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The financial system and trading of currencies among banks and financial institutions, excluding retail investors and smaller trading parties. While some interbank trading is performed by banks on behalf of large customers, most interbank trading takes place from the banks’ own accounts.

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.

What is the Interbank Market?

When seeking funds for borrowing, consumers, financial speculators, and corporations contact a bank representative to discuss the terms of the proposed credit agreement. These discussions and transactions between clients and banks take place at the retail level, where banks charge a premium over the cost of the funds acquired in the wholesale market in order to make a profit. The interbank market is the name of the wholesale market where banks trade between themselves in order to remain liquid and meet customer demands for deposits, withdrawals, and borrowing for many different purposes.

The main difference between the interbank market and the retail market (that is, the bank counter) is the interest rate charged on borrowed funds. Since commercial banks have access to the central bank of the nation, they are able to acquire funding at a much lower cost than what it available to the end-user. By passing the low-cost money acquired through the terms and conditions set and maintained by the central bank to the consumer at a higher price, banks can make a profit, and stay in business.

The interbank market is also the medium where the vast majority of forex transactions take place.

Participants

As its name suggests, the main participants in the interbank market are mostly the major banks such as Deutsche Bank, UBS, Citibank, but other banks, large international corporations, hedge funds also create smaller portions of the activity in this medium. The activities of hedge funds and investment banks, while significant, are much smaller in comparison to the volume generated by the major international banks. However, since these firms are able to utilize much higher levels of leverage in comparison to commercial banks, they can play greater roles in the market from time to time. The trade-related foreign exchange volumes generated by the activities of international corporations are not very significant in comparison to the speculative activity created by major banks and financial institutions.

The activities of retail forex brokers and their clients is estimated to constitute about two percent of the overall activity in the interbank market, and it is increasing.

Forex Brokers and the Interbank Market

Forex brokers are the intermediaries between clients and the interbank market. As market makers themselves, brokers pool the orders of their customers together, match buy and sell orders internally with each other, and pass the remaining balance to the interbank market in order to meet orders. Thus the amount of orders communicated by brokers to the banks is smaller than the total amount of orders received by them.

Apart from the internal matching of orders, forex brokers charge a usually small fee over the prices quoted by the various banks in the interbank market before passing it to customers. This small fee is called the spread and is the main source of income for brokers.

How to understand the interbank market?

Understanding the interbank market can be beneficial because of its role as the circulatory system of a nation’s economy. Tensions in the interbank market are reflected in the various other financial markets as widening spreads, lack of liquidity, increased volatility, and currency shortages. If banks themselves are unable to obtain the funds necessary to maintain their own businesses, they will be unable to extend credit to consumers, firms, mortgage borrowers, students, and many other types of borrowers. As such, tensions and turmoil in the interbank market have important implications for general economic stability, and market trends, and they are carefully monitored by the relevant authorities. Difficulties in the interbank market are often mirrored by severe reactions in the forex market, where banks try to obtain funding for their cross-border operations.

The interbank market is decentralized, meaning that there is no central exchange quoting prices and collecting statistics. However, both national central banks, and international institutions such as the Bank of International Settlements collect data from the various participants in the interbank market on a voluntary basis in order evaluate economic developments better. The data and interpretations generated by them are widely used by traders, economists, analysts, and politicians.

Overnight rates

The maximum maturity term of most transactions in the interbank market is one month, and a majority of interbank activity is conducted through overnight unsecured lending over the real time gross settlement system (RTGS) where there is no requirement of collateral. In performing overnight transactions, banks use the main interest rates declared by the central bank of the nation. This rate is called the federal funds rate in the US, in the Eurozone it is the main refinancing rate, in Japan it is named the overnight call rate, and Bank Rate in the United Kingdom. In india this is called Call Money Rate.

When funding is not readily available, the first option considered by banks is overnight borrowing, since this is the safest option for the lender, and still solves the problems of the illiquid institution. Consequently, any problem in the interbank market manifests itself first at the overnight rates which are very sensitive to illiquid conditions. In emerging markets and the third world, lending in the interbank market can evaporate completely, which leads illiquid banks to seek funding in the repo market for their immediate liquidity needs. If the quality or quantity of the required collateral is too high, bank failures can result. It is rare to see the overnight market completely shut down, and in such cases the central bank of the nation will intervene in a heavy handed manner to maintain its rate target.

Banking crises, as described simplistically, and briefly above, can cause massive volatiliy in the forex market, and create great dangers as well as opportunities for traders. A trader who is able to detect a deteriorating liquidity conditions can sell the currency of the suffering nation and make great profits in the ensuing turmoil. The main tool for examining and evaluating liquidity conditions in the interbank market is the overnight libor rate.

Overnight Libor

The overnight libor rate is the actual rate at which transactions in the interbank market take place, in contrast to the target rate which is the level at which transactions ought to take place, as desired by the central bank. Discrepancies between the overnight libor rate and the target rate signal conditions of laxity (abundant liquidity), or tension (liquidity shortage) in the interbank market. All else being constant, a libor rate lower than the target rate will result in a depreciating currency since there is more supply than there is demand in the interbank market, and vice versa. The relationship is in fact a lot more complex with a number of other variables influencing currency prices in the short term, however, if the gaps are too large, they can override every other concern as banks scramble to raise capital.

There is no general overnight libor rate, but an average is calculated based on the data communicated by banks and later passed on to news providers. This rate is termed EONIA in the Eurozone, SONIA in the United Kingdom. These rates are calculated on the basis of locality, and not nationality. For example, a British bank operating in the U.S. will also communicate quotes which will be included in the calculation of the day’s dollar libor. Only the currency of the overnight transaction matters.

Central banks explicitly aim to keep the overnight rate in line with the target rate declared, and they will never allow a large divergence to exist for long. To bring the actual rates in the interbank market in line with the target rate, central banks conduct open market operations.

Open market operations

Open market operations involve repurchase agreements (repos) and reverse repos where the central bank buys or sells government bonds in return for cash for a specified maturity. By using this tool, the central bank can control the amount of liquidity in the system, as well as the overnight rate, since it is very sensitive to liquidity conditions in the market. Central banks regularly intervene in the interbank market in order to manage routine, and insignificant reserve imbalances that arise, but they can also conduct special, unscheduled operations in response to tensions.

Libor over longer maturities

Although the central banks can influence conditions in the interbank market at shorter maturities by direct interventions and enforcing the target rate through open market operations, they have less influence over rates on longer maturities. Although libor values exist for maturities up to a year, these are mostly used for benchmarking purposes, and do not represent actual lending between banks. Nonetheless, the three-month dollar libor, and its equivalent in other currencies is a common indicator of difficulties and insecurity in the interbank market because of its role as a benchmark for many different kinds of contracts and agreements.