Interbank Market

What Is the Interbank Market?

The interbank market is a global network utilized by financial institutions to trade currencies and other currency derivatives directly between themselves. While some interbank trading is finished by banks for large customers, most interbank trading is proprietary, implying that it takes place for the benefit of the banks' own accounts. Banks utilize the interbank market to deal with their own exchange rate and interest rate risk as well as to take speculative positions in light of research.

The interbank market is a subset of the interdealer market, which is an over-the-counter (OTC) scene where financial institutions can trade a variety of asset classes among each other and for the benefit of their clients, often facilitated by interdealer brokers (IDBs).

Understanding the Interbank Market

The interbank market for foreign exchange (forex) serves commercial turnover of currency investments as well as a large amount of speculative, short-term currency trading. The typical maturity term for transactions in the interbank market is overnight or six months.

The forex interdealer market is characterized by large transaction sizes and tight bid-ask spreads. Currency transactions in the interbank market can either be speculative (initiated with the sole intention of profiting from a currency move) or for the reasons for hedging currency exposure. It might likewise be proprietary but less significantly customer-driven — by an institution's corporate clients, like exporters and importers, for instance.

A Brief History of the Interbank Forex Market

The interbank forex market developed after the collapse of the Bretton Woods agreement and following the decision by former 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 just incidental government intervention. There is no centralized location for the market, as trading takes place simultaneously around the world, and stops just for ends of the week and occasions.

The advent of the floating rate system concurred with the development of low-cost computer systems that allowed progressively quick trading on a global basis. Voice brokers over telephone systems matched purchasers and venders in the beginning of interbank forex trading, but were progressively replaced by computerized systems that could examine large numbers of traders at the best costs.

Trading systems from Reuters and Bloomberg allow banks to trade billions of dollars on the double, with daily trading volume topping $6 trillion on the market's busiest days.

Participants in the Interbank Market

To be considered an interbank market maker, a bank must make prices to other participants as well as asking at costs. Interbank deals 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. There are several other participants in the interbank market, including trading firms and hedge funds. While they contribute to the setting of exchange rates through their purchase and sale operations, other participants don't affect currency exchange rates as large banks.

Credit and Settlement Within the Interbank Market

Most spot transactions settle two business days after execution (T+2); the major exception being the U.S. dollar versus the Canadian dollar, which settles the next day. This means banks must have credit lines with their counterparts to trade, even on a spot basis.

To reduce settlement risk, most banks have netting agreements that require the offset of transactions in a similar currency pair that settle on a similar date with a similar counterpart. This substantially reduces the amount of money that changes hands and thus the risk implied.

While the interbank market isn't regulated — and therefore decentralized — most central banks will collect data from market participants to evaluate whether there are any economic implications. This market should be monitored, as any issues can straightforwardly affect overall economic stability. Brokers, who put banks in touch with one another for trading, have additionally turned into an important part of the interbank market ecosystem over the years.

Highlights

• Most transactions within the interbank network are for a short duration — anyplace between overnight to six months.
• The interbank market is a global network utilized by financial institutions to trade currencies and other currency derivatives directly between themselves.
• Banks utilize the interbank market to deal with their own exchange rate and interest rate risk as well as to take speculative positions in view of research.