What Is the Interbank Market?

The interbank market serves as a global network where financial institutions engage in direct trading of currencies and currency derivatives among themselves. While some interbank trading is conducted on behalf of large clients, the majority is done for the banks’ own accounts.

Financial institutions worldwide utilize the interbank market to hedge their exchange rate and interest rate risks and also to take speculative positions based on market research. This market is a subset of the interdealer market, an over-the-counter (OTC) venue where institutions trade various asset classes, often facilitated by interdealer brokers (IDBs).

Key Takeaways:

• The interbank market functions as a global network for financial institutions to directly trade currencies and currency derivatives.
• Financial institutions use this market to manage exchange rate and interest rate risks, as well as to take speculative positions based on research.
• Most transactions in the interbank market are short-term, ranging from overnight to six months.

Understanding the Interbank Market

The interbank market for foreign exchange (forex) caters to commercial currency transactions and a significant volume of speculative, short-term trading. Transactions typically have a maturity term of overnight to six months.

The forex interdealer market is characterized by large transaction sizes and competitive bid-ask spreads. Interbank currency transactions could be for speculation or hedging purposes, with some client-driven trades from corporate entities like exporters and importers.

History of the Interbank Forex Market

The interbank forex market emerged post the Bretton Woods agreement collapse and US President Richard Nixon’s decision to delink the country from the gold standard in 1971.

Currency rates of major industrialized nations began to float freely without constant government involvement. The market operates globally without a centralized location, transacting around the clock except on weekends and holidays.

The shift to a floating exchange rate system coincided with the rise of efficient computer systems facilitating rapid global trading. Computerized trading systems like those from Reuters and Bloomberg enabled high-volume transactions, with daily market turnover sometimes exceeding $6 trillion.

Participants in the Interbank Market

To be an interbank market maker, a bank must quote prices to and seek prices from other participants. Deals in the interbank market can reach values exceeding $1 billion in a single transaction.

Major players like Citicorp, JP Morgan Chase in the US, Deutsche Bank in Germany, and HSBC in Asia dominate the interbank market. Other participants such as trading firms and hedge funds impact exchange rates through their trading activities, albeit to a lesser extent than large banks.

Credit and Settlement Within the Interbank Market

Most spot transactions in the interbank market settle two business days post execution (T+2), except for USD-CAD transactions which settle next day. Banks need credit lines with their counterparts to trade, even on a spot basis.

Netting agreements among banks require offsetting transactions in the same currency pair and settlement date with the same counterparty to minimize settlement risks and reduce transaction amounts.

What Is a Bid-Ask Spread?

The bid-ask spread represents the discrepancy between the bid and ask prices, with the bid being typically lower.

What Is a Market Maker?

Market makers continuously engage in stock transactions, offering bid-ask spreads to maintain market liquidity.

What Is a Spot Transaction?

A spot transaction involves immediate sale or purchase of a commodity or currency, typically settled within two business days, varying based on market conditions.

The Bottom Line

The decentralized interbank market, although unregulated, is crucial for economic stability, with central banks monitoring for any potential economic impacts. Brokers facilitating trading activities between banks are integral to the interbank market ecosystem.