The Basics of Foreign Trade and Exchange

Role of Central Bank

Despite the size and importance of the foreign exchange market, it remains largely unregulated. There is no international organization that supervises it, nor any institution that sets rules. However, since the advent of the flexible exchange rate system in 1973, governments and central banks, such as the Federal Reserve System in the United States, occasionally intervene to maintain stability in the FX market.

There is no standard definition of instability or a disorderly market—circumstance must be evaluated on a case-by-case basis. Sharp rapid fluctuations of exchange rates and traders’ reluctance to be ready to either buy or sell currencies (maintaining a “two-way” market) may be signs of disorderly market.

To restore stability, the central banks often work together. However, a country taking a conservative view on intervention would act only in response to unusual circumstances that require immediate action, like political unrest or natural disasters. Most monetary authorities would be less likely to intervene to counteract the fundamental forces that drive FX markets, such as trade patterns, interest rate differentials and capital flows.

Intervention

The U.S. Treasury has the overall responsibility for managing the U.S. government’s foreign currency holdings. It works closely with the Federal Reserve to regulate the dollar’s position in the FX markets. If the Treasury feels that there is a need to weaken or strengthen the dollar, it instructs the Federal Reserve Bank of New York to intervene in the FX market as Treasury’s agent. The Federal Reserve uses the Exchange Stabilization Fund (ESF) to finance these interventions. Learn more about the ESF Your browser may not support display of this image..

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