FX MARKET DEVELOPMENT AND FINANCIAL STABILITY

Basic ingredients of FX market development

Place

*An active and vibrant interbank market, either exchange-traded or OTC

*An exchange-traded market

-highly regulated; prices are transparent; anonymity of counterparties; low settlement risk

*An OTC market

-prices less transparent; flexible contract; lower transaction cost

HK's experience

*Daily turnover of USD/HKD: US$24.3 bn (BIS 2001 Survey of Forex and Derivatives Market Activity)

*USD/HKD is traded in the OTC market through

-direct deals between banks (around 40%)

-deals through brokers (around 60%)

1. voice brokers - around 30%

2. electronic brokers (Reuters and EBS) - about 70%

*FX/MM brokers are regulated by HKMA under the Banking Ordinance. Currently, there are 13 approved brokers in Hong Kong.

Platform

FX settlement platform --

*through correspondent banks

*Payment versus Payment (PvP) settlement system in Hong Kong

*CLS

Advantages of PvP

*Elimination of Herstatt risk

*Application of bilateral counterparty trading limits may assume less importance

*Interbank liquidity improves as the traded currencies are put to immediate use in the respective clearing systems

*Enabling banks, in particular small and medium ones, to participate more actively in the FX market.

Product

*As in other major FX centres, there is a full range of FX products in Hong Kong

-spot trade, forward trade, currency options

*Range of interbank market products

-variety: IRS, basis swap, currency swaps

-tenors: from overnight to over 10 years

*With the above as building blocks, structured products can be tailor-made for institutional investors and retail customers

Overnight Index Swap

*Introduced in HK in July 2001

*SONIA in UK and EONIA in Europe

*fixed/floating interest rate swap, with the floating leg tied to a published index of an overnight reference rate contributed by HKFEDBA members

*the reference rate is the weighted average rates of all overnight HKD deals transacted through the contributing brokers

*helps market participants manage overnight interest rate risk

Pricing

*An efficient price discovery process requires active market players and high market transparency

*Fixing mechanism can increase transparency of the market and improve market liquidity. However, fixing for FX is rare nowadays given the depth and breadth of the market

In Hong Kong, there are fixings on the following money market instruments:

Participants

*A full range of FX market participants in HK - banks, brokers, corporations (both local and multinational)

*Professionalism and quality promoted through concerted efforts of industry associations

Self Regulatory Entities

*Major self-regulatory bodies in Hong Kong include:

-Hong Kong Foreign Exchange Market Practices Committee (MPC)

-ACI - The Financial Markets Association Of Hong Kong (ACI-HK)

-Hong Kong Capital Markets Association (HKCMA)

-Hong Kong Foreign Exchange and Deposit Brokers' Association (HKFEDBA)

*ACI-HK and MPC are responsible for the promotion of ethical conduct among market participants

*To upgrade the knowledge of market participants, ACI-HK and MPC have offered various training programs and seminars

*Co-operation and synergy in

-formulation of codes and standards

-product and market development

-training and accreditation of qualifications

-promotion of Hong Kong's role as a hub for treasury market business

Code of Practice

*ACI International Code of Conduct & Practice for the Financial Markets observed by players of major markets including Hong Kong

*The Working Group on Highly Leveraged Institutions (HLIs) under the Financial Stability Forum assessed challenges posed by HLIs and devised regulatory measures to minimise the destabilising potential

-one recommendation is the promotion of model FX trading guidelines (Davies Report, April 2000)

*Good practice guidelines for FX trading (Feb. 2001) following the Davies Report

-prohibit the deliberate exploitation of electronic dealing system to generate artificial pricing

-encourage heightened emphasis on market risk and credit management during times of market volatility

Regulatory concerns about FX market development - the case of Hong Kong

Regulatory Concerns

*A free and open FX market attracts the swift and massive flows of capital into and out of the market

*Challenge to fixed exchange rate regime

*Pressure on both strong and weak sides

*Coordinated manipulation in various markets exacerbates market volatility

*Cross market surveillance to be in place

The 1997/98 episode - FX and money market turbulence

Double market play in August 1998

*HK$ funding through supranational debt issues and related swaps (HK$ 43 bn or 9 times normal level)

*Short stock futures on major blue chip stocks

*Attack HK$ to engineer :

-sharp rise in HK$ interest rates

-sharp fall in stock market

*Take profits from

-short positions in stocks and stock futures

-long positions in HK$

Currency Board Strengthening

*Hong Kong does not believe in exchange controls - prohibited under Basic Law

*Hong Kong determined to bear cost of adjustment under currency board arrangements

*Two major reform themes

-Convertibility Undertaking

-Provision of liquidity under Discount Window

*Greater transparency and disclosure

Convertibility Undertaking

*Convertibility Undertaking extended to the Hong Kong dollar balances held in the clearing accounts maintained by banks with the HKMA

*Objective

-Clear demonstration of Government's commitment to the linked exchange rate system

Discount Window

*Concern to be addressed

-Small size of Aggregate Balance susceptible to market manipulation

*Objectives

-Give banks greater assurance of their access to day end liquidity

-Dampen excessive interest rate volatility

Other Measures

*Publication of the monetary base and the forecast change in the Aggregate Balance

*Explicit backing arrangement for coins

*Monthly disclosure of Currency Board Account

*Interest payments on EF paper to expand the monetary base

Central Bank Transparency

Increasing the transparency of central bank operations can:

*create a level playing field for all market participants

*smooth out unwarranted volatility arising from market misunderstanding the central bank's operations

*improve credibility of the central bank

Recent Strengthening of HKD

*Reasons:

-Improving fundamentals of the Hong Kong economy attracted hot money into Hong Kong

-Some speculative accounts who had shorted HKD positions, speculating HKD to depreciate, unwound their positions

-Speculation that if RMB were to appreciate, HKD would follow

To stabilise the spot USD/HKD, HKMA has been intervening the market since 23 September.

Market surveillance

*Owing to the inter-dependence of different financial markets, HKMA has set up a cross market surveillance framework to

-collect market intelligence and information of flows in various markets

-maintain close contacts with players in various financial markets

-identify areas of risk and vulnerability

-prevent systemic risk

*The Financial Stability Committee allows senior officials from the following regulatory bodies to exchange market intelligence and information

-HKMA

-Securities and Futures Commission

-Hong Kong Exchanges and Clearing Ltd.

-Financial Services Bureau

Concluding remarks

*FX market activity will increase in the Mainland alongside fast economic growth and investment activity

*An efficient market place with a cost-effective trading and settlement platform, professional participants, price transparency and a wide product variety is imperative to FX market development

*A cross-market surveillance framework is equally important to guard against volatile capital flows

*HK stands ready to share our market development experience with the Mainland authorities