Interbank Forex: what is it?

Interbank forex is a wholesale foreign exchange arena in which traders from large banking institutions trade among themselves. Other market participants, such as hedge funds or trading firms that decide to participate in large trades, are also part of the interbank market.

The purpose of the interbank market is to provide liquidity to other market participants and obtain information about the flow of money. Large financial institutions can trade directly with each other or through electronic interbank foreign exchange platforms. Electronic Broking Services (EBS) and Thomson Reuters Dealing are the main competitors in this space, and together they represent more than a thousand banks.

Trade flow through the interbank foreign exchange market accounts for approximately 50% of the $5 trillion per day that trades in foreign exchange markets. Trading participants include commercial banks, investment banks, central banks, as well as investment funds and brokers. Understanding the roles of the different players in the interbank market can help you gain a deeper understanding of how the major players in the market interact with each other.

Transactions in the interbank market are carried out either directly between large financial institutions or through brokers who execute transactions for their clients. Some traders enter into trades specifically for speculative purposes, while others provide liquidity or hedge currency risks.

Participants in the interbank forex market

Participants in the interbank market include commercial banks, investment banks, central banks, hedge funds and trading companies. With the exception of central banks, which have a different end goal, most other players are in the interbank market solely to make a profit.

Most of this liquidity flows through approximately ten to fifteen financial institutions. The largest players in the interbank market are commercial banks such as Citibank, Deutsche Bank, Union Bank of Switzerland and Hong Kong Shanghai Bank.

The central bank provides liquidity by participating in money market operations. Central banks are generally viewed as lenders of last resort, providing loans to commercial banks. Central banks also protect a country’s exchange rate and are responsible for foreign exchange reserves.

Foreign exchange reserves form part of the central bank’s balance sheet and are considered a liability. Although central banks try to avoid intervening in the foreign exchange market, there are times when it may become necessary. For example, when a currency is either under pressure or its value exceeds a predetermined level, the central bank may intervene to keep the exchange rate in balance.

When the central bank decides that it is appropriate to intervene in forex trading, it will enter into a transaction with several primary dealers to maximize the effect of its trades.

Commercial banks, investment banks, trading companies and hedge funds typically participate in interbank forex trading as market makers. A market maker is a trader who determines the price for another trader. Market makers are willing to accept the risks associated with holding positions in a currency pair for a certain period of time.

Typically, an interbank transaction has only one or two dealers for each currency pair. There is usually a primary interbank dealer and possibly a secondary dealer. Every region around the world has a place where there is a main dealer who will be in charge of the currency pair. For example, a large commercial bank will have a EUR/USD dealer in Japan, London and New York.

These dealers transfer the order flow book from region to region as the previous region becomes less liquid. Thus, at 15:00 London time, the EUR/USD dealer will transfer his obligations to the New York dealer. Large financial institutions need experts for each currency pair, so instead of 4 or 5 dealers covering 20 currency pairs, they will most likely have 1 or 2 dealers for each pair.

To trade in emerging markets, dealers typically focus on a specific region. This means that there may be 1-2 dealers who, for example, focus on South America, quoting the Chilean Peso as well as the Brazilian Real.

Profit from bid and offer price

Market makers earn income by buying a currency pair at the bid price and selling it at the ask price. They are trying to make money on the interbank currency spread. The spread is the price at which traders are willing to buy a currency pair, while the bid is the price at which traders are willing to sell a currency pair.

Market makers attempt to make a profit by buying on bids and selling on bids while hedging the risk of their position. In many cases, the dealer will need to hold a position for an extended period, especially if the transaction size is too large to lock in a particular trade right away.

If a dealer is long EUR/USD and wants to get rid of it, he is more likely to unload his currency position at a price below his desired price.

Dealers also have an understanding of the market and this also influences the interbank exchange rate. If a dealer believes that the EUR/USD rate will rise over the next few hours, he will be more likely to wait until the market reaches a certain price level.

Another reason market makers quote exchange rates is to obtain information. By providing liquidity to clients and other market participants, they can see large trades that can move the market. This type of information can be extremely useful because in many cases this information is only available to the market maker.

Access to market depth

An interbank broker typically has thousands of clients around the world. Many of these financial institutions have clients who transact and receive advice on all aspects of their activities. For example, a large commercial bank may provide loans to a client, as well as provide corporate finance and foreign exchange investment banking advice. By managing a wide range of services, a commercial bank can attract investors to work with clients.

These institutions may also provide other dealing services, such as interest rate transactions for swaps and credit default swaps. Cross-trading capabilities make the bank an attractive place to trade in the interbank foreign exchange market.

What is key for an interbank forex broker is access to market depth. Market depth shows the dealer the different levels at which clients want to be able to enter or exit their trades. Many of the clients are not bothered by trying to get all available pips and may be more interested in entering a trade or hedging their position at a certain level.

Market depth includes not only the specific exchange rate at which the order is expected to be executed, but also the volume of the transaction. This information is very important because it can provide the dealer with key information about support and resistance levels. Each level shows which client is on a buy or sell order, as well as the number of trades and the trade size. Each order book is different and shows you the volume along with the price.

With access to market depth, an interbank dealer can use this information to make money.

When prices reach a certain level, the interbank dealer can use the order book to determine whether the market will support that level or whether the level will be broken and the price will move further. Many times interbank dealers will use support and resistance lines or moving averages to help determine if there is a technical confluence in tandem with their order book and market depth.

Information collected from customers is also key to the success of interbank transactions. For example, if a dealer has a large trade with a hedge fund, the direction the market moves after their transaction may be different from the direction the market follows if a multinational client is trading primarily to hedge their portfolio.

If an interbank dealer enters into a large transaction with a corporate client, he may assume that the transaction was not specifically intended to generate transaction income. In fact, the dealer in this situation may determine that this type of transaction will not move the market in a particular direction for any extended period of time.

On the other hand, if the trade is traded by a hedge fund, the interbank dealer may decide that the hedge fund knows where the market is going and use that information to make a profit.

Most of the time, the interbank dealer will try to reduce the risks he is taking. Before the 2008 financial crisis, many interbank dealers were able to trade significant volumes of currencies, taking positions over days, weeks or even months. Today, the opportunities to take long positions have decreased significantly.

Risk of Position Shift

Once the primary dealer takes a position, he must compensate for his risk. In many cases, the risk cannot be removed immediately and the dealer must use many counterparties.

There are two main platforms that interbank dealers use. One of them is the Reuters Dealing system, and the second is the Electronic Brokerage Service. The interbank market system provides access only to those traders who have sufficient creditworthiness to participate in electronic trading.

The system is based solely on the credit relationships that financial institutions have established with each other. The more relationships a dealer has, the more trading partners he can enter into deals. Obviously, the larger the bank, the more relationships it has. Credit relationships are established between credit departments, where the amount of outstanding debt is expressed by a certain number. Banks use the International Swaps Dealer Agreement (ISDA) to define their interbank lending relationships.

A financial crisis is one example of a scenario where things can get out of control due to default. When companies like Lehman Brothers went bankrupt, many clients were left behind, creating a cascade of problems. For example, if Bank of America made a $1 billion EUR/USD trade with a client and hedged that exposure with Lehman, the market risk associated with that trade was zero because the two trades offset.

Credit risk, on the other hand, was on both sides, and since Lehman declared bankruptcy, Bank of America remained in a market risk position since it no longer held the hedge from Lehman Brothers.

Cross currency pairs can create problems for interbank dealers who trade in large quantities because most electronic systems do not offer cross rates. If you are an EUR/JPY cross dealer, you will need to look at the interbank forex rate for EUR/USD and the USD/JPY rate to generate the cross rate for EUR/JPY.

Interbank dealers also work hand in hand with many interest rate trading desks. When a client wants to trade beyond spot, he can obtain a rate from the forward rates trading desk. Many times when a hedge fund wants to trade but does not want to close out the position within two business days, it will make a transaction in spot currency and then, once that transaction is completed, clients will roll over the position for later delivery.

Many dealing desks have an automatic quoting system that they use for trades. The offer spread is fixed, but can be changed when the market experiences increased volatility.

Interbank Forex: conclusion

The focus of an interbank dealer is to provide liquidity to its clients. Most of the volume in the interbank market flows through about ten to fifteen of the largest commercial and investment banks. The interbank dealer also receives important information. Having depth of market data that reflects bids in a currency pair can help dealers make more informed decisions and generate additional revenue.

A competent market maker must buy on demand and sell on offer, while constantly hedging his positions. Interbank dealers communicate with each other through electronic systems and by telephone. In many cases, the trade size is too large to be dealt with by the dealing system for one reason or another.

To have access to most interbank trading systems, a bank must be considered creditworthy. Credit is determined outside of an interbank forex trading transaction and an ISDA agreement is typically signed.