How Does the Government Regulate Exchange Rates?

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••• These forex traders in Kabul, Afghanistan, are influenced by government policies, but probably not regulated. Photo: Doug McKinlay/Getty Images

The government regulates exchange rates only indirectly. That's because most exchange rates are set on the open foreign exchange market. In countries like China, where the rate is fixed, the government directly changes the rate. This action of China affects the U.S. Dollar because the yuan, the Chinese currency, is loosely pegged to it.

The U.S. government has various tools to influence the U.S. dollar exchange rate against foreign currencies. An independent arm of the government is the nation's central bank, the Federal Reserve. It indirectly changes exchange rates when it raises or lowers the fed funds rate.

For example, if it lowers the rate, that drives down interest rates throughout the U.S. banking system. It also reduces the supply of money. Both of these results make the dollar stronger relative to other currencies. That's because U.S. dollar-denominated credit has become more expensive. At the same time, dollar-denominated assets generate a higher return. Both create more demand for the dollar, while taking it out of circulation. The laws of demand and supply tell you that less supply and more demand drives up the price.

When that happens to the dollar, it can purchase more foreign currency on forex markets.

The Treasury Department is a government agency that also indirectly affects the exchange rate. It prints more money. This increases the supply and weakens the dollar. It can also borrow more money from other countries. That's done by selling Treasury notes. That not only increases the supply of money, it also increases the debt. Both will send the dollar's value down.

The third government tool is expansionary fiscal policies. They weaken the dollar by increasing the money supply. But these policies can also improve economic growth. That often makes investors demand more dollars as a safe haven. It's like a vote of confidence in the economy. Sometimes this demand is so high that investors overlook the low interest rate they are getting by investing in dollars or U.S. Treasurys. The demand is even greater than the expansion in supply of dollars.

Exchange rates, Treasury notes, and foreign exchange reserves offer three ways to measure the value of the dollar. Although the government is powerful in influencing exchange rates, it is still forex trading that actually changes them.

How the Government Regulates Foreign Exchange Trading

The Chicago Futures Trading Commission regulates the forex brokers. It oversees all U.S. forex brokerage companies, enforces its regulations, and prosecutes outright fraud. Its authority was strengthened in 2010 with the Dodd-Frank Wall Street Reform Act.

Approximately 95 percent of the $5.3 trillion traded daily on forex markets are spot currency transactions, rather than futures transactions. Since they consist of two-day delivery rather than cash, they are considered the same as futures contracts. For this reason, brokers must register as a Commodity Trading Advisor, a Futures Commission Merchant, an Introducing Broker, or a Commodity Pool Operator with the Commodity Futures Trading Commission and become members of the National Futures Association.

 

The U.S. National Futures Association is a self-regulating association. All U.S. forex brokers operating for other U.S. clients must register. The NFA’s objective is to protect the integrity of U.S. markets and to protect investors from fraud. But it doesn't get involved with the value of any particular currency.

In addition, banks are responsible for most of the trades. The Federal Reserve regulates many of them. For example, in 2013, the Fed required banks to add more liquidity. They began buying Treasurys since they could be sold for cash whenever crisis threatened. The 25 largest banks increased their Treasury holdings by 88 percent in February 2015. It pushed down yields on long-term Treasurys. That strengthened the dollar. 

How bonds affect the stock market could depend on how the economy is doing.  If the economy slows down, investors may prefer to invest in safer instruments, such as bonds, rather than in the more unpredictable stocks. But this is not a formulaic response because sometimes stocks and bonds can go up or down in value at the same time.

The U.S. Treasury Department is also on the lookout for any price-fixing in forex trading