What is the 'Interbank Market'

The interbank market is the financial system of trading currencies among banks and financial institutions, excluding retail investors and smaller trading parties. While some interbank trading is done by banks on behalf of large customers, most interbank trading is proprietary, meaning that it takes place on behalf of the banks' own accounts.

BREAKING DOWN 'Interbank Market'

The interbank market for forex serves commercial turnover of currency investments as well as a large amount of speculative, short-term currency trading. According to data compiled in 2004 by the Bank for International Settlements, approximately 50% of all forex transactions are strictly interbank trades.

Background

The interbank foreign exchange market developed after the collapse of the Bretton Woods agreement and following the decision by U.S. President Richard Nixon to take the country off the gold standard in 1971. Currency rates of most of the large industrialized nations were allowed to float freely at that point, with only occasional government intervention. There is no centralized location for the market, as trading takes place simultaneously around the world, stopping only for weekends and holidays.

The advent of the floating rate system coincided with the emergence of low-cost computer systems with allowed increasingly rapid trading on a global basis. Voice brokers over telephone systems matched buyers and sellers in the early days of interbank forex trading, but they were gradually replaced by computerized systems that could scan large numbers of traders for the best prices. Trading systems from Reuters and Bloomberg allow banks to trade billions of dollar instantaneously, with daily trading volume topping $6 trillion on the market's busiest days.

Largest Participants

In order to be considered an interbank market maker, a bank must be willing to make prices to other participants as well as asking for prices. The minimum size for an interbank deal is $5 million, but most transactions are much larger, and can top $1 billion in a single deal. Among the largest players are Citicorp and JP Morgan Chase in the United States; Deutsche Bank in Germany; and HSBC in Asia.

Credit and Settlement

Most spot transactions settle two business days after execution; the major exception is the U.S. dollar vs. the Canadian dollar, which settles the next day. This means that banks must have credit lines with their counterparts in order to trade, even on a spot basis. In order to reduce settlement risk, most banks have netting agreements that require the offset of transactions in the same currency pair that settle on the same date with the same counterpart. This substantially reduces the amount of money that changes hands and thus the risk involved.

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