Foreign Exchange MarketsStructure

THE FOREIGN exchange market is, by most accounts, the oldest, largest, and most extensive financial market in the world. Unlike the futures exchange, which brings buyers and sellers together in a central location, the forex market is not centrally located.  It is an over-the-counter market where buyers and sellers conduct business linked by telephones, computers, fax machines, and other means of instant communications. Among its participants are large corporations, commercial banks, money centers, pension funds and investment banking firms.  Foreign exchange involves trading one nation's currency for the currency of another nation.  As individuals or companies from one country trade across borders, the need for foreign currency arises.  For example, when a Pakistan importer buys Malaysian Palm Oil, either the importer needs Ringgits to pay the Malaysian merchant or the Malaysian merchant must accept Pak Rupees and convert them to Ringgits.  A trading differential develops and this is how profits are generated in the forex markets.  This is how profits are generated in the forex markets.

In its most recent triennial survey of foreign exchange markets, the Bank for International Settlements (BIS) estimated that average daily turnover in the global foreign exchange market was $1,190 billion in April 1995. In comparison, average daily turnover during the same period in the next largest financial market--US government securities--was $175 billion (excluding repurchase and reverse repurchase agreements); in the world's ten largest stock markets together, it was a mere $42 billion.

Players in the Market

Generally there are four levels of transactors or participants in a foreign exchange market. The first or the lowest level comprises of tourists, importers, exporters, investors and the like who are the immediate user and suppliers of foreign currencies. The next or second level consists of commercial banks which act as clearing houses between users and earners of foreign exchange. The foreign exchange brokers, through whom the commercial banks even out their foreign exchange inflows and. outflows among themselves are at the third level. The fourth and the highest level is the one of central

bank of a country, which acts as the lender or buyer of last resort when the total foreign exchange earnings and expenditures of the country are unequal. The central bank then either draws down its foreign exchange reserve or adds to them.

1. The State Bank of Pakistan:

State Bank of Pakistan (SBP) which is the Central Bank of the country has been entrusted with the responsibility for an ongoing effective supervision of the financial sector. The relevant provisions of law which vest powers in State Bank of Pakistan (SBP) to carry out inspection of banks are contained in the Banking Companies Ordinance, 1962. Besides, State Bank of Pakistan Act, 1956 and the Bank’s Nationalization Act, 1974, The Banking Companies (Recovery of Loans, Advances, Credits & Finances) Act, 1997 (Act No. XV of 1997), Companies Ordinance, 1984 and Statutory Regulatory Orders (SROs) are the relevant legislations which cover the activities concerning the financial sector.

The financial sector in Pakistan comprises of commercial banks, non-banking financial institutions (NBFIs), leasing companies, modarabas, mutual funds, stock exchange and insurance companies. Under the prevalent legislative structure the supervisory responsibilities in case of banks and non-banking financial institutions falls within legal ambit of State Bank of Pakistan while the rest of the financial institutions are monitored by other authorities such as Securities and Exchange Commission and Controller of Insurance.

Under the WTO commitments the operational status of branch network of foreign banks operating in Pakistan as on 12-12-1997 has been protected and frozen. However, existing foreign banks having less than 3 branches can have branches to the extent of maximum number of 3 only. New foreign banks desirous of entering banking business in Pakistan will now be required to incorporate as domestic bank under the local laws.

Equity participation of foreigners can be upto 49% in the total minimum capital of US $ 11.5 million, subject to the principle of reciprocity. The branches of foreign banks operating in Pakistan can also be converted into a local commercial bank by incorporating under the local laws and subject to a minimum paid up capital of Rs. 500 million provided foreign share holding is restricted to a maximum of 49%.

OPENING OF FOREIGN CURRENCY ACCOUNTS WITH BANKS IN PAKISTAN UNDER NEW SCHEME

Under the existing instructions, the Authorized Dealers (Banks authorized to deal in foreign exchange) without the prior approval of the State Bank, open foreign currency accounts in Pakistan of Pakistan national resident in of outside Pakistan including those having dual nationality. These accounts can also be opened in the joint names of residents and non-residents, Residents Firms and resident companies including investment banks and the companies incorporated in Pakistan with foreign share holding are also eligible to open and maintain foreign currency accounts. Charitable Trusts, Foundations ctc. which are exempt from payment of income tax can also open foreign currency accounts in Pakistan. This facility is also available to all foreign nationals residing abroad, all foreign firms/corporations other than banks incorporated and operating abroad provided these are owned by persons who are otherwise eligible to open foreign currency accounts. Foreign nationals residing in Pakistan and foreign firms and companies registered abroad and operating in Pakistan can also open and maintain foreign currency accounts with the Authorised Dealers provided the foreign exchange credited to such accounts does not represent their earnings abroad in respect of business conducted in Pakistan or services rendered by such foreign national and firms/companies while in Pakistan. These accounts can be fed by remittances received from abroad as well as cash deposits locally.

The Authorised Dealers are free to decide the rate of return on these accounts payable to the depositors. They are also free to recover reasonable bank charges on handling cash transactions in foreign currencies received into or paid out of such accounts.

The non-residents are exempted from payment of withholding tax and compulsory deduction of Zakat. Withdrawals from these accounts in the shape of cash currency notes is allowed and account holder is at liberty to make remittances from his account to the extent of his balance in his account.

ACCOUNTS OF DIPLOMATIC MISSIONS AND INTERNATIONAL ORGANISATIONS ETC.

The Diplomatic Missions’ staff in Pakistan, their Diplomatic Officers and home based members of the Missions’ staff in Pakistan, as also all international organizations in Pakistan and their expatriate employees are allowed to open special foreign currency accounts outside the scope of Foreign Currency Accounts Scheme for the purpose of receiving funds from abroad.

The diplomatic officers and home based members of the mission’s staff in Pakistan and the expatriate employees of International Organizations can withdraw in the shape of foreign currency notes from their foreign currency accounts without any restrictions. However, withdrawal in the shape of cash is not allowed from the official accounts of diplomatic missions and International Organizations.

EXCHANGE RATE MANAGEMENTAND BALANCE OF PAYMENTS

One of the major responsibilities of the State Bank is the maintenance of external value of the currency. In this regard, the Bank is required, among other measures taken by it, to regulate foreign exchange reserves of the country in line with the stipulations of the Foreign Exchange Act 1947. As an agent to the Government, the Bank has been authorised to purchase and sale gold, silver or approved foreign exchange and transactions of Special Drawing Rights with the International Monetary Fund under sub-sections 13(a) and 13(f) of Section 17 of the State Bank of Pakistan Act, 1956.

The Bank is responsible to keep the exchange rate of the rupee at an appropriate level and prevent it from wide fluctuations in order to maintain competitiveness of our exports and maintain stability in the foreign exchange market. To achieve the objective, various exchange policies have been adopted from time to time keeping in view the prevailing circumstances. Pak-rupee remained linked to Pound Sterling till September, 1971 and subsequently to U.S. Dollar. However, it was decided to adopt the managed floating exchange rate system w.e.f. January 8, 1982 under which the value of the rupee was determined on daily basis, with reference to a basket of currencies of Pakistan’s major trading partners and competitors. Adjustments were made in its value as and when the circumstances so warranted. During the course of time, an important development took place when Pakistan accepted obligations of Article-VIII, Section 2, 3 and 4 of the IMF Articles of Agreement,

thereby making the Pak-rupee convertible for current international transactions with effect from July 1, 1994.

After nuclear detonation by Pakistan in 1998, a two-tier exchange rate system was introduced w.e.f. 22nd July 1998, with a view to reduce the pressure on official reserves and prevent the economy to some extent from adverse implications of sanctions imposed on Pakistan. However, effective 19th May 1999, the exchange rate has been unified, with the introduction of market-based floating exchange rate system, under which the exchange rate is determined by the demand and supply positions in the foreign exchange market. The surrender requirement of foreign exchange receipts on account of exports and services, previously required to be made to State Bank through authorized dealers, has now been done away with and the commercial banks and other authorised dealers have been made free to hold and undertake transaction in foreign currencies.

As the custodian of country’s external reserves, the State Bank is also responsible for the management of the foreign exchange reserves. The task is being performed by an Investment Committee which, after taking into consideration the overall level of reserves, maturities and payment obligations, takes decision to make investment of surplus funds in such a manner that ensures liquidity of funds as well as maximises the earnings. These reserves are also being used for intervention in the foreign exchange market. For this purpose, a Foreign Exchange Dealing Room has been set up at the Central Directorate of State Bank of Pakistan and services of a ‘Forex Expert’ have been acquired.

Instruments of Monetary Policy

Before the financial sector reforms, monetary policy was conducted through administrative controls and quantitative restrictions on money and credit aggregates. After the introduction of financial sector reforms in the beginning of1990s, a number of fundamental changes were made in the conduct of monetary and credit management, which essentially marked a departure from administrative controls and quantitative credit restrictions to market-based monetary and credit management. The system of bank-specific credit ceilings as an instrument of money and credit control was gradually abolished in September, 1995.

Building on the introduction of an auction system for government securities, SBP now manages domestic liquidity, to a large extent, by intervening in the secondary market through Open Market Operations (OMOs). OMOs involve purchase or sale of government securities by the SBP in order to supply or absorb bank reserves. State Bank conducts OMO in the intervening period between public debt auctions. It buys and sells Government securities both outright and under repurchase agreements.

INTRODUCTION TO PAKISTAN’S BALANCE OF PAYMENTS

The credit entry for merchandise in Pakistan’s Balance of Payments is based mainly on proceeds of exports recorded by the Foreign Exchange Department. The money value against shipments of goods abroad is either realised in foreign exchange or in non-resident rupees. Both forms of settlement tend to improve the country’s international position: the former by increasing its reserves and the latter by decreasing its liabilities to foreigners.

The banks (i.e., the authorized dealers in foreign exchange) report each transaction in the currency of settlement. For purposes of aggregation, the amounts received in foreign currencies have been converted to Pakistan Rupees at the rates prevailing during the respective periods.

Consequent upon delinking of Pakistan Rupee from U.S.Dollar w.e.f. 8th February, 1982 transactions have been converted at midpoint of buying and selling rates.

The timing of transactions is related to the transfer of ownership of money and not the movement of goods across Pakistan’s international border. For example, if a foreign buyer makes an advance payment for purchase of cotton ahead of the normal export season, the Foreign Exchange Department will record it a receipt from exports as soon as a bank account is credited although the actual shipment or shipments may take place a few months later. Similarly, if Pakistan enters into a deferred payments agreement with a foreign country, the shipment of goods will precede the receipt of their money value. Here again, the sale proceeds will be recorded at the time when the money is received. Between these two extremes, the majority of transactions is financed by usance bills of 90-120

days maturity and accordingly the export proceeds lag behind the physical movement of commodities. This also holds good for merchandise sold on consignment basis.

For purposes of exchange record, the valuation depends on the terms of contract. Most of the deals are on f.o.b. basis but in some cases goods are shipped on c. & f. contracts. The recorded proceeds are, therefore, on a mixed basis. The balance of payments entry is arrived at a uniform f.o.b. valuation by deducting the element of freight and adjustment of coverage and timing from the total recorded figures of exports. This sophistication is, however, not possible for individual commodities and as such the figures presented here are on a mixed basis.

Upto June, 1965 the Bank compiled and released figures of export proceeds for eight commodities viz.; Cotton, Cotton Manufactures, Jute, Jute Manufactures, Hides and Skins, Tea, Wool and Miscellaneous.

In July, 1965, the list was elaborated to include 86 commodities. From July, 1967, twelve more commodities were added to the list which was further enlarged to cover 141 commodities from July, 1970.

From July, 1972, three digit commodity codes based on the Pakistan Standard Trade Classification (PSTC) were introduced and the previous group classification, i.e. primary products, semi-manufactured commodities and manufactured goods was replaced by the ten sections of PSTC as under:-

1. Foods & Live Animals

2. Beverages & Tobacco

3. Crude Materials

4. Mineral Fuels

5. Oils & Fats

6. Chemicals

7. Manufactured Goods

8. Machinery

9. Misc. Manufactures

10. Misc. Commodities

2. Commercial Banks

Commercial banks in Pakistan have been authorized to engage in one or the following which may include:The borrowing, raising, or taking up of money; the lending or advancing of money either upon or without security; the drawing, making, accepting, discounting, buying, selling, collecting and dealing in bills of exchange, hundis, promissory notes, coupons, drafts, debenture certificates, scrip’s and other instruments, and securities whether transferable or negotiable or not; the granting and issuing of letters of credit; traveler’s cheques and circular notes; the buying, selling and dealing in bullion and scrips; the buying and selling of foreign exchange including foreign bank notes; the acquiring, holding, issuing on commission, underwriting and dealing in stock, funds, shares, debentures, debenture-stocks, bonds, obligations, securities and investment of all kinds; the purchasing and selling of bonds, scrips bills of lading, railway receipts, warrants, debentures, certificates, receipts (participation term certificates, term finance certificates, musharika certificates, modarabah cer-tificates and such other instruments as may be approved by the State Bank or other forms of securities on behalf of constituents or others; the negotiating of loans and advances; the receiving of all kinds of bonds scrips or valuables on deposits or for safe custody or otherwise; the providing of safe deposit vaults; the collecting and transmitting of money and securities;

The State of the Market Although participants in the foreign exchange market are increasingly scattered around the globe, most transactions still take place in London, New York, and Tokyo. London dominates the foreign exchange markets, with 30 percent of all transactions; New York's share is 16 percent. Tokyo's share, now 10 percent, has been whittled away by the markets of Singapore and Hong Kong, which are fast gaining prominence. Singapore has become the world's fourth largest foreign exchange market, and Hong Kong has overtaken Switzerland to become the fifth largest. Even though 56 percent of the world's foreign exchange transactions are executed in the three largest financial centers, between one-half and three-fourths of daily turnover is cross-border during the centers' business hours, suggesting that one side of many transactions occurs outside of their business hours.

Market concentration

Nearly two-thirds of daily foreign exchange transactions take place between bank dealers. About 16 percent of transactions involve nonfinancial customers, an increasingly diverse group. Originally, this group consisted primarily of customers executing transactions related to trade; it now includes international investors, speculators, and other new players. The remaining 20 percent of transactions involve financial institutions other than bank dealers, mostly securities firms active in the international debt and equity markets that have entered the foreign exchange market as intermediaries, providing one-stop shopping for their customers.

Despite the growing diversity of customers, market concentration has increased since 1992, as the proportion of trading carried out by the top banks continues to rise. This trend is most evident in the smaller markets, which are being abandoned by foreign banks seeking to consolidate their business in the major centers, but it is also being seen in the major centers. Between 1992 and 1995, the market share of the top ten dealers in Tokyo rose from 44 percent to 51 percent, in New York from 41 percent to 47 percent, and in London from 43 percent to 44 percent. The top 20 banks accounted for 70 percent of daily foreign exchange transactions in New York in 1995, up from 60 percent in 1992, and 68 percent in London, up from 63 percent in 1992. The picture of the foreign exchange market that emerges from the 1995 survey resembles the flight map of a growing airline, in which the hubs are getting bigger and the spokes more numerous--and market participants are increasingly interconnected.

Liquidity

The foreign exchange market is highly liquid--transactions tend to be large and are executed frequently. A typical dealing institution writes between 3,000 and 4,000 trading tickets for foreign exchange transactions during an average 24-hour day, and about 50 percent more than that on a busy day. Quoted prices can change 20 times a minute for major currencies, with the dollar-deutsche mark rate changing up to 18,000 times during a single day. During periods of extreme stress, a single dealer may execute a trade every two to four minutes. Single transactions worth between $200 million and $500 million are not uncommon in the foreign exchange market and, at most times, do not affect prices. While often overshadowed by the spot market, there is a growing and vibrant derivatives market based on foreign exchange. Over-the-counter (OTC) derivative contracts involving foreign exchange accounted for 37 percent of the estimated $47.5 trillion in outstanding notional principal of derivatives contracts at the end of March 1995, as reported by the first BIS survey of derivatives. Since notional principal provides information only about the outstanding face value of the contracts being held and not about their economic value, the BIS estimates their gross market value as well. Foreign exchange contracts account for 64 percent of the gross market value of $2.2 trillion, which itself represents roughly 5 percent of reported notional principal. Of total OTC derivative contracts, 6 percent were foreign exchange options contracts. While this is still a relatively small percentage, there is keen interest in foreign exchange options products. The hedging strategies of many "exotic" and "plain vanilla" options require the continuous buying and selling of the underlying currencies to maintain risk-free hedges. Thus, they are often written on the most liquid foreign currencies, increasing the volumes traded in the spot market.

Systemic Risks

FREE-FLOATING EXCHANGE RATES CREATE RISK:

While all the above examples illustrate how currency exchange-rates can float in the forex market, free-floating currency exchange-rates create risk.  For example, when an American wine merchant contracts to buy 1,000 cases of French wine, the merchant may agree to pay in French francs, say 600 francs per case, when the vintage is ready for shipment in two years.  However, over the next two years, the value of the U.S. dollar could drop from 20 cents/franc to 40 cents/franc, raising the price of each case from $120 U.S. dollars to $240 U.S. dollars.  Thus, pricing the wine in francs exposes the American wine merchant to a currency exchange-rate risk.

Of course, if the wine was priced in dollars ($120 per case) it would relieve the American merchant from the currency exchange-rate risk.  But now the French wine producer would suffer, as the value of the dollar fell from 20cents/franc to 40cents/franc.  In this example the French merchant would only receive half as much per case (i.e., 300frncs).

Because of these risks, governments throughout history have intervened to fix currency exchange-rates.  In 1944, for example, western world leaders met in Bretton Woods, New Hampshire, to create the International Monetary Fund to cope with world economic and financial problems that occurred following the Great Depression and World War II.  As part of the agreement, the value of the U.S. dollar, the world's leading currency at the time, was set at 1/35 of an ounce of gold.  And, world central banks were asked to keep the exchange-rates of their currencies pegged to the dollar's gold content, with variations limited to plus or minus 1%.

Since 1944, there have been several instances when world leaders have met to adjust the fixed currency exchange-rate; but these rates have been abandoned over the years, and volatility in the market continues.  Firms exposed to currency-exchange risk have turned to the forex market and currency futures markets to manage these risks.  In the forex market, transactions are customized.

Firms exposed to currency-exchange risk have turned to the forex market and currency futures markets to manage these risks. In the forex market, transactions are customized where the rate of exchange and other terms are agreed upon by both parties.  Participation in the forex market is generally limited to very large customers.

It is precisely for this reason that we devote the energy required to do the homework to ensure that we have an advantage over individuals or concerns who count on luck for success.  As successful technicians we are not just analyzing and forecasting the direction of currency exchange-rates, we're also analyzing and forecasting the behavior of an assortment of people, cultures and nations, and how the mixture of these elements will determine the direction of the exchange-rates.

As technicians, we look behind every event that is traced out in our charts and relate it to the market participants whose interests were either impacted or benefited.  Only after the exchange-rate scenario in one event is understood, can we go on to the next exchange-rate change under examination.

Markets behave sequentially.  There is a prominent or an obscure thread of continuity and cause/effect rationale that ties each moment of market behavior to those that preceded it.  Our task, as trading technicians, is to find this thread. Having found it, we then exert every effort to follow it through each step of its meandering as it changes the value of a currency.  We also look back over a few hours, days, or weeks of price and trading volume to reach accurate conclusions about a particular currency's strengths and vulnerabilities.  Through this exercise we can determine whether a position should be established, increased, reduced or offset completely.

As technical traders, we must view price as the cause and changes in trading volume as the effect.  Price is both the trigger and the yardstick by which profits and losses are measured.

Settlement risks Despite its vast liquidity and geographic breadth--or perhaps, in part, because of them--the foreign exchange market has the capacity to bring modern global financial markets to their knees. Recognizing that the large and numerous cross-border settlements that accompany foreign exchange trading pose a systemic risk, the public and private sectors have proposed various mechanisms for managing this risk.

Transactions in the foreign exchange market take place at all hours of the day and night and, more often than not, involve institutions in different national jurisdictions. It is this last feature--the cross-border, cross-time-zone nature of the transactions--that poses the greatest challenge for the efficient settlement of the nearly $2.4 trillion two-way payments or the estimated 250,000 to 300,000 exchanges of currency every day. Large settlements pose at least two types of risk.

Herstatt riskThe first has been called Herstatt risk, after Bankhaus Herstatt, which failed to deliver US dollars to counterparties after it was ordered into liquidation by the German authorities in 1974. Banks are exposed to large amounts of cross-border settlement risk because irrevocable settlement of the separate legs of a foreign exchange transaction may be made at different times. For example, delivery of yen to a New York bank's Japanese correspondent bank in Tokyo occurs during Tokyo business hours, while the corresponding delivery of dollars by a New York bank to a Japanese counterparty's US correspondent bank in New York occurs during New York business hours. Since the two national payment systems are never open at the same time, there is the risk that after the first counterparty has delivered one side of the transaction, the other counterparty may go bankrupt and fail to deliver the offsetting currency. More than 20 years after the collapse of Herstatt, there is still no widely accepted method of quantifying settlement risk. The Foreign Exchange Committee, a private sector group sponsored by the Federal Reserve Bank of New York, was the first to survey foreign exchange dealers and provide a methodology for examining settlement risk, as well as a set of recommended best practices, in its report, "Reducing Foreign Exchange Settlement Risk." More recently, in March 1996, the Committee on Payment and Settlement Systems of the Group of Ten (the ten industrial countries with the largest economies) released the Allsopp Report, which, building on the earlier methodology, analyzes existing arrangements and sets out a strategy for reducing settlement risk. The Allsopp Report found that foreign exchange settlement is not just an intraday phenomenon and that payment lags can initially last at least one to two business days; another one to two business days may then elapse before a bank is assured that it has received the requisite payments. The amount at risk at a bank could exceed three days' worth of trades, so that the exposure to even a single counterparty could exceed a bank's capital. While the risk is only beginning to be recognized and quantified, recent foreign exchange payment defaults, including those of the Bank of Credit and Commerce International (BCCI) and Barings Plc, demonstrate that the risk cannot be ignored.

The liquidity riskThe second risk has to do with the possibility a counterparty will default because of an operational or systems problem that leaves it with insufficient liquidity to make payment. In most cases, operational failures can be resolved within 24 to 48 hours, and overnight funding can be obtained to cover a failed delivery of currency. It is not uncommon, however, to have more than $2 billion outstanding between banks overnight. A large operational failure could surpass

the ability of even some of the best-capitalized institutions to access money markets, especially when notice of the failure is received during off-hours in the institution's domestic market or when the undelivered currency is not one in which the exposed institution customarily borrows. This is an especially important issue in emerging markets, where the physical infrastructure for payment and settlement may not be adequate to accommodate transactions that are increasing in size and number.

Impact on financial marketsA counterparty that defaults because of either an insolvency or a liquidity problem could trigger a systemic problem. The most commonly articulated scenario is one in which the failure of one large bank causes a second bank to fail, in turn causing a third bank to fail, and so on--a "domino effect." Another situation might arise in which a small number of institutions independently fail to deliver, causing other institutions to fail or to encounter liquidity problems. These scenarios are more likely to occur when institutions are highly interdependent. Using actual gross settlement numbers from a day in 1994 when the yen appreciated against the dollar by 5 percent, Multinet, a multilateral foreign exchange netting facility under development, showed that the failure of the participant with the largest position within its system could have caused a number of other participants to fail.

Solutions to Reduce Risk

Proposals for managing settlement risk are based on two approaches: (1) eliminating the delay between the two legs of a transaction and (2) reducing the number and size of payments requiring settlement.

Simultaneity The first approach is based on the belief that settlement risk could be eliminated, or at least substantially reduced, if payments in the corresponding currencies were delivered and guaranteed simultaneously, thereby averting the possibility of default between the time one payment is made and the other is received. This approach requires important changes in arrangements for international payments. First, gaps in the operating hours of the major wholesale domestic payment systems would need to be closed. Second, some type of linked payment systems or verification of payments is required to guarantee intraday "finality of payment"--that is, the irrevocability of the payments and the ability of the counterparties to use their payments as soon as they are received.

The elimination of gaps in operating hours is fairly straightforward. While there is still much work to be done before every country has a payment system capable of processing and settling large-value transactions in real time (a "real-time gross settlement," or RTGS, system), improvement for the major currencies is expected in 1997 when the United States' RTGS system, Fedwire, will open at 12:30 a.m. local time. This will create an overlap between payment systems in the United States and Japan and increase the overlap between the US and German payment systems. More improvements should occur in 1999, when the Trans-European Automated Real-Time Gross Settlement Express Transfer (TARGET) system in Europe will link the existing and new RTGS systems of member countries in the European Union. The second change involves larger public policy issues and is more problematic. It is typically assumed that only a central bank can guarantee finality of payment in its own currency; the achievement of simultaneous finality would thus require the coordination of foreign exchange-related payments among central banks. Although it is technically feasible to create cross- border links within the RTGS systems run by the central banks so that, for example, verification that a yen payment has been received in Tokyo is made before the corresponding dollar payment is released in New York, there are difficult practical and political issues that need to be resolved. For example, one potential side effect of linking national RTGS systems is that a disruption at one site would affect other sites. This would be an especially difficult situation if the ability to access off-hour money markets were inhibited or the money markets were not deep enough to provide adequate liquidity for the duration of the disruption. Multiple central banks running such linked RTGS systems may be required to supply central bank credit and liquidity facilities until the site where the dislocation occurred is able to adapt. Questions regarding which banks would supply the credit, to whom, and for how long, and how excess funds would be "mopped up" after the event would all have to be addressed. There would be a need for increased international coordination of macroprudential, supervisory, and lender-of-last-resort policies. The central banks of the Group of Ten countries have thus far been reluctant to link their domestic payment systems and instead have pressed the private sector for solutions to settlement problems. One way to reduce settlement risk would be by altering or augmenting bank risk-management techniques. For example, credit risk control processes could be adapted to identify and control the foreign exchange settlement exposures of counterparties. Improved back office payment processing, correspondent banking arrangements, and bilateral netting capabilities may also reduce settlement risks. Altering the timing of payments and identifying final or failed receipts

as soon as possible could also help banks shorten the duration of settlement risks. These solutions require no public sector involvement and could substantially reduce settlement exposures. A more aggressive private sector approach being examined by 20 internationally active banks known as the Group of Twenty is to set up a "global clearing bank"--a private sector institution that would act as the link between national payment systems, verifying payments so that simultaneity could be achieved. While a global clearing bank appears to be, in principle, the most direct method for managing Herstatt risk, there are remaining challenges. First, the clearing bank's ability to guarantee finality of payment in each country is uncertain. Finality would require that the legal status of settlements be similar in all participating countries, which, in turn, requires that the participants address such issues as the clearing bank's location, corporate form, and relation to national settlement facilities. Second, the operation of a global clearing bank might have an impact on liquidity in short-term money markets and, thus, on management of liquidity by the central banks, and, perhaps, on monetary policy objectives. If a global clearing bank required its members to pay large sums of money into their accounts to cover large settlements, it might drain liquidity from domestic money markets. The loss of liquidity might offset the ability of a central bank to control short-term interest rates and provision of intraday liquidity to domestic money markets. Furthermore, until the RTGS systems involved in the settlement of the major currencies are operating 24 hours a day, the clearing bank's procedures may require funds to be available to support settlement during the short periods of overlapping hours between the various national RTGS systems. It is unclear whether sufficient liquidity would develop during these periods to support the settlement of cross-border transactions. Finally, a single system purporting to settle the majority of global foreign exchange payments would be vulnerable to technological failures; several redundant systems would probably be required to minimize this risk.

Reducing settlementsIn theory, a well-constructed global clearing bank could eliminate foreign currency settlement risk. However, the problems of harmonizing national laws and developing procedures for adequate liquidity provision, although not insurmountable, are difficult and time consuming. Because the development of such a bank is still in its early stages, private sector bilateral and multilateral netting arrangements are receiving increased attention. These arrangements are based on the second approach to managing settlement risk--that of dramatically lowering the size and number of payments.

Formal bilateral netting systems, available since 1990, periodically aggregate the amounts owed between counterparties and calculate one payment per currency for each pair of counterparties--there are no automatic payment facilities and the systems do not assume foreign exchange exposures. (Informal bilateral arrangements may be privately negotiated between counterparties at any time.) Bilateral netting can reduce amounts at risk by an estimated 50 percent, on average. Multilateral netting systems net the amounts owed among a group of counterparties through a clearinghouse arrangement, resulting in one payment each day in a given currency to or from the clearinghouse by each counterparty. While Multinet is still under development, another system, the Exchange Clearing House (ECHO), became available in August 1995. Multilateral netting can reduce settlement risk by 73 percent for a group of about 20 participants, and by as much as 95 percent for a bigger group. One of the primary difficulties faced by multilateral netting systems has been making netted contracts legally enforceable. Compared with other types of clearinghouses, a foreign exchange netting system cannot operate effectively without resolving the legal status of contracts in many different jurisdictions. The clearinghouse itself needs to be able to guarantee that the contracts it enters into are legally binding, and institutions from different legal jurisdictions need to guarantee their ability to net and enter into contracts with the clearinghouse. In addition, in situations of insolvency, the counterparties and clearinghouse need to assure themselves of access to collateral that may be held outside any of their legal jurisdictions. To attract members and satisfy regulators, netting systems need to ensure that the clearinghouse does not take on settlement exposures that cannot be covered in the unlikely event of a failed payment or the bankruptcy of a user. As a general rule, netting systems are required to meet the Lamfalussy minimum standards established by the Group of Ten's central banks, which require that the multilateral netting system "be capable of ensuring timely completion of daily settlements in the event of an inability to settle by the participant with the largest single net debit position." To meet this requirement, the multilateral netting system relies on a combination of real-time exposure limits, the collection of collateral or margin, and precise operating procedures for limiting the duration of settlement risks and for dealing with a defaulting member. To avoid transferring a failure to its other members, a multilateral netting system needs to be able to acquire funding if payments are withheld and to continue payments to other members. Multilateral netting systems have broached the funding issue either by holding collateral or by assuring themselves of outside sources of liquidity--for example, lines of credit and foreign exchange swap facilities, mostly

with member banks. However, it is unclear whether the systems can rely on lines of credit with member banks, because these may also be affected by a liquidity problem during a period of stress. Ultimately, then, central banks would serve as the backstop in a liquidity crisis, just as they do without private multilateral netting systems. It is worth emphasizing that netting systems are not stand-alone methods for eliminating settlement risk. After payments are netted, banks must still use a payment system that guarantees finality of payments. Thus, once the netting has been accomplished, the system's operating procedures are critical in determining the amount of time between the settlement of the two legs of the transactions. Both netting systems have the ability to collect payments from participants a few hours before releasing their payments to the recipient participants for currencies in which it is feasible to access large-value RTGS systems simultaneously, shortening the exposure period. But, unless there is simultaneous finality of received payments, there remains some degree of Herstatt risk. Two multilateral netting systems may not be sustainable. The degree of risk reduction is a function of the number of linked counterparties and is therefore greatest when all the largest participants join the same system. It may not be cost-effective for a single bank to become a member unless the other banks with which it does business join the same netting system. Furthermore, a bank may wait to see what its counterparties do, delaying realization of the system's full potential for risk reduction until enough banks join one netting system to make it cost-effective for the others. With the recent Group of Twenty initiative to develop a global clearing bank, the bilateral and multilateral netting systems face further challenges. While the two approaches to lowering Herstatt risk could be viewed as complementary, both require scarce funds from banks' foreign exchange trading businesses. Further, as competing approaches to the reduction of Herstatt risk present themselves, banks may wait until one system emerges a clear winner before attempting to reduce their own settlement exposures. But both the bilateral and the multilateral netting system and a global clearing bank are economically viable only for the transfer of large payments. Hence, competition among the groups developing methods to lower Herstatt risk may reduce the effectiveness of any one system and slow the adoption of strategies to reduce Herstatt risk.

The Foreign Exchange

Factors Effecting Exchange Rates: Economic forces determine exchange-rates.  In the forex, this type of free market environment is most often referred to as a floating exchange-rate environment.  In a floating exchange-rate environment, the exchange-rate responds to many factors including the flow of imports and exports, the flow of capital, relative inflation rates, etc.  Often, limits are placed on exchange-rate fluctuations according to government policies.

One factor affecting the exchange-rate between the Pak Rupee and other currencies is the merchandise trade balance.  By definition, the merchandise trade balance is the net difference between the value of merchandise being exported and imported into a particular country.  For example, consider the exchange-rate for Deutsche marks.  The United States imports products from Germany.  To pay for them, Americans need Deutsche marks; therefore, the U.S. companies trade U.S. dollar for Deutsche marks. On the other hand, because Germans desire American-made goods, they purchase U.S. dollars to pay for U.S. goods.  The net effect is an increase in the supply of Deutsche marks and U.S. dollars.

The American demand for German goods and services contributes to the demand for Deutsche marks while German purchases of American goods and services contribute to the supply of U.S. dollars.  In this case, the net difference between American purchases of German goods and services, and German purchases of American goods and services, is the merchandise trade balance between the two countries.

The flow of funds between countries to pay for stocks and bonds purchases also contributes to the currency exchange-rate between currencies.  In the near term, these capital flows are greatly influenced by yield differentials. All else being equal, the higher the yield on German securities compared to American securities, the more attractive German securities are relative to American securities.  An increase in German yields would tend to raise the flow of U.S. dollars into German securities as well as decrease the outflow of Deutsche marks to American securities.  Combined, this increased flow of funds into Germany would lower the value of the U.S. dollar and increase the value of the Deutsche mark, therefore, the Deutsche mark to U.S. dollar ("DM/USD") ratio, as it is represented in the forex market, would decrease.

The rate of inflation is another factor influencing currency exchange-rates. Consumers try to avoid the eroding effect inflation has on their purchasing power.  Consequently, goods from countries with a low inflation rate become more attractive than the goods from countries with higher inflation.  In turn, the currency from the lower inflation country rises in value, while the currency from the higher inflation country falls in value.  Both the inflation factor and the purchasing power of the currencies directly impact currency exchange-rates.

For example, if the United States is experiencing lower inflation than its trading partner Germany, the DM/USD ratio rises to reflect the growing price level in Germany relative to the United States.  This fact is rooted in the concept of a purchasing power parity , which holds that, over the long run, a currency exchange-rate adjusts to reflect the difference in price levels between countries.

How to Determine Foreign Exchange Rates:

1. MARKET ACTION DISCOUNTS EVERYTHING

There are three premises on which the technical approach is based: (1) market action discounts everything; (2) prices move in trends; and, (3) history repeats itself.

The statement, "market action discounts everything," forms what is probably the cornerstone of technical analysis.  Unless the full significance of this first premise is fully understood and accepted, nothing else that follows makes much sense.  We believe anything that can possibly affect a currency market price, i.e., fundamental, political, psychological, or otherwise, is actually reflected in the price of that market.  It follows, therefore, that a study of price action is all that is required. While this claim may seem presumptuous, it is hard to disagree with if one takes the time to consider its true meaning.

As a rule, chartists do not concern themselves with the reasons why prices rise or fall.  Very often, in the early stages of a price trend or at critical turning points, no one seems to know exactly why a market is performing a certain way.  While the technical approach may sometimes seem overly simplistic in its claims, the logic behind this first premise... "that markets discount everything..." becomes more compelling the more market experience one gains.

It follows then that if everything that affects market price is ultimately reflected in market price, then the study of that market price is all that is necessary.  By studying price charts and a host of supporting technical indicators, we in effect let the market tell us which way it is most likely to go.  We do not necessarily try to out-smart or out-guess the market.  We know there are reasons why markets go up or down, we just don't believe that knowing what those reasons are is necessary in the forecasting process.

2. PRICES MOVE IN TRENDS

The concept of trend is absolutely essential to our technical approach. Here again, unless one accepts the premise that markets do in fact trend, there's not any point in reading any further.  The whole purpose of charting the price action of a market is to identify trends in early stages of their development and then trade in the direction of those trends.  In fact, most of the techniques used in this approach are trend-following in nature, meaning that their intent is to identify and follow existing trends.

There is a corollary to the premise that prices move in trends, and a trend in motion is more likely to continue than to reverse.  This corollary is an adaptation of Newton's first law of motion.  Another way to state this corollary is that a trend in motion will continue in the same direction until it reverses.  This is another one of those technical claims that seems almost circular.  But the entire trend-following approach is predicated on riding an existing trend until it shows signs of reversing.

In accepting the premises of technical analysis, one can see why technicians believe their approach is superior to the fundamental approach.  If a trader had to choose only one of the two approaches to use, the choice would logically have to be the technical.  Because by definition, the technical approach includes the fundamental.  If the fundamentals are reflected in market price, then the study of those fundamentals becomes unnecessary.  Chart reading becomes a short-cut form of fundamental analysis.

The reverse however, is not true.  Fundamental analysis does not include a study of price action.  It is possible to trade in markets using just the technical approach, however, it is doubtful that anyone could trade using the fundamentals alone with out consideration of the technical side of the market.

CAN THE PAST BE USED TO PREDICT THE FUTURE?

The field of statistics makes a distinction between descriptive statistics and inductive statistics.  Descriptive statistics refers to the graphical presentation of data, such as the price data on a standard bar chart.  Inductive statistics refers to generalizations, predictions, or extrapolations that are inferred from that data.  Therefore, the price chart itself comes under the heading of the descriptive, while the analysis that technicians perform on price data falls into the realm of the inductive.

Population forecasts, industry forecasts, and the like are based in large part on what has happened in the past.  In business and in science, as well as in everyday life, we project our experience of the past in an effort to predict what may happen in the uncertain future.

So it seems that the use of past price data to predict the future [in technical analysis] is a well grounded statistical concept.  If anyone were to seriously question this aspect of technical forecasting, he or she would have to also question the validity of every other form of forecasting based on historical data, which includes all economic and fundamental analysis.

AUTOMATION, OPTIMIZATION, & PROFITABILITY TESTING

Once a technician has decided on the historical data he needs to analyze, it is then possible to automate the analysis using a computer.  The technician can put together certain analytical procedures or tasks, which can then be tied to the various data files, leaving the technician free to do other things, while the computer does all the work.  For example, a "Profitability Editor" allows the technician to test predetermined trading rules over historical data, and test for optimized results.

This ability to test any trading system or technical indicator over historical data and, at the same time, seek out the best parameters through the optimization process may prove to be the most valuable feature of the computer.  Finally, technical studies enable the more ambitious technicians, with some background in computer programming, to write their own analysis routines.

ELECTRONIC BROKING FOR MARKET PROFESSIONALS

In 1993, 12 of the world's leading foreign exchange banks came together to respond to the market's need for efficient, low cost, brokered dealing.

Today EBS is a partnership between 13 of the world's major market making banks and the Minex Corporation of Japan. Together, these 13 banks provide the majority of the liquidity to the foreign exchange market

Established in 1993 by 12 of the world's largest foreign exchange banks, EBS is the leading provider of electronic broking services to the interbank trading community. Today the EBS Partnership comprises subsidiaries of 13 banks and the Minex Corporation.

Together with its EBS Dealing Resources subsidiaries, EBS is a fully integrated supplier of a range of interbank transaction services marketed worldwide by EBS Dealing Resources' global network of sales and service offices.

EBS Dealing Resources' Netting & Credit Division is the licensee and supplier of the FXNET automated bilateral netting service, the first and largest netting system available to banks. Bilateral netting enables pairs of banks to reduce their foreign exchange obligations to a single payment per currency per value date.

THE FUTURE

With EBS' acknowledged expertise in the provision of low cost, efficient broking solutions to the FX market, we are constantly evaluating new business opportunities in other markets for future growth and expansion. In addition, we are always looking for new technology solutions to maintain the reliability and efficiency our customers demand.

A valuable addition

In July 2000, EBS launched precious metals trading on the EBS Spot Dealing System. In doing so, EBS became the first electronic broking platform in the interbank bullion market. Today over 50 banks including the leading market makers trade a significant amount of their spot gold and silver on EBS.

PRODUCTS

EBS provides a fully integrated range of dealing solutions to the professional interbank community. EBS' products are acknowledged world leaders and have been a driving force of change in the foreign exchange market since the launch of the EBS Dealing System in 1993.

The EBS Dealing System is the leading screen-based anonymous dealing system for trading interbank spot foreign exchange. With unrivalled liquidity in the major currency pairs, over 2,500 traders in 850 banks around the world today use EBS.

EBS Dealing Resources' Netting and Credit Division is the sole licensee and supplier of FXNET, the world's largest automated bilateral netting service, which is proven to reduce settlement risk by 50%.

The EBS Spot Dealing System is the leading screen-based anonymous dealing systems for trading inter bank spot foreign exchange, in all major currencies. Average daily volumes are in excess of $80bn.

Delivered over a proprietary network, it combines the features of voice-broking services with the latest technology for electronic trading. One to six currency pairs can be traded at any time with deals completed by keystroke or automatic deal matching within the system.

An important feature of EBS is its pre-screened credit facility - dealers can only see prices that they can 'hit', thereby eliminating the potential for failed deals because of counter party credit issues.

EBS is always looking at the markets in which it operates and upgrading the dealing system to meet changing market conditions. Feedback from our customers is an invaluable and integral part of this process. An Automated Systems Interface (ASI) provides an electronic interface between EBS and a bank's internal banking system applications, for straight through transaction processing and the elimination of duplicate trade entry activity.

FXNET BENEFITS

With nearly 100 user banks in fifteen countries, FXNET is the netting process of choice for major foreign exchange banks. In an ideal world

all foreign exchange transactions would be confirmed and settled in a risk-free payment-versus-payment environment. In reality the only effective way to reduce settlement risk today is with FXNET.

Operational Efficiency and Lower Costs FXNET interfaces to your back office system, eliminating completely the need to re-key transaction details. Deal confirmation messages for each trade are sent to the bank's local FXNET system, which automatically matches and confirms each deal and updates the bank's net position for each counter party, by currency and value date.

FXNET provides timely settlement and streamlined back office operations through full netting automation:

Real-time bilateral netting and exception reporting Automated deal matching and net settlement reconciliation, Used SWIFT message formats, Streamlined back-office processing Quantified payment/cost reduction, Quantified settlement risk reduction.

USING SYSTEM SIGNALS AS A DISCIPLINING DEVICE

Another advantage of computer automation is generating system signals which can be used simply as a mechanical confirmation along with other technical factors.  Even if a system is not being traded mechanically, and other technical factors are being employed, the signals could be used as a disciplined way to keep the trader on the right side of the major trend.  No short positions would be taken as long as the computer generated trend signal is up.  No long positions would be taken in a computer generated down-trend signal.

3. HISTORY REPEATS ITSELF

Much of the body of our technical analysis and our study of market action has to do with the study of human psychology.  Chart patterns for example, which have been identified and categorized over the past one hundred years, reflect certain pictures that appear on price charts.  These pictures reveal the psychology of the market.  Since these patterns have worked well in the past, we assume they will continue to work well in the future.  This is based on the study of

human psychology, which tends not to change.  Another way of saying this last premise is that "history repeats itself."  This means that the key to understanding the future lies in a study of the past, or that the future is just a repetition of the past.

TECHNICAL VERSUS FUNDAMENTAL FORECASTING

While technical analysis concentrates on the study of market action, fundamental analysis focuses on the economic forces which cause prices to move higher, or lower, or stay the same.  The fundamental approach examines all of the relevant factors affecting the exchange-rate between two currencies to determine the intrinsic value of each currency.  The intrinsic value is what the fundamentals indicate one currency is actually worth against another currency. If this intrinsic value is under the current market price, then the currency is overpriced and should be sold.  If market price is below the intrinsic value, then the market is undervalued and should be bought.

Both of these approaches to market forecasting attempt to solve the same problem, that is, to determine the direction prices are likely to move.  They just approach the problem from different directions.  A "fundamentalist" studies the cause of market movement, while a technician studies the effect.  We are market technicians, and we believe that the effect is all that we want or need to know, and that the reasons or the causes are unnecessary.  In contradistinction, a fundamentalist always has to know why.

Most market traders classify themselves as either technicians or fundamentalists.  In reality, there is a lot of overlap.  Most fundamentalists have a working knowledge of the basic tenets of chart analysis.  At the same time, most technicians have at least a passing awareness of the fundamentals.  The problem is that the charts and fundamentals are often in conflict with each other. Usually at the beginning of important market moves, the fundamentals do not explain or support what the market seems to be doing.  It is at these critical times in the trend that these two approaches seem to differ the most.  Usually they come back into sync at some point, but often too late for the trader to act.

One explanation for these seeming discrepancies is that market price tends to lead the known fundamentals.  Stated another way, market price acts as a leading indicator of the fundamentals or the conventional wisdom of the moment.  While the known fundamentals have already been discounted and are already "in the market," prices

are now reacting to the unknown fundamentals. Some of the most dramatic market movements in history have begun with little or no perceived change in the fundamentals.  By the time those changes became known, the new trend was well underway.

The technician learns to be comfortable in a situation where market movement disagrees with the so-called conventional wisdom.  A technician begins to like being in the minority.  He knows that eventually the reasons for market action will become common knowledge.  It is just that the technician is not willing to wait for that added confirmation.

USING SIGNALS AS ALERTS

Computer generated signals relieve a trader of some degree of uncertainty by preventing him from falling into the trap of top and bottom picking. The point here is simply that computer trend signals can be especially valuable even when used only as another technical indicator.  The computer can also be used as an excellent screening device to alert the trader to recent trend changes.  The computer just makes that task quicker, easier, and more authoritative.

The computer has made the technician's task easier by providing quick and easy access to a vast array of technical tools and indicators.  At the same time, the technician's work has been made more difficult.  Whereas before, the technical analyst only had to deal with a handful of favorite tools, now they have to contend with as many as forty different indicators at the same time.

Based on research in cognitive psychology, it is believed that the human mind has difficulty interrelating with more than three separate variables at the same time.  Therefore, the analyst trying to assimilate four or more indicators simultaneously may become overwhelmed.  If the analyst decides to follow only three indicators, which three are the best?

ARTIFICIAL INTELLIGENCE PATTERN RECOGNITION

The computer has been used almost exclusively in market analysis as a computational device.  Its main function has been to calculate and present data to save us time.  However, a more important use for the computer may be in the interpretation of all of the data it has calculated for us; that is, to use its logical powers along with its computational powers.  That brings us to the subject of Artificial Intelligence and Pattern Recognition.

Artificial Intelligence refers to the use of heuristic programs to solve problems in much the same way a person does.  The computer actually performs in a way that would be described as intelligent.  The computer assesses situations, makes decisions, and learns from mistakes.  Pattern Recognition enables the computer to learn how to make decisions and predictions based on classifications of different items or indicators.  The term "pattern" used in this context is different from the earlier use of the term to describe various chart patterns.  The intent in Pattern Recognition is to produce a synergistic effect by combining all of the indicators instead of treating each one individually.

The first step in the process is to find the best single indicator from all of those available.  The second step is to find the best pair of indicators.  The third step is to find the best three indicators used together.  That process is continued until the addition of a new indicator no longer improves the final combined result.

In the testing process, two different sets of data are used: learning and test data.  The results found in the learning data must then be confirmed on separate test data.  This technique of using two different sets of data prevents "curve-fitting," a charge often leveled against the testing of other technical methods, in particular, testing for optimized results.

The use of Artificial Intelligence and Pattern Recognition may hold the answer as to how to contend with so much conflicting information.  In dealing with conflicting information, the computer is asked to calculate all of the indicators and then to choose the best combination of those indicators to use in a given situation.  Because that solution seems so obvious, why isn't more work being done in that direction?  So far, this type of work has been applied mainly to academic situations and not to real world conditions.  The cost is huge and requires extensive computer power.  Even when patterns in the market are identified, they tend to be unstable and require constant re-testing.

ADVANTAGES AND DISADVANTAGES OF ELECTRONIC TRADING

Here are some of the pros and cons of mechanical system trading using computer-generated signals.  System trading represents a

"black box" approach to currency trading.  The technician does not have to get involved in the decision-making process, or for that matter, know or understand what's in the system.  Other computer oriented traders stay involved in the process and use computer-generated signals and indicators in the analytical process, but reserve the right to make the final market decision.

There is not any question that the growing dependence on computer trading systems, particularly by pooled private and public commodity funds, is having a greater influence on market trading.  The new game in the markets is trying to out-smart the computer funds.  The ability of those pooled funds to influence and even distort short-term market behavior is growing.  The proliferation of microcomputers with easy access to technical analysis routines, including on-line data, has increased the general level of sophistication of the average trader and caused more short-term trading.  Day trading has become more popular because of easier access to computer terminals that can chart intra-day data.  Where all this will lead is uncertain. However, it is clear that the computer is revolutionizing market trading.  One important fact emerges from all of this.  The market traders who do not have access to computer technology are placing themselves at a severe disadvantage.

ConclusionThe foreign exchange market has registered healthy increases in turnover and continues to be the most liquid of markets. However, the size and number of transactions, and the increased concentration of transactions in a handful of international banks place the foreign exchange market at the nexus of the global network of interbank payments. Any disruption in the settlement of foreign exchange transactions could have serious consequences for global trade and finance and for the international banking system. One of the main difficulties in settling foreign exchange payments is that it is not always possible to make final payments simultaneously. This creates a window in which one of the counterparties could fail to deliver, with possible repercussions for the international banking system. Both the private and the public sectors are aware of this difficulty and are pursuing several initiatives that will enable them to reduce and better manage foreign exchange settlement exposures. However, these initiatives are not yet comprehensive or coordinated. Their success will require vigilance and persistence on the part of central banks.