Finance ministers and central banks worldwide have been taking a number of actions to increase liquidity and stabilize financial markets. However, despite the recent drop in interbank lending rates which led to a marginal improvement in investor's appetite for risk, forex trading conditions remain relatively difficult.
For instance, liquidity in the currency market has been so thin that relatively small orders can potentially move exchange rates up or down by one or two pips. Moreover, the recent spike in exchange rate volatility has made banks reluctant to take the other side of many trades.
Lack of Liquidity Has Been Affecting the CLS, a Global Settlement System for Foreign Exchange Trades
In 2002, the world's largest banks created a global settlement system for managing settlement risk on foreign exchange trades. Continuous Linked Settlement, also known as CLS, was set up to mitigate the risk of default in interbank FX settlement and radically changed the way FX deals were settled. For instance, CLS allows financials institutions to settle payment instructions related to foreign exchange deals almost in real time, eliminating the time zone differences that can cause payment delays and give rise to settlement risk. As of September 2008, CLS was settling more than 1.5 million trading instructions a day in 17 currencies, which represent nearly 95% of global foreign exchange trading. Despite the benefits, the CLS also has some disadvantages and the system is very dependent on the credit worthiness of its members. For instance, to settle a trade through the CLS system, a bank delivers the currency it owes to the CLS Bank but that payment is not released unless the counterparty deposits the offsetting payment for the transaction. However, given more pressing needs elsewhere in their businesses, many banks have pulled the plug on their forex dealing exposure which means more illiquid markets and less competition in setting bid and ask rates.
Forex Trading Conditions Have Been More Difficult but the Currency Market is Still the Most Liquid
Even though, making forex trades has been more difficult over the last few days, the currency market is still the most liquid financial market in the world with an average daily volume of US$ 4 trillion, according by the Bank for International Settlement. This is more than three times the total amount of the stocks and futures markets combined. Moreover, there are several mechanisms you can use to mitigate the lack of liquidity which stems from the crisis in the global financial system. For instance, with a no-dealing-desk forex broker, every trade is executed with one the world's premier banks which compete to provide you with the best bid and ask prices. This competition between banks reduces the potential for market manipulation by price providers and the best spreads are streamed to you with a small markup.
Central Banks Have Been Injecting Liquidity into the Banking System. But Will They Succeed?
To some extent, there is a growing concern among international investors that the recent efforts to bail out banks around the world will fail to restore investor's confidence and avoid a global recession. In fact, judging by the recent price action, many investors have been reluctant to take leveraged positions on foreign currencies and liquidity in the forex market has been drying up due to a strong demand for U.S. dollars from financial institutions seeking a safe-haven currency. In addition, some companies have been keeping their money in house to meet their operational needs and there is even some speculation that foreign banks increased their demand for dollars to settle some credit derivatives contracts tied to the bankruptcy of Lehman Brothers. However, central banks have been pumping unprecedented amounts of cash into financial institutions, and the introduction by governments worldwide of several stimulus plans could lead to a substantial improvement in investor's confidence in the global financial system. Other reason to be optimistic is the recent sell off in commodities which should alleviate some pressure from the world economy. In fact, recent data on consumer prices points towards lower inflation going forward and lower interest rates could be the last defense of the world economy against a global recession. This week, the rate that banks use to charge each other for overnight loans in dollars fell to the lowest level in four years, and many investors are confident that lower borrowing rates in the interbank market could lead to a world wide recovery in the appetite for risky assets like higher yielding currencies.
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