…urges stronger systemic risk monitoring, stress testing, scenario analysis
The Foreign Exchange (FX) market, now reaching nearly $10 trillion in daily turnover, is the world’s largest and most liquid financial market, but remains vulnerable to shocks, according to a new report by the International Monetary Fund (IMF).
This warning was published in a blog post entitled “Economic Uncertainty Can Test the Resilience of the Foreign Exchange Market”, co-authored by Andrea Deghi, Mahvash S. Qureshi, and Tomohiro Tsuruga, all experts in the IMF’s Monetary and Capital Markets Department.
The IMF emphasised that the FX market underpins global trade and finance, but its structure is evolving. Nonbank financial institutions (NBFIs) are playing an increasingly central role in managing currency risk and accessing foreign funding.
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Due to its centrality in the international financial system, the FX market is highly sensitive to macroeconomic changes and policy uncertainty. The IMF’s analysis, featured in the Global Financial Stability Report, shows that rising global uncertainty typically boosts investor demand for safe-haven assets like the US dollar, leading to increased volatility and liquidity strains.
For instance, during the March 2020 COVID-19 shock, dollar purchases by non-US residents surged by 24 percentage points in response to heightened financial uncertainty, measured through expected swings in US stock prices. This spike in safe-haven demand was particularly strong among NBFIs, whose activity can support liquidity during normal times but may amplify fragility during stress episodes.
Periods of uncertainty often trigger sharp currency swings, wider bid-ask spreads, and rising hedging and funding costs. These dynamics are captured using the “cross-currency basis,” a key stress indicator that reflects the cost of currency swaps. The impact tends to be more severe in emerging markets, which often lack deep dollar liquidity and robust financial infrastructure.
Recent geopolitical and policy shifts such as evolving trade tensions and supply chain changes have further tested market resilience. Following US tariff announcements in April, for example, nonresident demand for dollars increased, though less dramatically than during earlier shocks. Cross-country trading patterns also diverged, with some economies shifting to net dollar selling. Notably, hedging demand from nonresident NBFIs remained strong and persistent, signaling evolving market responses.
Stress in FX markets doesn’t remain contained. Rising funding and hedging costs can spill over to other asset classes, affecting yields and risk premiums in equities and bonds. These conditions can also strain financial institutions’ intermediation capacity, tightening overall financial conditions and increasing systemic risks.
Such spillover effects are particularly intense in economies with high macro-financial vulnerabilities, such as elevated public debt or significant foreign currency exposures across financial institutions.
Beyond economic shocks, FX markets are also vulnerable to operational disruptions, including cyberattacks, system outages, and settlement risks, the failure of one party to fulfill its side of a currency trade. The IMF notes that even short outages on trading platforms can severely impair market liquidity. Settlement risk is especially pronounced in emerging and developing markets that lack access to mechanisms like real-time simultaneous settlement systems.
Despite its deep liquidity, the FX market remains exposed to multiple forms of stress. The IMF calls on policymakers to strengthen market surveillance and address systemic risks more proactively. Enhanced stress testing and scenario analysis are critical for identifying vulnerabilities, especially in funding channels.
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Authorities should also close existing data gaps, ensure adequate capital and liquidity buffers in financial institutions, and establish strong crisis management frameworks for swift responses to shocks.
Operational resilience must also improve, the IMF urges, through greater investment in cybersecurity and contingency planning to protect critical market infrastructure. Broader adoption of simultaneous settlement systems could reduce settlement risk. Additionally, modernising trading platforms can help lower transaction costs, reduce volatility, and enhance reliability.
By advancing comprehensive surveillance, strengthening institutional safeguards, and embracing digital innovation, the FX market can be better positioned to support global financial stability.
