Common Practices in Foreign Exchange Markets

In this post, we will discuss some of the common market practices in foreign exchange markets.

Choice Prices

A choice price is one where the market marker quotes a single rate at which the market user can choose to buy or sell. This is sometimes done where the amount is small, but the counterparty relationship is a good one. Alternatively, if the market maker already has a profitable position he may be content either to close that position or to increase it at the same price.

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.