Why is an automatic price-matching transaction maintained after the introduction of OTC transactions?
OTC approach is a basic practice in the international foreign exchange market and accounts for most of the trading volume in spot transactions globally. For example, OTC transactions in the U.S. made up more than 90 percent of the total foreign exchange trading volume in that country. Given the international nature of foreign exchange transactions and market participants' wide-spread physical presence and diversity, OTC has the advantages of lowering cost and diversifying credit risks. Thanks to its flexibility, OTC transactions have developed rapidly and offered increasingly rich products as they adapt to the diversity of market participants and their varying demands.
When China reformed its foreign exchange management system in 1994, it was not realistic to adopt the OTC approach, given the weak credit basis and regional segregation of foreign exchange markets at that time. For the managed floating exchange rate regime based on market supply and demand to function smoothly and to replace dual exchange rates with a single exchange rate, the People's Bank of China decided to set up a centralized, automatic price-matching, inter-bank foreign exchange market. In the past 11 years, this market saw substantial growth, its trading volume reaching US$209 billion in 2004, 3.2 times of the trading volume in 1995. Along with the increase in trading volume and in market participants, demand for transactions and risk management has diversified day by day, and the introduction of OTC has become an objective necessity, as a way to encourage financial institutions to make full use of the comparative advantages of the OTC and automatic price-matching transactions, and to engage in financial innovation to satisfy the risk management needs of enterprises and households, under the precondition of effective risk control.
On July 21, 2005, the reform of the RMB exchange rate regime was implemented smoothly. The goal of RMB exchange rate reform is to establish and improve a managed floating exchange rate regime based on market supply and demand and keep the RMB exchange rate basically stable at an adaptive and equilibrium level. Therefore, an important part in improving RMB exchange rate regime is to deepen and broaden the foreign exchange market in line with established practice in international foreign exchange market development, form a multi-layered foreign exchange market system with a variety of transaction modes that fully reflects changes in market demand and supply.
In an effort to implement the reform in a proactive, controllable and gradual way, the People's Bank of China introduced over-the-counter transactions in the inter-bank RMB forward market in August 2005. In the four months since then, the forward market has functioned smoothly. The market has been brisk and trading volume grown larger and larger. In order to further develop the foreign exchange market, improve RMB exchange rate regime and enhance the core competitiveness of financial institutions, the People's Bank of China has decided to introduce OTC transactions as of January 4, 2006.
Considering that small and medium sized financial institutions may find it difficult to acquire credit authorization in the early days of OTC transactions, it is necessary to keep automatic price-matching transactions in the inter-bank spot market.