03 December 2008

Interbank foreign exchange market

In recent weeks, foreign exchange transactions between financial institutions have been carried out in accordance with temporary arrangements based on the Central Bank of Iceland's currency auction market. The Central Bank has been virtually the only provider of foreign exchange on this market, and the exchange rate has been determined by other parties' purchase offers and the Central Bank's decision in each instance. A new arrangement will take effect tomorrow. Emphasis will be placed on creating the most effective market possible, with the most effective price formation possible. This requires a sound framework and transparent transactions.

After consulting with financial institutions, the Central Bank has adopted Rules on the Foreign Exchange Market. The Rules, which take effect tomorrow, Thursday, December 4, 2008, assume that financial institutions will become market makers in the foreign exchange market. The requirements concerning amounts and frequency of quotes are less stringent than those which market makers were previously obliged to meet in the interbank market. There are two reasons for this: financial institutions have less capacity than before to engage in large-scale business, and it is considered desirable that the group of market makers be expanded to include undertakings other than the three banks that carried out this task previously. At first, there will be three market makers – NBI, New Glitnir, and New Kaupthing – but others are expected to join them.

The exchange rate of the króna must be determined by supply and demand in the marketplace, and not by the sale of foreign exchange from the Central Bank's reserves. The new arrangement promotes orderly development in this regard. It cannot be ruled out that the Central Bank might participate in the foreign exchange market in the near future. If the Bank does so, it will be with the aim of controlling excessive volatility and not to support any particular exchange rate. Improvements in foreign exchange framework will be based on the submittal of foreign-denominated export revenues to domestic financial institutions and on the trading of currency by these institutions on an organised market.

As the Board of Governors stated in its policy statement of November 28, the real exchange rate of the króna is extraordinarily low at present. A sharp turnaround in the trade account, tight monetary policy, and the Rules on Foreign Exchange, which took effect last Friday, after Parliament had passed an act amending the Foreign Exchange Act, are conducive to the strengthening of the króna.

No. 46/2008
December 3, 2008