The interbank market is a vast, global network where financial institutions trade currencies and currency derivatives directly among themselves. While some banks trade on behalf of large customers, the majority of interbank trading is proprietary, conducted for the banks’ own accounts.
Banks globally leverage the interbank market to manage exchange rate and interest rate risks, as well as to take speculative positions based on extensive research. This market is a vital component of the larger interdealer market, where various asset classes are traded over-the-counter (OTC) among financial institutions.
Key Takeaways
- The interbank market is a global network for exchanging currencies and derivatives directly among financial institutions.
- Financial institutions use this market to manage exchange rate and interest rate risks.
- It also enables speculative positions based on market research.
- Transactions in the interbank market are typically short-term, ranging from overnight to six months.
Understanding the Interbank Market
The interbank foreign exchange (forex) market facilitates both the commercial turnover of currency investments and high volumes of speculative, short-term currency trades. Transaction durations in this market are typically short, from overnight to six months.
The forex interdealer market is marked by substantial transaction sizes and tight bid-ask spreads. Transactions may be speculative, aimed at profiting from currency movements, or for hedging currency exposure. Although proprietary trading dominates, corporate clients like exporters and importers also play a role.
History of the Interbank Forex Market
The interbank forex market blossomed after the collapse of the Bretton Woods agreement and the U.S.’s departure from the gold standard in 1971. Since then, the exchange rates of major industrial nations have been allowed to float freely, subject to occasional government intervention.
With no centralized trading location, the market operates globally around the clock, pausing only for weekends and holidays. The advent of low-cost computers has progressively enabled rapid, global trading. Initially conducted over telephone, interbank trading has since evolved to sophisticated systems offered by firms like Reuters and Bloomberg. These enable trades worth billions, with daily trading volumes topping $6 trillion on peak trading days.
Participants in the Interbank Market
To qualify as an interbank market maker, a bank must be willing to quote prices and request prices from other market participants. Interbank deals can exceed $1 billion per transaction. Major players include Citicorp, JP Morgan Chase in the U.S., Deutsche Bank in Germany, and HSBC in Asia. Additionally, various trading firms and hedge funds participate, affecting exchange rates through their operations, though not as much as large banks.
Credit and Settlement Within the Interbank Market
Most spot transactions settle within two business days (T+2), with U.S. dollar versus Canadian dollar transactions being the major exception, settling the next day. To facilitate trading, banks must have credit lines with their counterparts, even for spot trades.
Netting agreements between banks require offsetting transactions in the same currency pair, set to settle on the same date with the same counterpart, minimizing settlement risk and reducing the amount of money that physically changes hands.
What Is a Bid-Ask Spread?
The bid-ask spread represents the difference between the bid price and the ask price, with the bid price generally being lower.
What Is a Market Maker?
Market makers constantly facilitate stock transactions by providing bid/ask spreads, maintaining market liquidity and continuity.
What Is a Spot Transaction?
A spot transaction involves the immediate delivery of a currency or commodity, typically within two business days—timing can vary depending on the market’s nature.
The Bottom Line
The interbank market operates in a decentralized mode and lacks regulation. However, central banks collect market data to monitor financial stability. Proper monitoring is crucial because instability could impact overall economic stability.
The role of brokers, who connect banks for trading purposes, has become increasingly important, contributing to the robustness of the interbank market.
Related Terms: Foreign Exchange Market, Speculation, Hedging, Market Makers, Spot Transactions, Bid-Ask Spread.
References
- Dietrich, Diemo, and Achim Hauck, via Springer Link. “Interbank Borrowing and Lending Between Financially Constrained Banks”. Economic Theory, vol. 70, 2020, pp. 347–385.
- Federal Reserve History. “Nixon Ends Convertibility of US Dollars to Gold and Announces Wage/Price Controls”.
- NASDAQ. “Global Daily FX Trading at Record 6.6 Tln As London Extends Lead”.
- Investor.gov. “Bid Price/Ask Price”.
- Britannica Money. “Market Makes: Keeping Markets Efficient, Liquid, and Robust”.
- Federal Reserve Bank of New York. “Background”, Page 2.
