While the 10 largest banks which make up the forex Interbank market account for over 75% of the daily trading volume, there is actually a level of participants with even more clout in the market. While generally nowhere near as active as the banks just mentioned, the Central Banks of countries also participate in the forex market, and as they have such deep pockets, have huge clout when they decide to enter the market.
There are two main reasons why a central bank would participate in the forex market which are:
1. To fix the value of its currency to a particular level: Unlike the main currencies which we are going to be focusing on in this course, the currencies of many developing countries are fixed in value to the dollar or to some other currency or basket of currencies. This is done to try and promote international competitiveness in the market and a currency environment that is more conducive to economic stability.
Probably the most talked about example of a country that does this is China who up until recently maintained a fixed value of their currency against the US Dollar. A central bank normally accomplishes this by buying their own currency when the value gets too weak creating more demand for the currency and therefore driving the value up, and selling their own currency when it gets to strong creating a greater supply of that currency and therefore lowering its value back to the desired level.
2. To protect the value of a floating currency from extreme movements: Unlike China and many other developing economies in the world, the US, The Euro Zone, Japan and the other major economies of the world have what is known as a floating exchange rate. Very simply what this means is that instead of having the value of the currency pegged to something else which therefore determines its value, the value of the currency is determined by market forces.
Although the values of these currencies float freely in the market most of the time, as a currency’s strength or weakness in the market has such a dramatic affect on a country’s international competitiveness, there are rare instances where a central bank will intervene in the market even with the major currencies. Normally this is only seen after large one directional moves in the market over a long period of time, to the point where the country’s stability or competitiveness is being severely damaged. As Japan’s economy relies heavily on exports the most notorious central bank for interventions is the Bank of Japan, however both the European Central Bank and the Federal Reserve have intervened in the currency markets in the pasts.
While some interventions have limited affect on exchange rates others, as you can see from the chart here of a past Bank of Japan intervention, can have a dramatic affect on the market.
Because of this often times a central bank can do what is termed a verbal intervention, where simply the talk of intervention is enough to have the desired affect on the market.