Abstract: The full text is 20,000 words and is divided into four parts, so the reference materials are put first. It takes a certain amount of time to read, it is recommended to bookmark first! The professional vocabulary in the text is accompanied by examples, and there is no reading barrier as a whole. Starting from foreign exchange tools, you must think about it when reading, otherwise it will affect the subsequent reading.
References:
Asian Development Bank Reports/Documents:
COVID-19 Exposes Asian Banks' Vulnerability to US Dollar Funding
Bank for International Settlements (BIS) report/document:
1. Covered interest parity lost: understanding the cross-currency basis
2. FX swaps and forwards: missing global debt?
3. BIS Quarterly Review: International banking and financial market developments
4. FX settlement risk remains significant
5. BIS Working Papers No 708: Global Banks Dollar Funding and Regulation
6. Triennial Central Bank Survey (Foreign exchange turnover in April 2019)
International Monetary Fund (IMF) documents/reports:
1. IMF Working Paper (WP/19/169): What Do Deviations from Covered llinterest Parity and Higher FX Hedging CoSts Mean for Asia? (Most of the data and graphs in this article come from this report)
2. IMF Working Paper (WP/19/14): Covered Interest Parity Deviations: Macrofinancial Determinants
Bank of Japan documents/reports:
1. Recent Characteristics of FX Markets in Asia—A Comparison of Japan, Singapore, and Hong Kong SAR—
2. Recent Trends in Cross-currency Basis
This time, let’s talk about the global foreign exchange market. First look at the picture below, which is the past and present state of the global foreign exchange market.
>> From fixed exchange rate to floating exchange rate: the birth of the foreign exchange market
1. Bretton Woods
The chart on the left is a snapshot of the Bretton Woods system in 1955, in its heyday. What are the most typical characteristics? The dollar and gold are at the center of the entire currency reserve.
At that time, the monetary system of the world was established around the US dollar and gold. Yen, mark, pound sterling, franc, lira, Canadian dollar, etc. All currencies are pegged to the dollar, and the dollar is pegged to gold. Only the U.S. dollar and gold are called international currency reserve assets, others are not.
To put it another way, whether it is Japan, Germany, the United Kingdom, France, or other countries, if banks want to lend, they must have reserve assets, otherwise they will not be able to expand credit.
The exchange rate formed by the Bretton Woods system is fixed. This system was disintegrated on August 15, 1971, when the United States announced that it would stop the gold exchange, close the gold window, and then disintegrate. Since 1971, China has gradually entered the era of floating exchange rates.
2. Floating exchange rate
Looking at the chart on the right again, the US dollar is still in a dominant position, which is called the central currency in the foreign exchange market. What is central currency? For example, if the Japanese yen is exchanged for the British pound, it must first be exchanged for the US dollar, and then the US dollar should be exchanged for the British pound. This is the central currency.
Compared with the Bretton Woods system era, the current international reserve assets have changed. All currencies are called reserve currencies. It is an international currency reserve asset. As long as a country has these foreign exchange reserves, it can carry out credit expansion.
Gold was behind the U.S. dollar back then, and now each reserve currency is backed by its own national debt. Therefore, the Leyton Woods system is also called the gold standard or the gold exchange standard. Now it is called the national debt standard. Behind the currency of any country, its core collateral is national debt, which is the biggest difference between the two eras.
3. The birth of the exchange rate market
When was the foreign exchange market born? Before the 1970s, there was no so-called foreign exchange market, because the currencies of these countries were all locked, the exchange rate was completely fixed, and there was nothing to exchange. So there is no foreign exchange market.
The foreign exchange market was formed in the 1970s, developed in the 1980s, and is now the largest financial market in the world. It was after the disintegration of the Bretton Woods system that the floating exchange rate was formed and the foreign exchange market emerged.
>> Dollar Hegemony: Enjoy Privileges, No Responsibilities
In the era of fixed exchange rates, the U.S. dollar enjoys the privilege of being an international reserve currency, and at the same time assumes the dual responsibilities of stabilizing the value of the U.S. dollar and stabilizing the exchange rate. To stabilize the currency value internally and to stabilize the exchange rate externally, of course, all of these need to be linked to gold.
In the era of floating exchange rates, which is now, the US dollar still dominates and becomes the central currency. The exchange between currencies of various countries mainly relies on the US dollar as an intermediary, but the US dollar does not undertake any corresponding international obligations. The Federal Reserve's monetary policy only considers its own domestic factors, and does not consider what problems will arise in the economies of countries affected by the dollar around the world.
The picture below (the red line represents 2016, and the blue line represents 2019) is one of the statistics of the global foreign exchange market trading volume. In fact, it always takes the lead in the transaction, that is to say, the US dollar must occupy one of the two sides in the transaction. The US dollar accounted for 88.3% of the total.
>> Four pillars of dollar hegemony
As a global settlement currency, the U.S. dollar enjoys currency hegemony, and U.S. dollar hegemony consists of four main pillars: global foreign exchange reserve currency, trade settlement currency, cross-border investment currency, and financial asset currency.
What are the cornerstones that make up these four pillars? It is the dominant position of the U.S. dollar in the foreign exchange market, and the exchange between all currencies basically goes through the U.S. dollar.
We always talk about the stock market and the bond market. Compared with the foreign exchange market, these are child's play. At this stage, the total transaction volume of the global foreign exchange market is as high as 6.6 trillion U.S. dollars per day, which is an astronomical figure. In 2019, the transaction volume with the US dollar as the counterparty accounted for 88.3% of the total foreign exchange transaction volume, which was further increased than that in 2016.
In other words, in the past three years, the proportion of the US dollar in transactions has actually increased. Many people say that the U.S. dollar is dying, or that the U.S. dollar has become increasingly unacceptable. Wrong, from a statistical point of view, the status of the dollar has not been weakened, but strengthened. Whether it is investment, trade, reserves, or financial assets, various countries are more dependent on the US dollar than they were three years ago.
Over the past three years, the euro has grown slightly, from 31.4% to 32.3%. The yen has clearly contracted. In 2016 it was 21.6%, in 2019 it was 16.8. Emerging market currencies have increased significantly, from 21% in 2016 to 24.5% now.
The trade between the dollar and the euro remains the largest in the world. Another opponent, the dollar and the yen, shrank sharply, from 17.8% to 13.2%. The US dollar and British pound increased slightly, from 9.3% to 9.6%, a small gain. The fastest growth is the US dollar and the currencies of emerging market countries, which have risen from 17.1% in 2016 to 20.2% now, which shows that the currency influence of emerging countries is growing.
>> Five foreign exchange markets
At present, there are five major foreign exchange trading centers in the world. From the perspective of transaction volume, among the five major trading centers, the UK alone accounts for 43.1%, accounting for almost half of the country. The daily transaction size is close to 3.6 trillion. It is a well-deserved foreign exchange trading capital, far exceeding other countries.
Relatively speaking, the United States is much worse than the United Kingdom. The transaction volume of the United States only accounts for 16.5% of the total transaction volume in the world.
London is still the center of foreign exchange transactions in the world, and a large number of financial derivatives are carried out in London.
Little Singapore is also very good, accounting for 7.6% of the total global foreign exchange transactions, and Hong Kong is similar to Singapore. Japan fell, with the volume of transactions falling to 4.5%.
>> Logical framework for US dollar exchange rate
Look at the picture below first, this picture is very important.
We know that the U.S. dollar is the central currency. All currencies are first converted into U.S. dollars and then converted into other currencies. What factors affect the U.S. dollar exchange rate market? How is the price in US dollars determined?
There are too many factors that can affect the exchange rate of the U.S. dollar, coming from all directions, such as problems in Iran, geopolitical conflicts, political economy, and so on. It feels very chaotic.
The following simply straightens out this logical relationship. As shown in the figure, the supply side of the dollar is on the left, the demand side is on the right, and the foreign exchange market is formed in the middle. On the left and right, apart from the central bank, the rest are institutions that can provide US dollar financing to the foreign exchange market.
From this picture, we can clearly see at a glance where the dollars in the world come from, and what is the basic relationship between the supply and demand of dollars in the international foreign exchange market.
1. USD Supply
1.1 Federal Reserve
Let’s first look at the supply of dollars. Of course, the Federal Reserve is the main source of dollars, and all dollars have to come from there. The Federal Reserve and foreign central banks conduct central bank currency swaps.
In the event of a financial crisis, the Federal Reserve can open the central bank’s currency swap channel and send out U.S. dollars, so that these central banks can provide U.S. dollars to their financial institutions to alleviate the U.S. dollar shortage. It should be noted that the currency swap between central banks is not a normal mechanism, but an emergency measure under a crisis.
1.2 Financial institutions
In addition to the Federal Reserve, the rest are some financial institutions or companies, which are the main force of the dollar supply side under normal circumstances.
Those financial institutions or companies can make cross-border investments, such as American companies investing in the UK, and sending US dollars to different continents, regions, and countries in the form of investment.
1.3 International trade
There is also international trade, which will generate an outflow of dollars. For example, the United States orders a batch of goods from China, and he needs to pay dollars, and then the dollars flow in through the foreign exchange deficit. For ease of reference, we call it the trade dollar, which is one of the sources of supply for foreign exchange transactions around the world.
1.4 Banks
Added to this, of course, is the long-term dollar financing provided by Bank of America. These dollar credits, dollar financing, dollar bonds constitute another source.
1.5 Monetary Fund
Monetary funds provide short-term financing, a few days, a few weeks or a few months. Generally speaking, the time span of long-term financing is not as long. The main supplier is the U.S. monetary fund, which, as a capital supplier, provides short-term U.S. dollar financing to financial markets around the world.
We can look at where the funds provided by the monetary fund go? In fact, it mainly flowed into the US money market. Examples include the repo market, commercial paper, Eurodollars, and certificates of deposit. Of course, there are many places such as federal funds, short-term treasury bonds, etc., but these places are not directly related to the foreign exchange market. The four places that are directly related are the repo market.
The money flowing in from the currency fund flows into the foreign exchange market after passing through the US money market. Therefore, the dollar has 4 taps. Of course, there are remaining leaders, such as foreign exchange reserves, sovereign wealth funds, etc., but the proportion is not large.
Some people may have doubts here, the proportion of foreign exchange reserves is not large? China claims to have 4 trillion foreign exchange reserves. If it is thrown out, it will be a nuclear bomb. Will it have a big impact?
Accounts are not calculated that way. Of the 4 trillion foreign exchange reserves, first you have to deduct non-dollar assets such as the yen and the euro, which is about 1 trillion.
Secondly, according to international regulations, a country's foreign exchange reserves must at least meet the country's import and export trade funds for three months. China is a big exporter, and this amount accounts for about 500 billion.
Then the BRICS Bank, AIIB and other capital accounted for 200 billion U.S. dollars.
The two companies' bonds with poor liquidity are about 200 billion (the main players in the two companies' bond market are the United States and China, so when the money is really short, it is difficult to cash out the bonds).
In the end, the external debt was 1 trillion yuan, which cannot be moved.
Do the math, how much money do you have left? 1 trillion. I remember that in 2016 or 2017, China's foreign exchange reserves dropped by more than 200 billion, causing the stock market to plummet. At that time, some people said that 4 trillion was less than 200 billion, which is drizzle. In fact, it is not. The available foreign exchange reserves have been reduced by one-fifth, which is already very powerful. That's why it is said that foreign exchange reserves account for a small proportion of the US dollar supply.
2. USD demand
After talking about the supply of dollars, let's talk about the demand for dollars.
In the international foreign exchange market, who needs US dollars? Of course foreigners need dollars. International asset management companies, insurance companies, and then enterprises, governments, and banks all need dollars. Because they have more or less dollar assets and dollars, they need dollars for financing. Even if the amount is large, risk hedging is required.
Therefore, no matter what the purpose is, if you want to hold US dollar assets, you must continuously obtain US dollars from the external market.
The U.S. financial system has continuously exported dollars to the world for many years, so the foreign exchange market is getting bigger and bigger. This is the flow chart we see.
3. International foreign exchange market
There are five major instruments in the international foreign exchange market: foreign exchange swaps, currency basis swaps, foreign exchange spot, forward contracts, options and other products. (will be described later)
In this market, the supply side and the demand side of the dollar use the above tools to realize dollar borrowing, financing, hedging and arbitrage, etc.
In the figure, it can be seen that the international foreign exchange market is actually a platform created by connecting the currency market of the United States with the currency markets of other countries. The currency markets of various countries and the currency markets of the United States are related through the foreign exchange market.
In the past two years, a term has appeared, the dollar circulation. The center of dollar circulation is the currency market, and the connection between currency markets is through the foreign exchange market.
Add
