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TITLE

Foreign Exchange Markets and Terminology

 
TOPIC

This article provides a general overview of foreign exchange markets and rates, explaining the meaning of words such as "interbank", "fx", "wholesale", "spot", "ask", "bid", "cash" and "swift".

 
DISCUSSION

The current system of flexible (or floating) exchange rates has been in place since 1972, when the fixed-rate system of currencies established by the Bretton Woods Agreement in 1944 broke down under inflationary pressure.

Foreign exchange market is the generic term for the worldwide institutions that exist to exchange or trade the currencies of different countries. There exists no single trading center, and the market operates 24 hours a day. "Foreign exchange" is often shortened to "forex", or "fx".

The foreign exchange market is loosely organized in two tiers: the retail tier and the wholesale tier. The retail tier is where the small agents buy and sell foreign exchange, orienting themselves to the reference rates of such agencies as Reuters which are adjusted round-the-clock to actual events in the market. The wholesale tier is an informal network of more than 1000 banks and currency brokerage firms that deal with each other and with large corporations. When the financial press talks about the foreign exchange market in general it refers to the wholesale tier.

The spot market is the exchange market for payment and delivery today. In practice, "today" means today in the retail tier and two business days in the wholesale tier. The forward market (or "futures") involves contracting today for the future purchase or sale of foreign currency. In a forward transaction the settlement date is deferred much further into the future than in a spot transaction, and no cash moves on either side until that settlement date.

Dealers and brokers, when acting as market makers, provide two prices: a bid (or buy) and an ask (or sell). Once given, the quote is binding (for a few seconds), i.e. the market maker will buy foreign exchange at the bid quote and sell at the ask quote. The arithmetic average of the bid rate and the ask rate is called the mid rate (or middle rate, or midpoint rate). As part of normal trading, bid prices are lower than ask prices. When quotes are displayed as pairs, the bid price is on the left side, and the ask price is on the right side. For example, for a EUR/USD quote of "1.2321/45", the bid price is 1.2321 and the ask price is 1.2345. This means you can sell one euro for $1.2321, or you can buy one euro for $1.2345.

The difference between the bid and the ask is the spread. Market makers make a profit from the bid-ask spread. Bid-ask spreads can usually range between 0.03% and 0.07%, which is significantly lower than spreads in other financial markets, but which is compensated by the high volume in the foreign exchange market (about ten times the volume of international trade in goods and services).

Commercial banks account for the largest proportion of total trading volume. About three quarters of all foreign exchange trading is between banks. These transactions are called interbank or direct dealing transactions. Direct dealing saves the commission charged by brokers.

The primary clearing system for international transactions is operated by SWIFT (Society for Worldwide Interbank Financial Telecommunication). The electronic transfer system works in a very simple way: two banks involved in a foreign currency transaction will simply transfer bank deposits through SWIFT to settle a transaction. The SWIFT message format also has some limited use outside of the SWIFT network, e.g. for internal communications between banks. Within the broader context of the trade execution process, SWIFT has a focus on the post-trade and settlement aspects, whereas trade-related messages tend to use protocols like FIX, which was designed as an open specification.

The daily reference (or "information", or "nominal") exchange rates published by financial institutions, newspapers, central banks and providers such as those which can be accessed by Currency Server are usually either based on an analysis of a high volume of foreign exchange trading during the previous day, or on concertation procedures which occur every day at a certain time between central banks. In the first case the providers analyze, over a period of time, bid and ask currency prices provided in real time by suppliers such as Reuters, Bloomberg, Tullett & Tokyo, etc. This raw data is validated with consideration to frequency, unusual peaks, possible errors, etc. The average of these filtered bid and ask prices over a certain period of time is called median price. Usually only the mid rate of the median price is provided. Where bid and ask rates are provided instead, the mid rate can easily be calculated (Currency Server does this automatically, depending on the data it receives).

Outside the foreign exchange trading community, "interbank rates", "reference rates", "nominal rates", "wholesale rates", "swift rates", "spot rates", and "cash rates" are often used to mean the same thing. Depending on the context, "cash rates" can however refer either to spot market rates (opposed to those of the forward market), or to rates which apply when a customer goes to the bank to exchange cash from one currency to another (opposed to interbank rates). Similarly, "retail rates" is also often used to refer to the exchange rates offered to customers by banks and exchange agencies, and not the rates of the retail tier of the foreign exchange market. "Cross rates" usually refers to exchange rates that do not involve the US dollar, but more in general it can also be used to indicate direct exchange rates between two currencies which usually use a third currency as a reference.

During their respective euro transition period (1999 to 2001, for a first group of currencies), national currencies of European Economic and Monetary Union (EMU) member states are considered sub-units of the euro currency unit, and are converted to and from each other and the euro using constant conversion rates (whereas the term "exchange rates" usually implies independent and floating units) and special triangulation and rounding procedures (which applications like Currency Server support).

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Article Information
Article ID: 13-138
Platform: Windows
Products: Currency Server
Additional Keywords: Dow Jones Telerate, Bridge, Knight-Ridder
Last Update: 2012-07-07
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