Ahile the t!o
a%%roaches to lo!ering Herstatt risk could be vie!ed as com%lementary, both
re7uire scarce unds rom banks' oreign exchange trading businesses" Further, as
com%eting a%%roaches to the reduction o Herstatt risk %resent themselves,
banks may !ait until one system emerges a clear !inner beore attem%ting to
reduce their o!n settlement ex%osures" *ut both the bilateral and the multilateral
netting system and a global clearing bank are economically viable only or the
transer o large %ayments" Hence, com%etition among the grou%s develo%ing
methods to lo!er Herstatt risk may reduce the eectiveness o any one system
and slo! the ado%tion o strategies to reduce Herstatt risk"
The Foreign Exchange
Factors Effecting Exchange Rates:
Economic orces determine exchange$rates" In the forex, this ty%e o ree
market environment is most oten reerred to as a loating exchange$rate
environment" In a loating exchange$rate environment, the exchange$rate
res%onds to many actors including the lo! o im%orts and ex%orts, the lo! o
ca%ital, relative inlation rates, etc" Oten, limits are %laced on exchange$rate
luctuations according to government %olicies"
One actor aecting the exchange$rate bet!een the (ak Ru%ee and other
currencies is the merchandise trade balance" *y deinition, the merchandise
trade balance is the net dierence bet!een the value o merchandise being
ex%orted and im%orted into a %articular country" For exam%le, consider the
exchange$rate or Geutsche marks" The #nited +tates im%orts %roducts rom
Germany" To %ay or them, &mericans need Geutsche marks4 thereore, the #"+"
com%anies trade #"+" dollar or Geutsche marks" On the other hand, because
Germans desire &merican$made goods, they %urchase #"+" dollars to %ay or #"+"
goods" The net eect is an increase in the su%%ly o Geutsche marks and #"+"
dollars"
The &merican demand or German goods and services contributes to the demand
or Geutsche marks !hile German %urchases o &merican goods and services
contribute to the su%%ly o #"+" dollars" In this case, the net dierence bet!een
&merican %urchases o German goods and services, and German %urchases o
&merican goods and services, is the merchandise trade balance bet!een the t!o
countries"
The lo! o unds bet!een countries to %ay or stocks and bonds %urchases also
contributes to the currency exchange$rate bet!een currencies" In the near term,
these ca%ital lo!s are greatly inluenced by yield dierentials" &ll else being
e7ual, the higher the yield on German securities com%ared to &merican
securities, the more attractive German securities are relative to &merican
securities" &n increase in German yields !ould tend to raise the lo! o #"+"
dollars into German securities as !ell as decrease the outlo! o Geutsche marks
to &merican securities" 8ombined, this increased lo! o unds into Germany
!ould lo!er the value o the #"+" dollar and increase the value o the Geutsche
mark, thereore, the Geutsche mark to #"+" dollar ,NG)H#+GN- ratio, as it is
re%resented in the forex market, !ould decrease"
The rate o inlation is another actor inluencing currency exchange$rates"
8onsumers try to avoid the eroding eect inlation has on their %urchasing
%o!er" 8onse7uently, goods rom countries !ith a lo! inlation rate become
more attractive than the goods rom countries !ith higher inlation" In turn, the
currency rom the lo!er inlation country rises in value, !hile the currency rom
the higher inlation country alls in value" *oth the inlation actor and the
%urchasing %o!er o the currencies directly im%act currency exchange$rates"
For exam%le, i the #nited +tates is ex%eriencing lo!er inlation than its trading
%artner Germany, the G)H#+G ratio rises to relect the gro!ing %rice level in
Germany relative to the #nited +tates" This act is rooted in the conce%t o a
purchasing power parity , !hich holds that, over the long run, a currency
exchange$rate adDusts to relect the dierence in %rice levels bet!een countries"
How to Determine Foreign Exchange Rates:
1. MARKET ACTION "ISCO#NTS E$ER%THING
There are three %remises on !hich the technical a%%roach is basedL ,/- market
action discounts everything4 ,6- %rices move in trends4 and, ,B- history re%eats
itsel"
The statement, Nmarket action discounts everything,N orms !hat is %robably the
cornerstone o technical analysis" #nless the ull signiicance o this irst %remise
is ully understood and acce%ted, nothing else that ollo!s makes much sense"
Ae believe anything that can %ossibly aect a currency market %rice, i"e",
undamental, %olitical, %sychological, or other!ise, is actually relected in the
%rice o that market" It ollo!s, thereore, that a study o %rice action is all that is
re7uired" Ahile this claim may seem %resum%tuous, it is hard to disagree !ith i
one takes the time to consider its true meaning"
&s a rule, chartists do not concern themselves !ith the reasons !hy %rices rise or
all" ?ery oten, in the early stages o a %rice trend or at critical turning %oints, no
one seems to kno! exactly !hy a market is %erorming a certain !ay" Ahile the
technical a%%roach may sometimes seem overly sim%listic in its claims, the logic
behind this irst %remise""" Nthat markets discount everything"""N becomes more
com%elling the more market ex%erience one gains"
It ollo!s then that i everything that aects market %rice is ultimately relected
in market %rice, then the study o that market %rice is all that is necessary" *y
studying %rice charts and a host o su%%orting technical indicators, !e in eect let
the market tell us !hich !ay it is most likely to go" Ae do not necessarily try to
out$smart or out$guess the market" Ae kno! there are reasons !hy markets go
u% or do!n, !e Dust don't believe that kno!ing !hat those reasons are is
necessary in the orecasting %rocess"
&' (RICES MO$E IN TREN"S
The conce%t o trend is absolutely essential to our technical a%%roach" Here
again, unless one acce%ts the %remise that markets do in act trend, there's not
any %oint in reading any urther" The !hole %ur%ose o charting the %rice action
o a market is to identiy trends in early stages o their develo%ment and then
trade in the direction o those trends" In act, most o the techni7ues used in this
a%%roach are trend$ollo!ing in nature, meaning that their intent is to identiy
and ollo! existing trends"
There is a corollary to the %remise that %rices move in trends, and a trend in
motion is more likely to continue than to reverse" This corollary is an ada%tation
o Ne!ton's irst la! o motion" &nother !ay to state this corollary is that a trend
in motion !ill continue in the same direction until it reverses" This is another
one o those technical claims that seems almost circular" *ut the entire trend$
ollo!ing a%%roach is %redicated on riding an existing trend until it sho!s signs
o reversing"
In acce%ting the %remises o technical analysis, one can see !hy technicians
believe their a%%roach is su%erior to the undamental a%%roach" I a trader had to
choose only one o the t!o a%%roaches to use, the choice !ould logically have to
be the technical" *ecause by deinition, the technical a%%roach includes the
undamental" I the undamentals are relected in market %rice, then the study o
those undamentals becomes unnecessary" 8hart reading becomes a short$cut
orm o undamental analysis"
The reverse ho!ever, is not true" Fundamental analysis does not include a study
o %rice action" It is %ossible to trade in markets using Dust the technical
a%%roach, ho!ever, it is doubtul that anyone could trade using the undamentals
alone !ith out consideration o the technical side o the market"
8&N THE (&+T *E #+EG TO (REGI8T THE F#T#REO
The ield o statistics makes a distinction bet!een descri%tive statistics and
inductive statistics" Gescri%tive statistics reers to the gra%hical %resentation o
data, such as the %rice data on a standard bar chart" Inductive statistics reers to
generali;ations, %redictions, or extra%olations that are inerred rom that data"
Thereore, the %rice chart itsel comes under the heading o the descri%tive, !hile
the analysis that technicians %erorm on %rice data alls into the realm o the
inductive"
(o%ulation orecasts, industry orecasts, and the like are based in large %art on
!hat has ha%%ened in the %ast" In business and in science, as !ell as in everyday
lie, !e %roDect our ex%erience o the %ast in an eort to %redict !hat may ha%%en
in the uncertain uture"
+o it seems that the use o %ast %rice data to %redict the uture Pin technical
analysisQ is a !ell grounded statistical conce%t" I anyone !ere to seriously
7uestion this as%ect o technical orecasting, he or she !ould have to also
7uestion the validity o every other orm o orecasting based on historical data,
!hich includes all economic and undamental analysis"
A#TOMATION) O(TIMI*ATION) + (ROFITA,ILIT% TESTING
Once a technician has decided on the historical data he needs to analy;e, it is then
%ossible to automate the analysis using a com%uter" The technician can %ut
together certain analytical %rocedures or tasks, !hich can then be tied to the
various data iles, leaving the technician ree to do other things, !hile the
com%uter does all the !ork" For exam%le, a N(roitability EditorN allo!s the
technician to test %redetermined trading rules over historical data, and test or
o%timi;ed results"
This ability to test any trading system or technical indicator over historical data
and, at the same time, seek out the best %arameters through the o%timi;ation
%rocess may %rove to be the most valuable eature o the com%uter" Finally,
technical studies enable the more ambitious technicians, !ith some background
in com%uter %rogramming, to !rite their o!n analysis routines"
E<E8TRONI8 *ROFING FOR )&RFET (ROFE++ION&<+
In /00B, /6 o the !orld's leading oreign exchange banks came together to
res%ond to the market's need or eicient, lo! cost, brokered dealing"
Today E*+ is a %artnershi% bet!een /B o the !orld's maDor market making
banks and the )inex 8or%oration o Ja%an" Together, these /B banks %rovide the
maDority o the li7uidity to the oreign exchange market
Established in /00B by /6 o the !orld's largest oreign exchange banks, E*+ is
the leading %rovider o electronic broking services to the interbank trading
community" Today the E*+ (artnershi% com%rises subsidiaries o /B banks and
the )inex 8or%oration"
Together !ith its E*+ Gealing Resources subsidiaries, E*+ is a ully integrated
su%%lier o a range o interbank transaction services marketed !orld!ide by E*+
Gealing Resources' global net!ork o sales and service oices"
E*+ Gealing Resources' Netting = 8redit Givision is the licensee and su%%lier o
the F>NET automated bilateral netting service, the irst and largest netting
system available to banks" *ilateral netting enables %airs o banks to reduce their
oreign exchange obligations to a single %ayment %er currency %er value date"
THE FUTUE
Aith E*+' ackno!ledged ex%ertise in the %rovision o lo! cost, eicient broking
solutions to the F> market, !e are constantly evaluating ne! business
o%%ortunities in other markets or uture gro!th and ex%ansion" In addition, !e
are al!ays looking or ne! technology solutions to maintain the reliability and
eiciency our customers demand"
A -alua.le addition
In July 6111, E*+ launched %recious metals trading on the E*+ +%ot Gealing
+ystem" In doing so, E*+ became the irst electronic broking %latorm in the
interbank bullion market" Today over 21 banks including the leading market
makers trade a signiicant amount o their s%ot gold and silver on E*+"
(RO"#CTS
E*+ %rovides a ully integrated range o dealing solutions to the %roessional
interbank community" E*+' %roducts are ackno!ledged !orld leaders and have
been a driving orce o change in the oreign exchange market since the launch o
the E*+ Gealing +ystem in /00B"
The E*+ Gealing +ystem is the leading screen$based anonymous dealing system
or trading interbank s%ot oreign exchange" Aith unrivalled li7uidity in the
maDor currency %airs, over 6,211 traders in @21 banks around the !orld today
use E*+"
E*+ Gealing Resources' Netting and 8redit Givision is the sole licensee and
su%%lier o F>NET, the !orld's largest automated bilateral netting service, !hich
is %roven to reduce settlement risk by 21C"
The E*+ +%ot Gealing +ystem is the leading screen$based anonymous dealing
systems or trading inter bank s%ot oreign exchange, in all maDor currencies"
&verage daily volumes are in excess o .@1bn"
Gelivered over a %ro%rietary net!ork, it combines the eatures o voice$broking
services !ith the latest technology or electronic trading" One to six currency
%airs can be traded at any time !ith deals com%leted by keystroke or automatic
deal matching !ithin the system"
&n im%ortant eature o E*+ is its %re$screened credit acility $ dealers can only
see %rices that they can 'hit', thereby eliminating the %otential or ailed deals
because o counter %arty credit issues"
E*+ is al!ays looking at the markets in !hich it o%erates and u%grading the
dealing system to meet changing market conditions" Feedback rom our
customers is an invaluable and integral %art o this %rocess" &n &utomated
+ystems Interace ,&+I- %rovides an electronic interace bet!een E*+ and a
bank's internal banking system a%%lications, or straight through transaction
%rocessing and the elimination o du%licate trade entry activity"
FXNET ,ENEFITS
Aith nearly /11 user banks in iteen countries, F>NET is the netting
%rocess o choice or maDor oreign exchange banks" In an ideal !orld all oreign
exchange transactions !ould be conirmed and settled in a risk$ree %ayment$
versus$%ayment environment" In reality the only eective !ay to reduce
settlement risk today is !ith F>NET"
O%erational Eiciency and <o!er 8osts F>NET interaces to your back oice
system, eliminating com%letely the need to re$key transaction details" Geal
conirmation messages or each trade are sent to the bank's local F>NET system,
!hich automatically matches and conirms each deal and
u%dates the bank's net %osition or each counter %arty, by
currency and value date"
F>NET %rovides timely settlement and streamlined back oice
o%erations through ull netting automationL
Real$time bilateral netting and exce%tion re%orting &utomated deal matching
and net settlement reconciliation, #sed +AIFT message ormats, +treamlined
back$oice %rocessing Muantiied %aymentHcost reduction, Muantiied settlement
risk reduction"
#+ING +E+TE) +IGN&<+ &+ & GI+8I(<INING GE?I8E
&nother advantage o com%uter automation is generating system signals !hich
can be used sim%ly as a mechanical conirmation along !ith other technical
actors" Even i a system is not being traded mechanically, and other technical
actors are being em%loyed, the signals could be used as a disci%lined !ay to kee%
the trader on the right side o the maDor trend" No short %ositions !ould be
taken as long as the com%uter generated trend signal is u%" No long %ositions
!ould be taken in a com%uter generated do!n$trend signal"
/' HISTOR% RE(EATS ITSELF
)uch o the body o our technical analysis and our study o market action has to
do !ith the study o human %sychology" 8hart %atterns or exam%le, !hich have
been identiied and categori;ed over the %ast one hundred years, relect certain
%ictures that a%%ear on %rice charts" These %ictures reveal the %sychology o the
market" +ince these %atterns have !orked !ell in the %ast, !e assume they !ill
continue to !ork !ell in the uture" This is based on the study o human
%sychology, !hich tends not to change" &nother !ay o saying this last %remise is
that Nhistory re%eats itsel"N This means that the key to understanding the uture
lies in a study o the %ast, or that the uture is Dust a re%etition o the %ast"
TE8HNI8&< ?ER+#+ F#NG&)ENT&< FORE8&+TING
Ahile technical analysis concentrates on the study o market action, undamental
analysis ocuses on the economic orces !hich cause %rices to move higher, or
lo!er, or stay the same" The undamental a%%roach examines all o the relevant
actors aecting the exchange$rate bet!een t!o currencies to determine the
intrinsic value o each currency" The intrinsic value is !hat the undamentals
indicate one currency is actually !orth against another currency" I this intrinsic
value is under the current market %rice, then the currency is over%riced and
should be sold" I market %rice is belo! the intrinsic value, then the market is
undervalued and should be bought"
*oth o these a%%roaches to market orecasting attem%t to solve the same
%roblem, that is, to determine the direction %rices are likely to move" They Dust
a%%roach the %roblem rom dierent directions" & NundamentalistN studies the
cause o market movement, !hile a technician studies the eect" Ae are market
technicians, and !e believe that the eect is all that !e !ant or need to kno!,
and that the reasons or the causes are unnecessary" In contradistinction, a
undamentalist al!ays has to kno! !hy"
)ost market traders classiy themselves as either technicians or
undamentalists" In reality, there is a lot o overla%" )ost undamentalists have a
!orking kno!ledge o the basic tenets o chart analysis" &t the same time, most
technicians have at least a %assing a!areness o the undamentals" The %roblem
is that the charts and undamentals are oten in conlict !ith each other" #sually
at the beginning o im%ortant market moves, the undamentals do not ex%lain or
su%%ort !hat the market seems to be doing" It is at these critical times in the
trend that these t!o a%%roaches seem to dier the most" #sually they come back
into sync at some %oint, but oten too late or the trader to act"
One ex%lanation or these seeming discre%ancies is that market %rice tends to
lead the kno!n undamentals" +tated another !ay, market %rice acts as a leading
indicator o the undamentals or the conventional !isdom o the moment" Ahile
the kno!n undamentals have already been discounted and are already Nin the
market,N %rices are no! reacting to the unkno!n undamentals" +ome o the most
dramatic market movements in history have begun !ith little or no %erceived
change in the undamentals" *y the time those changes became kno!n, the ne!
trend !as !ell under!ay"
The technician learns to be comortable in a situation !here market movement
disagrees !ith the so$called conventional !isdom" & technician begins to like
being in the minority" He kno!s that eventually the reasons or market action
!ill become common kno!ledge" It is Dust that the technician is not !illing to
!ait or that added conirmation"
#+ING +IGN&<+ &+ &<ERT+
8om%uter generated signals relieve a trader o some degree o uncertainty by
%reventing him rom alling into the tra% o to% and bottom %icking" The %oint
here is sim%ly that com%uter trend signals can be es%ecially valuable even !hen
used only as another technical indicator" The com%uter can also be used as an
excellent screening device to alert the trader to recent trend changes" The
com%uter Dust makes that task 7uicker, easier, and more authoritative"
The com%uter has made the technician's task easier by %roviding 7uick and easy
access to a vast array o technical tools and indicators" &t the same time, the
technician's !ork has been made more diicult" Ahereas beore, the technical
analyst only had to deal !ith a handul o avorite tools, no! they have to contend
!ith as many as orty dierent indicators at the same time"
*ased on research in cognitive %sychology, it is believed that the human mind has
diiculty interrelating !ith more than three se%arate variables at the same time"
Thereore, the analyst trying to assimilate our or more indicators simultaneously
may become over!helmed" I the analyst decides to ollo! only three indicators,
!hich three are the bestO
&RTIFI8I&< INTE<<IGEN8E (&TTERN RE8OGNITION
The com%uter has been used almost exclusively in market analysis as a
com%utational device" Its main unction has been to calculate and %resent data to
save us time" Ho!ever, a more im%ortant use or the com%uter may be in the
inter%retation o all o the data it has calculated or us4 that is, to use its logical
%o!ers along !ith its com%utational %o!ers" That brings us to the subDect o
Artificial Intelligence and Pattern Recognition"
Artificial Intelligence reers to the use o heuristic %rograms to solve
%roblems in much the same !ay a %erson does" The com%uter actually %erorms
in a !ay that !ould be described as intelligent" The com%uter assesses situations,
makes decisions, and learns rom mistakes" Pattern Recognition enables the
com%uter to learn ho! to make decisions and %redictions based on classiications
o dierent items or indicators" The term N%atternN used in this context is
dierent rom the earlier use o the term to describe various chart %atterns" The
intent in Pattern Recognition is to %roduce a synergistic eect by combining
all o the indicators instead o treating each one individually"
The irst ste% in the %rocess is to ind the best single indicator rom all o those
available" The second ste% is to ind the best %air o indicators" The third ste% is
to ind the best three indicators used together" That %rocess is continued until
the addition o a ne! indicator no longer im%roves the inal combined result"
In the testing %rocess, t!o dierent sets o data are usedL learning and test data"
The results ound in the learning data must then be conirmed on se%arate test
data" This techni7ue o using t!o dierent sets o data %revents Ncurve$itting,N a
charge oten leveled against the testing o other technical methods, in %articular,
testing or o%timi;ed results"
The use o Artificial Intelligence and Pattern Recognition may hold the
ans!er as to ho! to contend !ith so much conlicting inormation" In dealing
!ith conlicting inormation, the com%uter is asked to calculate all o the
indicators and then to choose the best combination o those indicators to use in a
given situation" *ecause that solution seems so obvious, !hy isn't more !ork
being done in that directionO +o ar, this ty%e o !ork has been a%%lied mainly to
academic situations and not to real !orld conditions" The cost is huge and
re7uires extensive com%uter %o!er" Even !hen %atterns in the market are
identiied, they tend to be unstable and re7uire constant re$testing"
A"$ANTAGES AN" "ISA"$ANTAGES OF ELECTRONIC TRA"ING
Here are some o the %ros and cons o mechanical system trading using
com%uter$generated signals" +ystem trading re%resents a Nblack boxN a%%roach
to currency trading" The technician does not have to get involved in the decision$
making %rocess, or or that matter, kno! or understand !hat's in the system"
Other com%uter oriented traders stay involved in the %rocess and use com%uter$
generated signals and indicators in the analytical %rocess, but reserve the right to
make the inal market decision"
There is not any 7uestion that the gro!ing de%endence on com%uter trading
systems, %articularly by %ooled %rivate and %ublic commodity unds, is having a
greater inluence on market trading" The ne! game in the markets is trying to
out$smart the com%uter unds" The ability o those %ooled unds to inluence and
even distort short$term market behavior is gro!ing" The %rolieration o
microcom%uters !ith easy access to technical analysis routines, including on$line
data, has increased the general level o so%histication o the average trader and
caused more short$term trading" Gay trading has become more %o%ular because
o easier access to com%uter terminals that can chart intra$day data" Ahere all
this !ill lead is uncertain" Ho!ever, it is clear that the com%uter is
revolutioni;ing market trading" One im%ortant act emerges rom all o this" The
market traders !ho do not have access to com%uter technology are %lacing
themselves at a severe disadvantage"

Conclusion
The oreign exchange market has registered healthy increases in turnover and
continues to be the most li7uid o markets" Ho!ever, the si;e and number o
transactions, and the increased concentration o transactions in a handul o
international banks %lace the oreign exchange market at the nexus o the global
net!ork o interbank %ayments" &ny disru%tion in the settlement o oreign
exchange transactions could have serious conse7uences or global trade and
inance and or the international banking system" One o the main diiculties in
settling oreign exchange %ayments is that it is not al!ays %ossible to make inal
%ayments simultaneously" This creates a !indo! in !hich one o the
counter%arties could ail to deliver, !ith %ossible re%ercussions or the
international banking system" *oth the %rivate and the %ublic sectors are a!are
o this diiculty and are %ursuing several initiatives that !ill enable them to
reduce and better manage oreign exchange settlement ex%osures" Ho!ever,
these initiatives are not yet com%rehensive or coordinated" Their success !ill
re7uire vigilance and %ersistence on the %art o central banks"