The Development of the Foreign-Currency Market in Israel since July 1994

September 13, 2000

The Development of the Foreign-Currency Market in Israel Since July 1994


The average volume of daily trading in Israel’s foreign-currency market rose from only $ 300 million in 1995 to $ 800 million in 1999. While the interbank bid-offer spread in foreign-currency trading in Israel is higher than in several other countries, the volatility of the shekel exchange rate is lower, on average. The rise in trading turnover in Israel in recent years reflects inter alia the greater involvement of foreign investors. The foreign-currency market in Israel has become more efficient in the last few years, following the transition to a more advanced trading method six years ago, the liberalization of the financial markets, and the Bank of Israel’s strategy of non-intervention in the context of the increased flexibility of the exchange-rate regime.

The Foreign Currency Department of the Bank of Israel reports that daily trading turnover in the foreign-currency market-regular exchange transactions and swaps-has risen considerably in recent years, from about $ 300 million in 1995 to about $ 800 million on average in 1999. This development, as well as other developments discussed below, took place in the context of the change in the foreign-currency trading system in July 1994, the liberalization of the financial markets, and the greater flexibility of the exchange-rate band which has enabled the Bank of Israel to adopt a strategy of non-intervention in this market. These developments encouraged Israel’s integration in the process of globalization and the growing involvement in Israel of foreign investors. Nonetheless, the extent of trading in Israel is still miniscule in global terms.

As will be recalled, within the framework of the continuous bilateral trading method-the conventional method of trading in currency markets worldwide-foreign-currency trading in Israel is conducted throughout the trading day, with banks serving as market-makers and quoting prices for transactions between buyers and sellers. Thus, the exchange rate fluctuates throughout the trading day in accordance with supply and demand. Between 1990 and 1994 the multilateral trading method was used in Israel’s foreign-currency trading, in which at midday each trading day the commercial banks transferred their surplus supply of and demand for foreign currency to the Bank of Israel. Under that system, after a brief period of electronic trading, the Bank of Israel bought or sold the surplus supply of and demand for foreign currency at the end of trading, thereby determining the exchange rate in effect for all transactions executed that day. Only in a few instances was trading concluded and the rate set without the Bank of Israel’s intervention.

The Foreign Currency Department also reported that most of the rise in the volume of daily trading in foreign currency reflects an increase in transactions between banks and their customers while the level of interbank transactions has remained more or less stable. Concurrently, the volume of swap transactions has soared-from a daily average of $ 90 million in 1997 to $ 300 million in 1999. This rise reflects mainly the growing involvement in Israel of foreign investors-particularly foreign financial institutions operating in Israel’s foreign-currency market for themselves and their customers. The Foreign Currency Department explained that swap transactions, in which one currency is sold against another with an undertaking to repurchase it at a predetermined exchange rate, enable foreign investors to operate in Israel’s capital market without being exposed to local-currency exchange-rate risk. In addition, the volume of foreign-currency trading between the banks and their customers-excluding swap transactions-has risen from a daily average of $ 200 million in 1995 to $ 400 million in 1999.

The Foreign Currency Department also noted that since November 1996 a broker has been operating in Israel, serving as an intermediary between banks. This activity has served to increase interbank competition and to reduce the bid-ask spread between buying and selling prices in interbank foreign-currency trading.

The bid-offer spread between buying and selling prices in interbank foreign-currency trading is usually less than 0.5 agora. This spread widens in situations of uncertainty, and in October 1998 it was 10 agorot. Note that the spread in Israel’s foreign-currency market is higher not only than it is in more liquid currency markets abroad, such as the dollar against the euro and the yen, but it is also wider than in less liquid markets, such as Sweden and Greece. Notwithstanding, there are countries-e.g., the Czech Republic, New Zealand-where the spread is relatively greater.

The Foreign Currency Department stated that the volatility of the shekel against the currency basket, i.e., the average standard deviation of daily changes in the exchange rate, has risen in recent years against the backdrop of the transition to the continuous bilateral method of foreign-currency trading and the Bank of Israel’s non-intervention policy in the foreign-currency market. The Bank of Israel has adopted a policy of not intervening in this market in the last three years. Despite the greater volatility of the shekel exchange rate, it is still lower than that of other currencies, apparently because the shekel-in contrast with similar currencies-is traded primarily in Israel and not in international markets. Past experience, and especially that of the last two years, has shown that the Shekel exchange rate is very sensitive to shocks. Thus, in August-November 1998 it fluctuated widely, more than other currencies. At the same time, the intra-day volatility of the shekel against the currency basket-defined as the difference between the highest and lowest rates in interbank trading that day-has not changed substantially since the continuous bilateral trading method was introduced. However, this volatility also rises markedly in periods of uncertainty on the foreign-currency market.