Box 14: The Foreign Exchange Market By 2010 the foreign exchange market had grown to be the largest and most liquid market in the world, with an average of more than $4 trillion of currency being exchanged (settled*) every day.28 Banks located in the UK dominate the foreign exchange market, accounting for 37 per cent of all foreign exchange market turnover, with banks based in the United States accounting for 18 per cent, Japan 6 per cent, Singapore 5 per cent, Switzerland 5 per cent, Hong Kong SAR 5 per cent and Australia 4 per cent. Of the currencies that are traded, the US dollar is the most prominent, accounting for 85 per cent of all transactions. The other key currencies are the euro, accounting for 37 per cent of all transactions, the Japanese yen accounting for 17 per cent and the pound sterling at 15 per cent†. 29
Any large commercial bank that deals in foreign currencies, including nearly all major high street banks, will have reserve accounts not only in their home country’s central bank but also at the central banks responsible for those foreign currencies. Let’s look at what happens when one currency is exchanged for another in terms of commercial bank money and central bank reserves. Let’s say that Jim, an American, has just got a job in London and wants to buy a house that costs £1m. Jim banks with Citibank and has both a dollar account in the US and a sterling account in the UK (figure 21). Let’s assume the exchange rate is US$1.50 = £1.00. He instructs Citibank to transfer $1.5m to his UK Citibank account. Jim will see his US dollar bank balance fall by $1.5m and his UK bank balance increase by £1m (after any fees from the bank) Behind the scenes, his US Citibank will do a ‘spot trade’ (see Appendix 3.2.1), seeking out a UK bank, say Barclays, which wishes to buy dollars in exchange for sterling. The US Citibank will send dollar reserves from its account at the Federal Reserve (the US central bank) to Barclay’s reserve account at the Federal Reserve. Both exchanges take place within the US monetary system. In the UK, Barclays’ will send sterling reserves from its account at the BoE to UK Citibank’s account at the BoE (all in the UK system). In terms of reserves, Barclays in the US has received dollar reserves and in return, Barclays in the UK has sent pound reserves to Citibank in the UK. Thus in both countries the total level of reserves are the same.