The foreign exchange (FX) swap market is one of the largest financial markets, generating nearly $4 trillion in new contracts on a daily basis. This is an enormous market that should be transparent and well-regulated, yet it is currently lacking in both of these aspects. The FX swap market is expanding rapidly and is very opaque, making it difficult to find key statistics related to the market.
FX swaps are derivatives where two parties exchange two different currencies. These swaps serve as an easy way for a party to obtain dollar or FX funds quickly. Banks are the main intermediaries in the FX swap market, and they handle different positions such as hedging, arbitrage, and market making.
The FX swap market is expanding rapidly due to factors such as profitability and advancements in technology. However, it remains heavily dominated by US banks, which account for more than 80% of positions in the market. The main risk posed by the FX swap market is the dollar squeeze, where entities without access to Fed dollars may struggle with large, short-term payment obligations.
Despite its large trade volume, the FX swap market lacks transparency and price efficiency. It is mostly unregulated and operated over the counter (OTC), making it difficult to assess the market’s stability during periods of financial distress.
In conclusion, the FX swap market requires regulatory management and effective risk management to ensure its stability and transparency. Technology and increased settlement through CLS may help alleviate some of these issues, but true reform will only come from increased intermediation competition or through regulatory intervention.
