LONDON (Reuters) -Financial institutions that dominate the $9.6 trillion currency market should hold the necessary liquidity and capital buffers and run enhanced stress tests to prevent disruptions to the financial system, according to an International Monetary Fund report released on Tuesday.

"Although stress testing and systemic risk monitoring have advanced, the role of FX markets as a conduit for risk transmission and cross-border spillovers remains underappreciated," the IMF said in one of the chapters of its semi-annual Global Financial Stability Report.

"Enhancing FX liquidity stress tests is essential to assess the sectoral resilience to funding shocks," according to the IMF. 

DERIVATIVES ADD TO VULNERABILITY

Global banks have significant dollar exposure in their balance sheets, making them vulnerable to potential funding shocks. The increasing involvement of non-bank financial institutions and growing trade in derivatives "may also raise the global FX market's vulnerability to adverse shocks," the IMF said. 

Stress in the FX market "can spill over to other asset classes, tightening financial conditions and posing risks to macro financial stability-especially in countries with significant currency mismatches and fiscal vulnerabilities," the IMF added.

Reuters reported earlier this year that European and U.K. regulators have asked banks to monitor and stress test their resilience to U.S. dollar shocks, in the latest sign of how the Trump administration's policies are eroding trust in the U.S. as bedrock of financial stability.

"A shifting global macro financial landscape underscores the need to strengthen FX market resilience," the IMF said on Tuesday, noting that following the US tariff announcements in early April 2025, investors in some countries have reduced their US dollar holdings.

Supervisors and banks should effectively monitor and manage liquidity risks in significant currencies, it added.

STRENGTHENING SWAP LINES

The Federal Reserve has lending facilities with other central banks to alleviate shortages of dollars and to keep financial stress from spilling over into the United States.

But European central banking and supervisory officials for months have been questioning whether they can still rely on the Fed, Reuters has previously reported.

For the IMF, "strengthening and expanding the network of central bank swap lines can enhance global FX liquidity backstops and help reduce contagion risks".

"Policy backstops are critical for stabilizing the global FX market during adverse shocks. Among the most effective tools are the Federal Reserve's US dollar liquidity swap lines."

The IMF also highlighted that "international reserves are a stabilizing force during stress episodes" as they can be used when private funding dries up.