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Foreign exchange is the larg­est and most liquid finan­cial market, with nearly $10 trillion changing hands daily. It’s the underpinning for global trade and finance—and its structure is changing as nonbank financial institutions, or NBFIs, assume a larger role in transac­tions used to manage currency risk and access to foreign funding.

The market’s central role in the international monetary and financial system makes it highly sensitive to macroeconomic devel­opments and policy shifts—partic­ularly those that heighten uncer­tainty. As we show in an analytical chapter of the Global Financial Stability Report, rising global fi­nancial or economic uncertainty typically increases investor risk aversion and boosts demand for safe-haven assets, leading to vola­tility and liquidity strains in for­eign exchange markets.

For example, dollar purchas­es by non-US residents tend to increase by 24 percentage points following a sharp spike in finan­cial uncertainty—proxied by a measure of expected US stock swings—like the one during the March 2020 onset of the pandem­ic. Our analysis of unique data on transactions across major currencies shows that this surge in demand for safe assets is espe­cially strong among NBFIs. Their activity, while supporting liquidi­ty in normal times, can increase market fragility during stress ep­isodes.

Indeed, exchange rates swing sharply, currency bid-ask spreads widen, and foreign funding and hedging costs rise during epi­sodes of elevated uncertainty. We gauge this using a proxy known as the cross-currency basis, which reflects the cost of swapping one currency for another, with a wid­ening basis indicating stress in currency markets. The effects il­lustrated by our analysis tend to be more pronounced for emerging market currencies, likely due to those being smaller markets with limited access to dollar liquidity.

Amid a shifting global econom­ic landscape—shaped by evolving trade policies, supply chain re­alignments, and geopolitical ten­sions—the surge in uncertainty following the US tariff announce­ments in April revealed patterns both familiar and new. Nonresi­dent demand for US dollars rose in spot markets, though less sharp­ly than during previous episodes such as the pandemic shock.

Cross-country differences in trading behavior also became more evident, with some econo­mies shifting to net selling of the dollar. Notably, hedging demand from nonresident NBFIs—aimed at protecting against future dollar depreciation—was stronger and more persistent, suggesting evolv­ing shifts in market responses to uncertainty.

Cross-market spillovers

Stress in foreign exchange markets can also spill over to other financial assets. For ex­ample, an increase in funding and hedging costs can raise the cost of managing currency risk, potentially affecting yields and risk premiums on assets such as stocks and bonds. Higher funding costs can also erode the interme­diation capacity of financial in­stitutions, tightening financial conditions, and posing broader stability risks.

These effects are much more pronounced for countries with higher macro-financial vulner­abilities such as elevated levels of public debt or when financial institutions hold a significant amount of their assets and debts in different currencies.

Operational disruptions

Beyond sensitivity to macroeco­nomic shocks, foreign exchange markets are also highly exposed to operational disruptions such as technical failures, cyber incidents, power outages, and settlement risk: the possibility that one party will deliver its currency without receiving what the counterparty owes.

Our analysis shows that even relatively brief outages of cur­rency trading platforms can sig­nificantly impair market liquidity. Similarly, settlement risk tends to increase exchange rate volatility and remains particularly relevant for emerging market and devel­oping economies, many of which lack access to risk mitigation mechanisms, such as simultane­ous settlement systems.

Strengthening resilience

Despite its deep liquidity, the FX market remains vulnerable to adverse shocks. That means policymakers should strengthen surveillance to monitor systemic risks arising from market stress. Enhancing liquidity stress tests and conducting scenario analy­sis are essential to assess specific funding vulnerabilities across fi­nancial institutions.

Authorities must prioritize closing data gaps and ensure that institutions maintain adequate capital and liquidity buffers. They should also establish robust cri­sis management frameworks that enable swift responses to shocks.

Regulators and market partic­ipants also need to improve oper­ational resilience by investing in cybersecurity and contingency planning, so that key foreign ex­change infrastructures and par­ticipants can recover quickly from disruptions.

To reduce settlement risk, broader adoption of arrangements that settle both sides of a trans­action simultaneously should be promoted. Finally, transitioning to well-designed financial platforms can also help lower transaction costs, volatility, and settlement risks.

Comprehensive surveil­lance, stronger safeguards, and modernized platforms can reduce risk, enhance efficien­cy, and better position foreign exchange markets to support global finance.