Nothing taxes the minds of international regulators more than the massive foreign exchange market.
But then again, no other asset class wields quite the power, or incites quite the emotion of the global currency markets. Finance ministers are slave to them, multinational companies live or die by them, speculators are addicted to them. Little wonder then, that the Swissbased Bank for International Settlements (BIS), arguably the most influential supervisor in the world, is currently trying to clean up the market's image.
Officials there privately admit they face a Herculean task. According to the bank's own figures, turnover in foreign exchange has more than doubled since 1989 to average a staggering $1.2trn a day. Around $500bn of that is generated in the cash or 'spot' market, the rest comes from derivatives deals such as forwards, swaps and over-the-counter options, which are even harder to police. Yet publicly, the BIS has issued something of an ultimatum to the market's major players: reduce the risks associated with moving such huge amounts of money around the place, or face swingeing new rules to blow the froth off the market.
That the BIS is targeting traders, rather than investors is significant. As much as 95% of total volume is now driven by banks and other financial institutions managing their own portfolios, rather than by clients managing their overseas earnings. According to the BIS, trading houses are often forced to wait days on end for counterparties to settle obligations running into billions of dollars. It is therefore supporting efforts to establish a global settlement bank to ensure that payments go through simultaneously and thus protect the markets from meltdown should a big bank be forced to close its doors.
If the foreign exchange markets are controlled by a relatively small number of trading houses, so too they are dominated by an even smaller number of currencies. More than three quarters of all foreign exchange trading involves the US dollar, the German mark or the Japanese yen. Together, the dollar and the mark account for almost all the trading in currencies such as the Swiss franc, the French franc and sterling. By establishing a new settlement bank which would allow players to lump all their outstanding trades together and make just one net payment at the end of the day, the BIS believes it could cut risk in the foreign exchange markets by more than 80%.
Surging foreign exchange volumes and intense regulatory pressure are, of course, two sides of the same coin. For just as the foreign exchange markets have grown in size, they have also grown in sophistication. According to Chris-topher Goekjian, president and CEO of Credit Suisse Financial Pro-ducts, investors are no longer interested in placing huge George Soros -style directional bets. Instead, he says, the smart money is looking for opportunities where the odds of turning a profit are a good deal more favourable than 50:50. If you make directional bets on individual currencies you stand only an evens chance of making money. So what you have to do is put on repeated bets with tight stop-losses and hope against hope that you come out ahead 51% of the time."
Richard Irving is executive editor of Risk magazine in London."