Financial and Non-financial Customers

According to the 1998 survey, 49 percent of the foreign exchangetrading activity in the over-the-counter marketrepresented “interdealer” transactions, that is,trading by the 93 reporting dealers amongthemselves and with comparable dealers abroad.Of the remaining 51 percent of total foreignexchange transactions, financial (non-dealer)customers accounted for 31 percent, and nonfinancialcustomers 20 percent.

The range of financial and nonfinancial customers includes such counterparties as:
smaller commercial banks and investmentbanks that do not act as major dealers, firms and corporations that are buying or selling foreign exchange because they (or the
customers for whom they are acting) are in theprocess of buying or selling something else(a product, a service, or a financial asset),managers of money funds,mutual funds, hedgefunds, and pension funds; and even high networth individuals.

For such intermediaries and end-users, the foreign exchange transaction is part of the payments process—that is, a means of completing some commercial, investment,
speculative, or hedging activity. Over the years, the universe of foreign exchange end-users has changed markedly, reflecting the changing financial environment. By far the most striking change has been the spectacular growth in the activity of those
engaged in international capital movements for investment purposes.

A generation ago,with relatively modest overseas investment flows, foreign exchange activity in the United States was focused on international trade in goods and services. Importers and exporters accounted for the bulk of the foreign exchange that was bought from and sold to final customers in the United States as they financed the nation’s overseas trade. But investment to and from overseas—as indicated by the capital flows, cross-border bank claims, and securities transactions reported expanded far more rapidly than has trade.

Institutional investors, insurance companies, pension funds,mutual funds, hedge funds, and other investment funds have, in recent years, become major participants in the foreign exchange markets. Many of these investors have begun to take a more global approach to portfolio management. Even though these institutions in the aggregate still hold only a relatively small proportion (5 to 10percent) of their investments in foreign currency denominated assets, the amounts these institutions control are so large that they have become key players in the foreign exchange market.

In the United States, for example, mutual funds have grown to more than $5 trillion in total assets, pension funds are close to
$3 trillion, and insurance companies about $2 1/2 trillion. The hedge funds, though far smaller in total assets, also are able to play an important role, given their frequent use of high leverage and, in many cases, their investors’ financial strength and higher tolerance for risk. Given the large magnitudes of these institutions’ assets, even a modest shift in emphasis toward foreign investment can mean large increases in foreign exchange transactions.

In addition, there has been a tendency among many funds managers worldwide to manage
their investments much more actively, and with greater focus on short-term results. Rapid growth in derivatives and the development of new financial instruments also have fostered international investment. Reflecting these developments, portfolio investment has come to play a very prominent role in the foreign exchange market and
accounts for a large share of foreign exchange market activity.

The role of portfolio investment may continue to grow rapidly, as fund managers and investors increase the level of funds invested abroad, which is still quite modest, especially relative to the corresponding levels in many other advanced economies.