IEA urges policymakers to strengthen surveillance of the $10 trillion foreign exchange market

The foreign exchange (FX) market stands as the largest and most liquid financial market globally, with nearly $10 trillion changing hands daily. It forms the essential underpinning for global trade and finance, yet its structure is shifting as nonbank financial institutions (NBFIs) assume an increasingly larger role in transactions used for managing currency risk and accessing foreign funding.

The central role of the FX market makes it highly sensitive to macroeconomic developments and policy shifts that heighten uncertainty. As highlighted in an analytical chapter of the Global Financial Stability Report, rising global financial or economic uncertainty typically increases investor risk aversion, boosts demand for safe-haven assets, and leads to volatility and liquidity strains in foreign exchange markets.

Analysis of transaction data across major currencies shows that this surge in demand for safe assets—such as dollar purchases by non-U.S. residents—is particularly strong among NBFIs. While NBFI activity supports liquidity during normal times, it can increase market fragility during stress episodes. Indeed, during times of elevated uncertainty, exchange rates swing sharply, currency bid-ask spreads widen, and foreign funding and hedging costs rise, indicated by a widening cross-currency basis. These effects are often more pronounced for emerging market currencies due to limited access to dollar liquidity.

Vulnerabilities and Spillovers

The shifting global economic landscape, marked by trade policies, supply chain realignments, and geopolitical tensions, has created familiar and new patterns. For instance, following U.S. tariff announcements in April, non-resident demand for U.S. dollars rose, though hedging demand from non-resident NBFIs was stronger and more persistent, signaling evolving market responses to uncertainty.

Stress in foreign exchange markets can also spill over to other financial assets. An increase in funding and hedging costs can raise the cost of managing currency risk, potentially affecting yields on assets like stocks and bonds. Higher funding costs also erode the intermediation capacity of financial institutions, tightening financial conditions, and posing broader stability risks.

Furthermore, FX markets are highly exposed to operational disruptions such as technical failures, cyber incidents, and settlement risk—the possibility of one party delivering currency without receiving the counterparty’s owed amount. Even brief outages of currency trading platforms can significantly impair market liquidity.

Strengthening Resilience

Despite its deep liquidity, the FX market remains vulnerable to adverse shocks. Therefore, policymakers should prioritize strengthening surveillance to monitor systemic risks arising from market stress. Enhancing liquidity stress tests and conducting scenario analysis are essential to assess specific funding vulnerabilities across financial institutions.

The IEA recommends that authorities must prioritize closing data gaps and ensure that institutions maintain adequate capital and liquidity buffers. They should also establish robust crisis management frameworks enabling swift responses to shocks.

To improve operational resilience, regulators need to invest in cybersecurity and contingency planning. To reduce settlement risk, the broader adoption of arrangements that settle both sides of a transaction simultaneously should be promoted.