Domestic Foreign Exchange Market

The domestic foreign exchange market in Sri Lanka is two- fold;

1.    The client or retail market

This includes transactions involving individual or institutional customers.

2.    The inter-bank or wholesale market

This is mainly organized among authorized dealers in forex exchange, which comprises all licensed commercial banks. This market helps to manage foreign exchange liquidity within the banking system through currency conversion.

The Main Functions in Foreign Exchange Market

(i)    Convert currency of one country into a currency of another.
(ii)   Help minimize the risks arising from changes in the exchange rate through various derivative products.

Above features of the foreign exchange market facilitate

(i)    Funding imports
(ii)   Converting export proceeds
(iii)  Other foreign currency transactions

The Main Risk in the Foreign Exchange Market

The main risk is the volatility in the exchange rate; i.e., undue fluctuations in the rate at which one currency is converted in to another currency. If the volatility is excessive it would create instability in the foreign exchange market and thereby would affect the value of foreign currency assets and liabilities of individual institutions. There are derivative instruments available in the foreign exchange market such as swaps, options and forwards which help minimize the risk of exchange rate volatility.

Transactions in the foreign exchange market are carried out on one of the following basis.

(i)   Cash basis 

Immediate delivery of purchases/sales of a foreign currency on the same day.

(ii)  Tom basis 

Delivery of purchases/sales of a foreign currency the next business day.

(iii)  Spot basis 

Delivery of purchases/sales of a foreign currency within two business days.

(iv)  Forward basis

Purchase/sale of a foreign currency at a price specified now with the delivery and settlement at some future date exceeding two business days.

Sri Lanka has a floating exchange rate system since 2001 which allowed the independent adjustment of the exchange rate according to the market forces of demand and supply. However, there could be interventions in the market for the purpose of curbing excess volatility in the exchange rate. The CBSL prescribes maximum net open position (NOP) limits for LCBs and closely monitors the activities in the domestic foreign exchange market to ensure an orderly functioning of the market.