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 flowsThe 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 
.
The Federal Reserve Bank of New York buys dollars and sells foreign currency to support the value of the dollar. The Fed also sells dollars and buys foreign currency to try and exert downward pressure on the price of the dollar.
The transactions in the intervention are small compared to the total volume of trading in the FX market and these actions do not shift the balance of supply and demand immediately. Instead, intervention is used as a device to signal a desired exchange rate movement and affect the behavior of investors in the FX market.
The frequency of intervention in the FX markets by the U.S. monetary authorities has reduced tremendously over the last decade. The Federal Reserve Bank of New York intervened only twice since 1995.
Central banks in other countries have similar concerns about their currencies and sometimes intervene in the FX markets as well. Usually, intervention operations are undertaken in coordination with other central banks.
Most of the Federal Reserve Bank of New York’s activities in the foreign exchange market are for far less dramatic purposes than to influence exchange rates. The New York Fed often intervenes in the FX market as an agent for other central banks and international organizations to execute transactions related to flows of international capital.
Learn more about the Federal Reserve Bank’s role in the FX market.
Some countries have special arrangements with other countries to help them keep their currencies stable. Many less developed countries have their soft currencies pegged to hard currencies, so their value rises and falls simultaneously with the stronger currency. Some peg, or target, their currency to a basket of hard currencies, the average of a group of selected currencies.
Countries that are part of the European Union (EU) had pegged their currencies to the euro. There were formulas set for converting from the euro to the currency of each member nation. However, since January 2002, all currencies that were part of the Economic and Monetary System of the EU ceased to exist.
Intervention in the FX market is not the only way monetary authorities can affect the value of their countries’ currencies. Central banks can also affect foreign exchange rates indirectly by influencing interest rates.
| Higher interest rates è | Value of currency goes up | è Investors want to buy currency to invest at high rates |
| German interest rate è 8% | U.S. interest rate 3% | è Demand for German mark goes up |
Eurocurrency, especially eurodollars (approximately two-thirds of Eurocurrency are U.S. dollars) are a source of concern to central banks and regulators because they are "stateless money"—subject to very little regulation. Rules governing currency and bank deposits— such as taxes, restrictions on capital movements and exchange controls—do not apply to the currency in the Eurocurrency markets.
Banks around the world use the Eurocurrency market to move and store funds more profitably than they could in many countries. This poses a problem for countries attempting to regulate capital flows.
International trade and foreign exchange cannot be viewed as two separate economic processes. The two are intimately connected on many levels. Increased trade and investment has brought the FX markets to their present level. Together, trade and foreign exchange affect peoples’ living standards and livelihoods all over the world.
Recent research by Kumar Venkataraman, finance professor at SMU's Cox School of Business, and Hendrik Bessembinder offers insight and evidence into new possibilities and difficult issues facing stock exchanges. In “Does an electronic stock exchange need an upstairs market?” from the July, 2003 issue of Journal of Financial Economics, the authors find that a large proportion of institutional trading in electronic exchanges is executed away from the centralized book in the informal 'upstairs market', thus presenting new challenges.
Despite the efficiencies of computerized markets, virtually every stock market is accompanied by a parallel "upstairs" market, where larger traders employ the services of brokerage firms to locate counterparties and negotiate trade terms. Upstairs markets are based on relationships. Rather than submitting an electronic order to effortlessly attract counterparties, the upstairs brokers seek out counterparties (from traders known to them who might be interested). They then negotiate transactions that might otherwise be executed at an inordinate cost or delay. An electronic trading system lowers the fixed costs of trading for relatively liquid stocks in block sizes not likely to overwhelm the current market. However, it does not allow for the informal exchange of information (?) that is important for certain types of large trades and for illiquid stocks.
In electronic markets, traders don’t get a sense of who they’re trading with, how much more the other party is trading, etc., and that information can be very important to some traders. Large (institutional) traders therefore seek other trading venues such as the 'upstairs market' to lower the risk of exposing their order positions, to ensure symmetric transfer of information, and to retain some of the give and take of the old open outcry market. Approximately 70% of block-size trade transactions are executed in the upstairs market in Paris.
The Paris Bourse provides an excellent illustration of the use of upstairs intermediation markets, because its electronic limit order market closely resembles the downstairs (electronic) markets envisioned by theorists. The best evidence from the Paris Bourse is that:
The second result is the most novel and arguably the most important. The upstairs broker completes transactions by searching for institutional investors who may be interested in the stock, but who have not as yet formally expressed their trading intentions. It is documented that executions costs of transactions completed by the upstairs broker average only 35% of what they would have paid if completed against limit orders in the centralized electronic exchange, suggesting that trading relationship and the informal exchange of information between upstairs brokers and institutional traders helps lower execution costs. One major challenge facing electronic markets is the lack of a comparable mechanism of certification of traders and information exchange.
The Euronext market allows large transactions in some stocks to be executed outside the quotes. Such outside-the-quote transactions are not permitted in United States markets. For eligible stocks in Paris, market participants agree to outside-the-quote execution mainly for more difficult trades and at times when downstairs liquidity is lacking. These likely represent trades that probably could not have been otherwise completed, suggesting that market quality can be enhanced by allowing participants more flexibility to execute blocks at prices outside the quotes. These findings are particularly relevant to U.S. markets because quoted spreads and depths have decreased substantially in the wake of decimalization.
The upstairs market in the Paris Bourse completes two-thirds of block trading volume, compared with 20% on the New York Stock Exchange (NYSE). A likely explanation is that the NYSE floor allows large traders to execute customized strategies through a floor broker, while avoiding the risks of order exposure. If orders submitted to electronic markets do not allow block initiators to limit order exposure and trade strategically, then order flow is likely to migrate to alternative trading venues such as the upstairs market. If you’re a liquidity trader, you don’t want the system to be anonymous. If you’re an informed trader you like anonymity because you can hide in the order flow.
To compete with broker-intermediated markets, the next generation of electronic trading systems needs to include features that better meet the needs of large traders, particularly the lack of anonymity. To allow large investors to manage order exposure in an electronic exchange, a wider range of order types that include state contingent exposure and execution algorithms need to be made available. The NYSE’s recently introduced “Conversion and Parity” (CAP) orders which are intended to be “smart” orders for large lots of stocks that are executed gradually through the day, contingent on market conditions, are a step in this direction.
The future of stock trading appears to be electronic, as competition is continually growing between the remaining traditional New York Stock Exchange specialist system against the relatively new, all Electronic Communications Networks, or ECNs. ECNs point to their speedy execution of large block trades, while specialist system proponents cite the role of specialists in maintaining orderly markets, especially under extraordinary conditions or for special types of orders.
The ECNs contend that an array of special interests profits at the expense of investors in even the most mundane exchange-directed trades. Machine-based systems, they argue, are much more efficient, because they speed up the execution mechanism and eliminate the need to deal an intermediary.
Historically, the 'market' (which, as noted, encompasses the totality of stock trading on all exchanges) has been slow to respond to technological innovation. Conversion to all-electronic trading could erode/eliminate the trading profits of floor specialists and the NYSE's "upstairs traders."
William Lupien, founder of the Instinet trading system and the OptiMark system, has been quoted as saying "I'd definitely say the ECNs are winning... Things happen awfully fast once you reach the tipping point. We're now at the tipping point."
Congress mandated the establishment of a national market system of multiple exchanges in 1975. Since then, ECNs have been developing rapidly.[citation needed]
One example of improved efficiency of ECNs is the prevention of front running, by which manual Wall Street traders use knowledge of a customer's incoming order to place their own orders so as to benefit from the perceived change to market direction that the introduction of a large order will cause. By executing large trades at lightning speed without manual intervention, ECNs make impossible this illegal practice, for which several NYSE floor brokers were investigated and severely fined in recent years.[citation needed] Under the specialist system, when the market sees a large trade in a name, other buyers are immediately able to look to see how big the trader is in the name, and make inferences about why s/he is selling or buying. All traders who are quick enough are able to use that information to anticipate price movements.
ECNs have changed ordinary stock transaction processing (like brokerage services before them) into a commodity-type business. ECNs could regulate the fairness of initial public offerings (IPOs), oversee Hambrecht's OpenIPO process, or measure the effectiveness of securities research and use transaction fees to subsidize small- and mid-cap research efforts.
Some[attribution needed], however, believe the answer will be some combination of the best of technology and "upstairs trading" — in other words, a hybrid model.
Trading 25,000 shares of Lucent stock (recent[when? ] quote: $2.80; recent[when? ] volume: 49,069,700) would be a relatively simple e-commerce transaction; trading 100 shares of Berkshire Hathaway Class A stock (recent quote: $88,710.00; recent volume: 450) may never be. The choice of system should be clear (but always that of the trader), based on the characteristics of the security to be traded.
Even with ECNs forming an important part of a national market system, opportunities presumably remain to profit from the spread between the bid and offer price. That is especially true for investment managers that direct huge trading volume, and own a stake in an ECN or specialist firm. For example, in its individual stock-brokerage accounts, "Fidelity Investments runs 29% of its undesignated orders in NYSE-listed stocks, and 37% of its undesignated market orders through the Boston Stock Exchange, where an affiliate controls a specialist post."
Fidelity says these arrangements are governed by a separate brokerage "order-flow management" team, which seeks to obtain the best possible execution for customers, and that its execution is highly rated.[citation needed]
