Interbank market

The interbank market is the top-level foreign exchange market where over 1000 banks can exchange different currencies.7 Winning Strategies for Trading Forex, Grace Cehng] The banks can either deal with one another directly, or through electronic brokering platforms. The Electronic Brokering Services (EBS) and Reuters Dealing 3000 Matching are the two competitors in the electronic brokering platform business and together connect over 1000 banks.

Market makers

Unlike the Stock Market, the Foreign Currency Exchange Market (Forex) does not have a physical central exchange like the NYSE does at 11 Wall Street. [ [http://www.nyse.com/about/newsevents/1095581297148.html NYSE, New York Stock Exchange > About Us > News & Events ] ] Without a central exchange, currency exchange rates are made, or set, by market makers. Banks constantly quote a bid and ask price based on anticipated currency movements taking place and thereby make the market. Major Banks like UBS, Barclays Capital, Deutsche Bank and Citigroup handle very large currency trading (forex) transactions often in billions of dollars. These transactions cause the primary movement of currency prices.

Other factors contribute to currency exchange rates and these include forex transactions made by smaller banks, hedge funds, companies, forex brokers and traders. Companies are involved in forex transaction due to their need to pay for products and services supplied from other countries which use a different currency. Forex traders on the other hand use forex transaction, of a much smaller volume with comparison to banks, to benefit from anticipated currency movements by buying cheap and selling at a higher price or vice versa. This is done through forex brokers who act as a mediator between a pool of traders and also between themselves and banks.

Central banks also play a role in setting currency exchange rates by altering interest rates. [ [http://www.bankofengland.co.uk/ Bank of England|Home ] ] By increasing interest rates they stimulate traders to buy their currency as it provides a high return on investment and this drives the value of the corresponding central bank's currency higher with comparison to other currencies.

Mechanism of interbank forex transactions through electronic brokering platforms

The EBS platform is the most popular tool for the interbank market [http://www.ebs.com/products/prime.asp] . Banks have accounts with EBS, where only an authorised employee may use the EBS Prime dealing service using his unique I.D. and password on behalf and with authorisation from the bank's Trading Floor Administrator (TFA).http://www.ebs.com/pdf/Microsoft%20Word%20-%20Prime_dealing_rules_29_sept.swf] The password is only known to the Employee. The bank is responsible for all instruction sent to EBS from its TFA, whether an authorised employee gave the instructions or not.

To break this down into simpler terms it can be regarded that the Bank informs its Trading Floor Administrator of the currency exchange transaction required. This could be the selling of 2 Billion British Pounds in exchange for the buying of the corresponding amount of US Dollars by Barclays Capital for instance. The TFA of Barclays then analyses the market conditions and current buying and selling prices using for instance the EBS Live and informs its authorised employee of the price it would like to buy the dollars at. For instance 1.97345 dollars in return for each pound sold. The EBS Live is a service that provides banks and large financial organisations with the latest currency exchange prices with a lag of only 200 milliseconds and also shows volume of trade and latest forex transaction deal rate for different currency pairs. [http://www.ebs.com/products/market-data.asp?page=2#Live]

The authorised employee then takes the information provided by the TFA and logs into the EBS system. He/She then creates an offer to sell GBP/USD. Note that currencies are always quoted in pairs as the selling of one currency must result in the buying of another. It is always the first currency in the pair that the selling/buying action applies to. Therefore, it is the selling of GBP that is applicable here. Currency pairs cannot be reversed around i.e. USD/GBP does not exist as a pair. Instead, if British Pounds were to be bought and US Dollars were to be sold, the employee would make a bid to buy GBP/USD. This would result in the opposite scenario and the selling of US Dollars and buying of British Pounds would be applicable instead. Also the rate that is associated with a pair ALWAYS shows how much the first currency of the pair would give you of the second. So in this case, a rate of 1.97345 for GBP/USD means that each pound gives 1.97345 dollars. Going back to our initial scenario, the offer to sell GBP/USD at a rate 1.97345 dollars each is confirmed by the authorised employee and enters the EBS system.

All the other banks that hold accounts with EBS will have the availability to sell US dollars and receive pounds at a rate of $1.97345 for each pound. They are now actively trading in the interbank market. If a bank agrees to the rate then an order will be made by that bank from its own TFA and the deal between the two banks will go through (be matched). If Citigroup does not want to sell 1.97345 Billion US Dollars, then it can set the amount it would like to sell to say for instance 1.5 billion US Dollars. The same rate will apply but only part of the deal would have been fulfilled with regard to the bank that is buying the US Dollars (Barclays). $1.97345 Billion – $1.5 Billion = $0.47345 Billion. Therefore, Barclays is still waiting for another bank on the EBS system to agree to sell $0.47345 Billion USD for pounds at a rate of $1.97345 for each pound it will buy. EBS charges a small commission on the transaction.

With such a large number of banks making constant bid and ask prices for forex transactions, banks get the best deals when it comes to exchanging currencies. If the volume of GBP being offered for exchange (for sale) with USD exceeds the volume of USD being offered for exchange with GBP, this will result in the USD rising in value with comparison to the GBP as less banks want to give up their USD for GBP, which makes the demand for GBP low and drives the price down. When banks can buy the GBP cheaper they will be more willing to give up their USD for it.

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