Interbank FX Trading by Malcolm Morley

Interbank FX Trading by Malcolm Morley

The following thread probably deserves to be read in full by those who are interested in how bank traders manage their positions, and how the Interbank market differs from retail fx trading. The thread is actually about leverage, and started off with the somewhat erroneous notion that leverage was a ‘loan’ from a market maker, and went on from there.

The following thread probably deserves to be read in full by those who are interested in how bank traders manage their positions, and how the Interbank market differs from retail fx trading. The thread is actually about leverage, and started off with the somewhat erroneous notion that leverage was a ‘loan’ from a market maker, and went on from there.

Here’s an extract:

You are right when talking about physical delivery. We would have to borrow one side of the transaction, and deposit the other. However the fx market only physically delivers a fraction on the volume traded and we, of course, NEVER get to physical settlement. All we are doing is going through the motions, and settling the net difference in p/l.

Even in the broader interbank market where there is ultimately physical settlement, players with positions rollover these positions daily to avoid the capital expense of holding their long or short view. The only physical deliveries that need funding tend to be for commercial requirements only, not for speculation. All the rest are netted out. We, by contrast, have continuous interest payments that factor in rollover costs. (btw rollover costs are calculated from interest rate differentials).

Basically, as long as the physical delivery of an outright position is always deferred, by whatever means, no real loan needs to take place. It’s all virtual, and can be settled net.

I’ll stop now, but I can see this possibly getting involved! We’ll see!

and it did! ….

Oh dear! I knew I would be digging a hole for myself! Your questions are perfectly valid, but a little more difficult to explain.

I didn’t actually say the fx market never goes to physical settlement. What I said was that WE never get to physical settlement, and that the only settlements that require funding in the interbank market tend to be commercially oriented, and not from speculative trades.

To understand this we have to understand how speculative trades don’t require funding even though the core fx market works on a 2 day settlement basis and speculative trades represent the majority of fx market volume.

At the heart of the fx market are the Banks. Now say a bank buys and sells EURUSD all day long, and wants to run a long position of EURUSD 1,000,000 for say a week.

Ok – the bank balances it’s trades so that it is net long EURUSD 1,000,000 by the end of the day. Maybe they have bought EURUSD 50,000,000 and sold EURUSD 49,000,000. Now even a Bank does not want to fund the remaining EUR 1,000,000 so it rolls the position over ‘Spot Next’. That’s to say it Sells Spot (2 business days out) EURUSD 1,000,000 and Buys back the next day (3 business days out). Now when settlement comes they have a completely balanced book, even though they are running a EURUSD 1,000,000 position. The only ‘funding’ that would need to take place is in their own bank account (known as a Nostro account), but this isn’t necessary because they are balanced on the day! EURUSD 50,000,000 went in, EURUSD 50,000,000 went out.

Now all that needs to be done is to continue to roll this position over for as long as it’s required. Rollovers can be done Cash (today/tomorrow), TomNext (tomorrow nextday), Spotnext, or in the forwards market.

If you can grasp this concept, and understand that OANDA and others plug into this system, you’ll understand that providing delivery is always deferred, there is no need to raise the full capital for a transaction, we just have to honor day-to-day price fluctuations. Yes there needs to be capital adequacy, but nothing like the full amount of the value of the underlying trades.

How does this work for us, since we never settle? Say every trader at OANDA was Long AUDUSD. OANDA would offset this in the interbank market becoming Long AUD/USD with their banking counterparties. They would also rollover this position each day with the Banks so they didn’t actually take delivery of the AUD (and have to come up with the corresponding USD). OANDA screens us from this process, but passes on the costs of these transactions by means of continuous interest payments (both debit and credit). Our capital adequacy is of course our underlying margin. That’s all we need.

and….

The spot dealer is generally responsible for the size of his position (within his limits) and balancing his settlement accounts in the currencies under his control on settlement day (which is everyday on a rolling basis). Backoffice certainly confirms settlement activity, so there is a double check.

If a dealer fails to do this the Bank will be up for a lot of interest, or worse, risk failing on payments.

Generally the dealer will make his adjustments ( ie balance his settlement accounts and defer any outright delivery) by trading spot next, or at the latest tom next. He could also swap for longer – 1 week, 1 month .. etc., if he so wished by trading forwards.

Clear as mud?

Let me just add that there are two distinct kinds of transactions in interbank fx. They are outrights and swaps.

Outrights are a Buy or Sell for a fixed settlement date, normally spot. We trade a pseudo version of spot at OANDA.

The other, ‘swaps’, are all double transactions – Cash (today,tomorrow), Tom Next, Spot Next, 1 week (Spot, 1week) , 1 month (Spot,1 month), etc. With all these transactions there are two dates, and the pair Bought and Sold, or Sold and Bought for the price of the swap.

By using a combination of spot and swaps, a dealer can create all kinds of positions as well as deferring delivery indefinitely, if necessary. It’s the mechanism that makes this whole circus go around.

Confused now?

~chaffcombe

and finally…

If we wanted to duplicate our OANDA trading as a Bank dealer, we would establish our positions by trading spot, and roll them over each day trading Spot Next or Tom Next for the life of our transaction.

I have lived and breathed trading ever since trading fx professionally in London, Toronto and Philadelphia in the early 70’s (yes I know that shows my age!). While my professional career subsequently took me from the trading desk to designing treasury systems for some of the world’s leading financial institutions, my desire was to always trade for myself. As a consequence, following 5 years with a major international stock-broker

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