What is the market between banks?
Financial institutions use the interbank market, a global network, to trade currencies and other currency swaps directly with each other. Banks do a small amount of interbank trading for big customers, but most of it is proprietary, which means it is done for the banks’ accounts. Banks handle their exchange rate and interest rate risk in the interbank market. They also use it to speculate based on research.
The interbank market is a part of the interdealer market. The interdealer market is an over-the-counter (OTC) place where banks can trade different types of assets with each other and for their clients. Interdealer brokers (IDBs) often help with this.
How the Interbank Market Works
On the interbank foreign exchange (forex) market, currencies are bought and sold for business purposes. There is also a lot of short-term, speculative dealing. The standard maturity time for deals on the interbank market is either one day or six months.1
Large trades and narrow bid-ask gaps make up the forex interdealer market. On the interbank market, banks can buy and sell currencies for speculative reasons (to make money from a change in the currency’s value) or to protect themselves from currency risk. It could also be proprietary but not as customer-driven. Exporters and importers are examples of an institution’s business clients.
A Quick History of the Forex Market Between Banks
The interbank forex market grew after the Bretton Woods deal fell apart and Richard Nixon, the 36th president of the United States, decided in 1971 to remove the country from the gold standard.
At that point, most big developed countries let their currency rates float freely, with the government only getting involved sometimes. Trading happens worldwide simultaneously and only stops on weekends and holidays. There is no one place where the market is organized.
At the same time, the floating rate method started to be used, and cheap computer systems became available, making trading faster worldwide. In the early days of interbank forex dealing, buyers and sellers were matched by voice brokers over the phone. Over time, computerized systems that could search through many traders to find the best prices took their place.
Reuters and Bloomberg’s trading tools let banks trade billions of dollars simultaneously. On the market’s busiest days, daily trading volume can reach over $6 trillion.3
People who trade on the interbank market
A bank must be willing to set prices for other players and take them to be an interbank market maker. Deals between banks can be worth more than $1 billion.
Citizens Bank and JP Morgan Chase are the biggest in the U.S. Deutsche Bank is one of the biggest in Germany, and HSBC is one of the biggest in Asia. Trading firms and hedge funds are two other types of players in the interbank market. However, other participants do not have as much of an impact on currency exchange rates as big banks do. This is because they only buy and sell currencies.
The interbank market is where banks lend and settle loans.
The main exception is the U.S. vs. Canadian dollar, which settles the next day. Most spot transactions settle two work days after they happen (T+2). That is, banks must have credit lines with each other to trade, even if it’s just overnight.
Most banks have netting deals that say transactions in the same currency pair that settle on the same date with the counterpart must be balanced out. This is done to lower settlement risk. This cuts down on the amount of money that changes hands and, by extension, the danger.
The interbank market is not regulated, so it is decentralized. However, most central banks will still collect information from market players to see if there are any economic effects. It’s essential to keep an eye on this market because any problems there could affect the whole economy. Over the years, brokers have also become essential to the IB environment. Brokers connect banks that want to trade with each other.
Conclusion
- Financial institutions use the interbank market, a global network, to trade currencies and other currency swaps with each other.
- Banks handle their exchange rate and interest rate risk in the interbank market. They also use it to speculate based on research.
- Most trades in the interbank network only last a short time, from one day to six months.
