FX Market Structure Change Brings Challenges: Liberty Street Economics

A new post from Liberty Street Economics, which operates under the auspices of the Federal Reserve Bank of New York, looks at the “fundamental” changes in the FX market structure and observes that maintaining a healthy price discovery process and fostering a level playing field among participants are areas to watch for challenges.

The post discusses the evolution of the FX market structure over the past 25 years in particular – observing that it is now 50 years since floating exchange rates were established – and suggests that the fragmentation of liquidity and the rise of non-bank liquidity providers has increased competition and provided new options to market participants, however, they may also have made price discovery more difficult in the FX market.

It notes the decline in market share at the primary trading platforms, as well as the growth of internalisation. These trends, along with larger market participants accessing data from a wider number of sources, “may have contributed to an increase in the information advantage of larger, more sophisticated market participants, who can dedicate more resources to assess the evolution of each exchange rate at high frequency”.

It adds that while electronification increases the availability of data and analytics and helps in reducing transaction costs, it also increases the risk that less-sophisticated market participants are disadvantaged relative to more technologically advanced, faster market participants, especially the non bank LPs.

The authors argue that these changes are relevant for their potential impact on the broader role of the dollar, observing that academic research shows that currency transaction environments and trading costs influence the selection of currencies for different roles, and these roles are synergistic. “From the vantage point of the United States, and as the dollar roles are strategic assets, our view is that the integrity, efficiency, and resilience of the FX market support the global economy, financial stability, and the public’s trust in the financial system,” the authors write.

Looking ahead, the post notes the ongoing efforts to reduce FX settlement risk, as well as to promote good behaviour through the FX Global Code – it also sees new challenges from the impending shift to T+1 settlement in securities markets.

On central bank digital currencies (CBDC), the authors observe, “If many countries adopt their own CBDCs, there will likely be far-reaching consequences for the fundamental structure and functioning of the global FX and payment ecosystem, including the role of the current intermediaries.”

With this in mind the post concludes by stating, “Our views are that research will have to focus on and identify the challenges that are likely to arise from these transitions and the broader evolution of the FX market. Global currencies play an essential role in both international trade and finance.

“For the US in particular, the dollar’s key international roles means that developments in this space bear further analysis and monitoring,” it continues. “As a well-functioning and resilient FX market is critical to the international economy, official institutions will then have to act decisively to foster beneficial outcomes in this immensely important global financial market.”

The full post, Alain Chaboud, Lisa Chung, Linda S. Goldberg, and Anna Nordstrom, “Towards Increasing Complexity: The Evolution of the FX Market,” Federal Reserve Bank of New York Liberty Street Economics, January 11, 2024,  can be found here.