Mr. McDonough examines recent developments and trends in the foreign
exchange markets Remarks by the President of the Federal Reserve Bank of New York,
Mr. William J. McDonough, before the 39th International Congress of the Association Cambiste
International, The Financial Markets Association in Toronto on 30/5/97.
I am delighted to be invited to address the 39th International Congress of the
Association Cambiste Internationale (ACI) -- The Financial Markets Association. I must confess
to a certain affinity for the foreign exchange community, stemming, no doubt, from my
commercial banking experience and my time overseeing the foreign exchange desk at the
Federal Reserve Bank of New York. I've long believed that, more so than in most other sectors
of the finance industry, there is a real community among those engaged in foreign exchange -- a
community that relies on close personal ties and contacts. It is this spirit of community that
makes events such as these ACI meetings today and tomorrow so enjoyable and important,
giving us the opportunity to renew old friendships and build new relationships that will enable
us to do our respective jobs that much better.
In my remarks to you this morning, I would like to highlight some recent
developments in the foreign exchange market and share with you my view, as a central banker,
of what has been driving some of the trends we've been observing. We heard a lot of talk in the
foreign exchange markets in 1996 about the "end of volatility." As the market performance of
the last few weeks has demonstrated, such commentary was a bit exaggerated. However, even
with the spike in volatility we've seen in recent weeks, there is no question that we have
witnessed a remarkable period of relative stability in foreign exchange rates over the past six
quarters or so.
What accounts for this relative stability in the foreign exchange markets since late
1995? Economic fundamentals are certainly one factor -- we have had a period of relative price
stability in the major world economies, and a general absence of severe market shocks.
However, I would argue that what we've been observing is also, in part, a by-product of
continuously greater transparency that has characterized the foreign exchange market over the
past several years. Moreover, I am convinced that the increased transparency in the foreign
exchange markets is beneficial: for the foreign exchange community, for financial markets in
general, and for the global economy as a whole.
Before explaining what I mean by greater transparency and why I believe it is so
beneficial, I would like to take a quick look at the record itself. Is the talk about declining
volatility reflected in hard evidence? Yes, it largely is. Thirty-day dollar-mark and dollar-yen
historical volatility remained below 10 percent throughout most of 1996 and the first quarter of
1997, and, even with the price action we saw in May, the spike in thirty-day historical volatility
we've observed is not particularly dramatic when compared with similar periods in past years.
Similarly, implied volatility on dollar-mark and dollar-yen options traded to near record lows in
1996.
But, as this month has shown, volatility has not been eliminated. There also have
been a number of days in the past year and a half with considerable volatility in the foreign
exchange market. And, I have no doubt that we'll have many more of these days -- at times, for
example, when markets rapidly adjust to new information or when periods of poor liquidity
result in exaggerated price swings.
What is clear is that this is a market that is constantly evolving. None of us can
say with any certainty whether we're observing the beginning of a trend or an anomalous period
that will ultimately be viewed as a brief lull in volatility. However, I don't think many of you
would disagree with me when I say that the foreign exchange market over the past six quarters
or so has changed significantly from that in 1994 and 1992. For those of you who, like me, were
involved in this business in the 1970s and 1980s following the collapse of the Bretton Woods
system, the contrast is very dramatic.
Given these realities, we must ask ourselves what has changed to alter the way
foreign exchange rates fluctuate in the global marketplace? It is obvious that this is not a case of
declining volume. The foreign exchange survey most recently published by the Bank for
International Settlements in 1996 shows that daily volume in foreign exchange grew by almost
50 percent between 1992 and 1995, and we have no reason to think that anything has changed
since then to alter this trend.
What has changed, however, is the new, higher level of transparency that has
been introduced in recent years into the foreign exchange market. When I speak of transparency,
I am actually referring to a combination of several factors. Broadly speaking, I define
transparency in this market as the degree to which its participants have equal and simultaneous
access to the inputs necessary to price assets and their associated risk accurately. By reducing
guesswork and uncertainty, transparency helps to smooth price adjustments and eliminate some
of the shocks that can result when market participants discover they have "priced in"
assumptions that are inaccurate. In my view, the current move toward greater market
transparency is reflected in four broad categories: policy, information, pricing, and risk
management.
The increased transparency of central bank policy -- which is a product of
deliberate steps taken by policymakers -- is an important aspect of the move toward more
transparent overall market conditions that we've been observing. Over the past several years,
central banks in a number of countries, most notably in Canada, New Zealand, Australia, and the
United Kingdom, have become increasingly convinced of the value of making a public
commitment to an articulated and transparent policy standard, usually price stability. By setting
clear policy objectives, the makers of monetary policy can eliminate much of the guesswork that
central bank watchers must engage in to figure out what the central bank will do next. In so
doing, they can help anchor inflation expectations over the long term, and thereby foster
economic growth by ensuring a stable price environment.
Many central banks are also increasingly coming to realize that much of the
secrecy and cautious signaling that once characterized monetary policy decisions is, to some
extent, counterproductive. In recent years, a number of central banks have taken measures to
further open up their policy processes to the public. For example, prior to February 1994,
changes in monetary policy in the United States were signaled to the market through open
market operations. Since that time, the Federal Reserve has publicly announced changes in
policy, typically following each meeting of the Federal Open Market Committee, or FOMC.
Some policymakers had been concerned that this shift in procedure for communicating policy
decisions might create additional market volatility. In fact, a recent study by some of my
colleagues at the Federal Reserve Bank of St. Louis found just the opposite -- that announcing
policy changes has not led to increased volatility in the federal funds rate. By making
information on monetary policy decisions available quickly and broadly, we at the Federal
Reserve have helped level the playing field and, I believe, contributed to smoothing the process
by which new information on FOMC policy is incorporated more quickly and efficiently in asset
prices.
Other central banks have similarly increased transparency in their monetary
policy processes. One example is the Bank of England's move to publish the minutes of the
monthly policy meetings between the Chancellor and the Bank of England Governor, a practice
that is to continue under the new monetary policy council. The Bank of Canada, too, has taken
steps to increase the level of transparency in its markets. It now publishes a semiannual
monetary policy report and sets an explicit level for its bank rate.
National governments also have contributed to greater transparency in monetary
policy by increasingly recognizing the value of endowing their central banks with greater
independence. Moves of this sort have occurred in several Western European countries and
many emerging market economies, especially in Latin America, over the past several years.
A second area where recent developments have resulted in improved transparency
in the foreign exchange market is information technology. Easy and inexpensive access to a vast
array of information has changed the way financial markets absorb new data. Most of us in this
room sit in offices or trading rooms with keyboard access to data, analysis, and news that once
took huge resources to manage. And, neither bankers nor traders have a monopoly on this
capacity -- corporate treasurers and institutional investors can pull up most of the same screens
we can. At one time, a presence in a local market and access to early newspapers could provide a
trading advantage for a large market maker. Today, news from that market is available
electronically worldwide with almost no lag. Information is cheaper and easier to come by than
ever before. The result? A global market that reacts quickly and efficiently to new data, and
participants who have more time to analyze information because they need to spend less time
gathering it. One consequence of this improved transparency in information technology is that
information gets reflected in asset prices more quickly and more smoothly than ever before.
A closely related development that has also contributed to increased transparency
in the foreign exchange market has been the rapid evolution of the price discovery process in the
past several years. Electronic brokerage and electronic interbank dealing systems have evolved
that have smoothed the dissemination of current pricing and improved market liquidity. Whereas
truly competitive pricing was once the province of only the largest market makers, smaller
interbank dealers -- and even some foreign exchange end-users -- now also have access to
narrow bid-ask spreads. The result so far has been a deeper market and, again, a more level
playing field for all market participants, with pricing no longer dominated by a few large
players.
The final area in which recent innovations have improved market transparency is
risk management. While we are far from being able to rest on our laurels, there is no denying the
fact that financial institutions, their customers, and their investors have become more
sophisticated over the past several years at evaluating, monitoring, and controlling market risk.
If market participants better understand the risk of the positions they put on their books, they are
more able to react effectively and efficiently when their assumptions are challenged or unwound.
Although it is crucial that rapid innovations in trading and risk management practices continue,
most of the institutions represented here have already made important progress along these lines
in recent years.
What needs to be stressed, however, is that it is not enough for a firm to
develop - for internal purposes alone -- sophisticated new techniques to assess, price, and
manage increasingly refined components of financial risk. If financial markets are to function
most efficiently, shareholders, creditors, and counterparties of these firms also must be able to
assess the risks when they make their evaluations. In order for them to do this, meaningful
information about risks and risk management performance must be available.
The Federal Reserve Bank of New York has been actively involved in
encouraging an evolution of disclosure practices that will improve the functioning of financial
markets. As you may know, Peter Fisher, an executive vice president of the New York Fed,
chaired a working group of the Euro-Currency Standing Committee of the G-10 central banks,
which published a discussion paper on "Public Disclosure of Market and Credit Risks by
Financial Intermediaries" in September 1994. This so-called Fisher report described how trading
and financial risk management practices had developed far beyond the public disclosure of
financial information, creating a gap between the precision with which a firm's management
could assess and adjust the firm's own risk exposures and the information available to outsiders
to help them assess the riskiness of that firm's activities.
Recognizing that such an asymmetry of available information could cause the
misallocation of capital among firms and amplify market disturbances, the Fisher report
recommended that all financial intermediaries -- regulated and unregulated -- move in the
direction of publicly disclosing periodic quantitative information. The information requested
would provide estimates relied upon by the firm's management of:
the market risks in the relevant portfolio or portfolios, as well as the firm's actual
performance in managing the market risks in these portfolios; and
the counterparty credit risks arising from the firm's trading and risk management
activities.
By and large, these proposed measures for reporting risk have been adopted
voluntarily by many major banking institutions around the world, with many others moving in
that direction. As such, they have contributed importantly to improved transparency in financial
markets.
The Federal Reserve Bank of New York has also been deeply involved in efforts
to reduce foreign exchange settlement risk -- efforts that should further serve to improve market
efficiency and overall financial stability. In October 1994, the New York Fed-sponsored Foreign
Exchange Committee issued a major report on "Reducing Foreign Exchange Settlement Risk."
The Bank has also been working actively in this area with other central banks through the G-10
central bank Committee on Payment and Settlement Systems, or CPSS, which I have had the
pleasure to chair in recent years. Building upon the work of the New York Foreign Exchange
Committee, the CPSS published a document in March of last year, often referred to as the
Allsopp report, that contains a comprehensive strategy outlining how the public and private
sectors can work together to reduce foreign exchange settlement risk. The strategy was endorsed
by the G-10 central bank governors and calls for specific action on the part of individual banks
and industry groups.
A survey conducted by the CPSS last autumn indicates that individual banks are
answering the G-10 governors' call for action. Many banks have made a good start in improving
their ability to measure, manage, control, and net their bilateral settlement exposures, and they
plan to push these efforts even further over the next year. While this is a very encouraging
beginning, we can't ignore the fact that more work must be done by individual banks. With this
in mind, the CPSS will continue to closely monitor progress over the next year for any signs of
slippage.
The search by individual banks for efficient ways to reduce their foreign
exchange settlement risk has brought about important progress at the industry-group level as
well. The Allsopp report noted the efforts of FXNET, S.W.I.F.T, ECHO, Multinet, and the
Group of 20 banks to offer various types of risk-reducing services, and these ongoing efforts are
very encouraging. Some banks are also exploring the elimination of settlement risk altogether by
shifting the market to trades that simply settle the gain or loss associated with exchange rate
movements -- called "contracts for difference" -- instead of requiring delivery of the underlying
currencies.
We are well aware that many market participants are currently debating what
constitutes the most efficient multi-currency netting and settlement services. While there will be
potential winners and losers, I believe that the market as a whole should ultimately benefit from
this rigorous competition. At the same time, settlement risk reduction should not be used to
justify the concentration of market power. The G-10 central bank governors have long been on
record in favor of fair and open access to services that permit participation by a broad range of
institutions, consistent with the prudent management of risk. Such access was formally adopted
as a requirement for multilateral netting systems, and I am convinced that the G-10 central banks
would apply a similar standard when evaluating the start-up of any major multi-currency
settlement service.
In sum, the evolution toward more transparent foreign exchange markets that
we've observed in the past several years is largely a product of both technological progress in
the private sector and conscious policy decisions in the public sector. None of the policy
decisions, I should stress, were taken with any explicit or implicit intention of reducing market
volatility. On the contrary, the policy community has viewed moves toward increased
transparency as desirable ends in and of themselves for a number of reasons.
For one, transparency promotes a more level playing field for all market
participants. In other words, transparent markets tend not to be dominated by just a few players.
Rather, they are open to new entrants, large and small. In such markets, no one group of
institutions or type of institution can develop a monopoly on information or competitive pricing.
As in most industries, competition in the area of financial services spurs innovation, better
service for customers, and a more efficient allocation of resources.
Second, transparency in these markets also promotes investment. If money and
investment fund managers or corporate CFOs can better understand the risks entailed in various
investment alternatives, they are more likely to make the investment decisions best suited to
their needs. The result, again, is a more efficient allocation of global capital than would
otherwise be possible.
To the extent, therefore, that reduced volatility in the foreign exchange market
stems from improved transparency, I would view this result as a beneficial by-product -- one
that also contributes to the ultimate goal of economic and monetary policy: namely, sustained
growth and a stable price environment.
The move toward increased transparency in global markets and the accompanying
relative decline in foreign exchange market volatility and trading ranges that we have observed
in the last year and a half have posed considerable challenges to market makers, spot traders, and
brokers, on both an institutional and a personal level. There is an axiom in these markets that
volatility is good for market makers. I believe that this is a short-sighted view. On the contrary, I
would submit that excessive volatility not only frightens investors, but also potentially
undermines growth and, in so doing, benefits none of us.
As a result, I cannot help but conclude that stable -- and not volatile -- markets are
in the best interests of both central banks and the financial community. Stability in foreign
exchange and other financial markets, along with price stability, is vital to the promotion of
sustainable economic growth and rising living standards for everyone. Reducing the diversion of
resources to deal with uncertainty and volatility allows resources to be directed toward more
productive uses and, in so doing, promotes long-term growth by increasing the resource base
available to the economy.
We have seen in high-inflation economies how the transfer of resources away
from productive activities and into financial transactions geared toward dealing with inflation
uncertainty can negatively affect growth. We have also seen how a proliferation of tax code
dodges can decrease the available resource base. If individuals must spend more time engaging
in financial maneuvers because of uncertainty, then more of the economy's productive capacity
is transferred to the activity of handling transactions. An expansion of the financial sector that
stems from an increasing number of people employed to handle distortions arising from inflation
and its attendant uncertainty is growth that diverts resources better employed elsewhere. By
contrast, an expansion of the financial sector that stems from growth of productivity is growth
that offers benefits to all.
The same basic principle applies to the foreign exchange market. Foreign
exchange rates are fundamentally determined by market forces and should be free to fluctuate as
a vital adjustment mechanism for the global economy. However, excessive volatility, like price
instability, can diminish resources otherwise available for productive growth. The economy in
which we live and work is a global one, and becomes more so every year. Regions and industries
in need of private capital and investors requiring adequate returns benefit when money can move
across national boundaries without excessive risk or hedging costs. Foreign exchange markets
that are more stable and more transparent ultimately will better allow investors to allocate their
capital efficiently, thereby improving global economic growth.
Change is difficult in any industry and can put enormous stress on individuals.
I'm not ignoring this dynamic. However, I am persuaded that, in the long run, what is good for
economic growth is in the best interests of the financial community, and, in turn, benefits the
individuals that make up that community. Just as U.S. industries went through enormous stress
in the 1970s and 1980s in coping with a new era of expanding international trade and emerged in
the 1990s as among the most competitive in the world, so too must global financial institutions
adapt and find new ways to add value and share in the larger benefits that transparency and
reduced volatility can bring.
We central bankers can contribute to this process. While we can do little to limit
market volatility directly, we can work toward more transparent markets supported by sound
infrastructure, and by these means lay the groundwork for market stability. And, while we're not
in the business of determining market rates or the ranges in which rates should trade, what we
are trying to do is move increasingly toward improving the transparency of our own operations
as an end in and of itself.
Our collective efforts, along with developments in information technology and
risk management techniques, have already contributed to improved market stability. The
growing, and successful, commitment of central banks to the achievement of price stability as
their primary goal is another crucial and positive contribution toward market stability.
Moreover, where we as central banks see gaps that develop in the global financial system, as we
did in the areas of market risk and settlement risk management, we play the role of facilitator to
private sector solutions. As central bankers, we tend to view our role in the global financial
markets as ensuring that the necessary infrastructure is in place to promote well-functioning
markets for all players. Then we step aside and let the markets take care of themselves.