Common Practices in Foreign Exchange Markets

In practice, choice prices are more frequently used to manipulate the market user. The convention is that it is extremely bad etiquette to turn down a choice price; the market user is morally obliged to deal. If the market maker is certain that the customer is a buyer of base currency, for example, he may quote a high choice price. This not only gives the market marker a deal at a good price. This not only gives the market marker a deal at a good price, but also shows the market user that his intentions are transparent.

Choice prices are also quoted to counterparties who call persistently for prices but never deal. Market makers do not like to be used as a market information service by other banks

Liquidity

The market for a currency is said to be liquid when customers can readily buy or sell any quantity of the currency. A feature of liquid markets is competition between market makers, resulting in narrow spreads between bid and offered prices. Liquidity in most currencies varies from one FX centre to another, and between the spot and forward markets. For example, there is a liquid spot market for the Spanish peseta in Madrid, Paris and London , but I other centers, especially outside Europe ,the peseta market is much less liquid and customers will have more difficulty in finding a bank willing to buy or sell the currency at a competitive price.

Interbank trading in currencies does have one significant benefit for trade-related and investment-related FX transactions. The high volume of speculative   interbank trading creates much greater liquidity in the market, which narrows the bid-offer spreads. This offsets to some extent, the problems of volatility in exchange rates created by speculative interbank trading.

Nostro Accounts

A bank that trades actively in the FX makers has to maintain currency bank accounts (nostro accounts) in all the currencies in which it trades, to meet payment requirements as these fall due. Current accounts are therefore maintained with correspondent banks in other countries. For example, a UK bank will keep a US dollar current account with a US correspondent bank, a Deutschemark current account with a German correspondent bank, a Hong Kong dollar account with a correspondent in Hong Kong, etc.

A banks trading desk is ‘long’ in a currency where the total open position (current balance plus money due in at forward dates: minus money payable at forward dates) is positive, and is ‘short’ in a currency when the total open position is negative.

A bank’s trading desk is long in a currency where the total open position (although new FX market transactions can be made to maintain its required position). Buying a currency lengthens the bank’s position in that currency: selling a currency shortens the position.

Banks do not always want to have a position (long or short) in currencies in which they trade, and can ‘square’ temporary positions through the FX ‘swap’ transactions. For example, if a UK bank does not wan to be long in Spanish pesetas, but has a pesetas dealing desk, it can buy a quantity of pesetas ‘spot’ and simultaneously sell them forward. This will give the bank a working balance in pesetas to meet its short term payments requirements, but the spot purchases and matching forward sale avoids the need to hold a long position in the peseta.

Dealing Activity

Within each FX centre, a bank will have a specialist spot market trader for each currency in which it deals. For example, ABC Bank in London will have a spot market trader for each currency in which it deals. For example, ABC Bank in London will have a spot trader for sterling against US dollars, another for euros and another for yen. The trader keeps a book of the purchases and sales of the currency transacted o behalf f the bank. If the aim is to keep a square position, buying and selling equal quantities of the currency, the trader will adjust bid and offered spot prices according to demand and supply from customers.

For example, suppose a German bank is quoting 1.3665-1.3670 for the US dollar/euro rate, and wished o maintain its current position in dollars. If it then transacts a deal involving the sale of, say, USD 5 million in exchange for euros, it will want to buy dollars to restore its position.

It could therefore alter its quoted rates to say, 1.3667-1.3672, i.e., raise the value of the dollars against the euros, hoping that its new rate will attract sellers of dollars. However, the market is very competitive and banks must avoid the risk of setting rates that are significantly out of line with other banks..

The job of the spot trader is to make markets in his currency. When a call is received from a customer asking for a quotation, the call is handled by a customer-dealer, who will ask for a spot price quotation from the trader in the currency. If the transaction is agreed, the trader is informed, so that he can keep his book up to date.

• If the dealer buys a currency, he will normally look to lay off the purchase, selling the currency to another bank or corporate buyer.

• Spot prices vary according to supply and demand in the market, so if a dealer wants to lay off a deal to earn a profit, speed is essential. Dealers will therefore commonly sell currency immediately after buying it, and vice versa.

Speed is critical when deciding which rate to offer.

• If a bank is long in the currency, the dealer will offer a spot rate more attractive more attractive to a buyer of that currency than a seller.(i.e. he will lower the rate).

• If a bank is short in the currency, it will be eager to buy and will offer higher spot rates.

• If the bank already has a square position, the rate being offered will depend on the dealers view of how easily and quickly he can lay off a deal.