![]()
Part One: Market-Making
![]()
1 Who Makes the Market?
According to Einzig, Vienna was the first important market-place in forwaed exchange.1 In the early 1870s, the newly formed German Empire adopted the gold mark and discontinued the free coinage of silver. It was not until 1879 that the silver standard was suspended in Austria-Hungary, and another fourteen years passed before its money was made convertible into gold. Thus for twenty years the gulden was floating vis-à-vis the German mark.
The gulden-mark exchange market was one of the most active in the world of the 1870s and 1880s, given the very substantial trade links between the German and Austro-Hungarian empires. With the exception of the Russian rouble, the other major European currencies were pegged to gold and formed thereby a fixed exchange rate system. Hence it was in the mark-gulden exchange market of the seventies and eighties that the institutions and techniques for trading in floating currency of a modern economy were developed. Foremost was the creation of a forward market in foreign exchange, used widely by commercial traders to insure the risk of changing currency values.
At first, forward trading was confined to actual bank notes rather than embracing bank transfers and bills. The famous Bear Squeeze of Count Witte, the Russian Finance Minister, in the Berlin exchange market of 1894,2 was effected in the forward market for rouble notes. In the late 1880s, forward markets began to extend to mail transfers and bills. Interest arbitrage became keen between the money markets in Vienna and Berlin.3 In the early 1920s, when the major currencies were floating in the aftermath of World War I, forward exchange trading spread, and the principles of interest arbitrage, known long since in Vienna and Berlin, became disseminated widely.4 Moreover, the hyperinflations in Central Europe during the early 1920s, and then the huge instability of exchange markets in the Gold Bloc during the 1930s, provided unprecedented conditions under which to test the workings of forward exchange markets.
After World War II, forward exchange markets have often been subject to restrictions. Under the Bretton Woods Agreement, nations bound themselves only to restore convertibility of their currencies for current payments and not to restrict for any purpose the convertibility of balances held by non-residents. Financial transactions by residents and borrowing by non-residents remained widely subject to controls. Access of residents to the forward exchange markets was frequently blocked. In the context of persisting controls, the principles and practices of forward exchange evolved.
The birth of offshore deposit markets in the 1960s and the generalised floating of currencies after 1973 brought important changes to forward exchange markets. Opportunities for interest arbitrage multiplied. Techniques of commodity futures trading were transposed to currency trading with the launching of Chicago's International Monetary Market. Internationalisation of the broking industry and revolution in communications broke down geographic separations between markets virtually entirely.
Different Types of Exchange Rate Contract
There are three types of contracts traded in exchange markets — spot, outright forward and swap.
A spot exchange contract involves the exchange of two sight deposits, denominated in different currencies. For example, consider a customer who buys spot Deutsche marks in exchange for US dollars from a bank in London. The underlying contract — which takes normally the outward form of an exchange of telex confirmations — provides for the customer to deliver dollars to the credit of a current account which the London bank maintains with a bank in the US (the US bank may, of course, be related to the London bank); in return, the London bank undertakes to deliver Deutsche marks to a current account with a bank in Germany nominated by the customer. Sometimes this latter account will be in the customer's name; sometimes it will be in another's name, such as when the customer is buying goods from Germany; sometimes the customer will nominate a current account in the name of the London bank, and request the London bank to issue him with a corresponding mark deposit in London. Such a deposit in London would be termed a euro-mark deposit. The transfers specified in the spot exchange deal are due to occur usually two days after the date of transaction. But other arrangements are possible, and exchanges can be made for settlement just one day ahead.
Spot exchange contracts expose the parties to both credit and political risks. In our example, the London bank can find that its current account in New York fails to be credited by the customer and yet the marks have been paid to the customer's account in Germany. Failure may be technical, due to a delay in transmission to New York; such technical failures are common and both parties agree to compensate for any loss of interest which results. But occasionally a genuine default occurs.
All exchange transactions involve the delivery of funds into an account in the country of issue of the money. In the mark-dollar example, accounts in the USA and Germany, the issuing countries of the two monies, are involved. The buyer of marks is subject to the risk that mark deposits in Germany will become frozen between the time of dealing and the delivery date; similarly the buyer of dollars is subject to the risk of deposits being frozen in the USA. Political risks can be reduced by the careful working out of delivery instructions. Thus a client from an OPEC state who is fearful lest any funds which he holds in New York be frozen by the US authorities could arrange that any dollars purchased be paid into the current account which his London bank maintains with a New York bank and obtain an equal credit to his euro-dollar deposit with the London bank.
An outright forward exchange contract provides for the exchange of one currency against another at a fixed date in the future (further ahead than the conventional two days for spot transactions). Again, the subject of exchange is sight deposits with banks in the country of issue of the respective currencies. It is not normal for the transactors to specify to which bank account funds are to be credited until near the time of delivery. Indeed, very often the customer will close out his forward contract before its maturity by offsetting another contract in the opposite direction for the same date. Any balance of profit or loss would then typically be settled when the two contracts mature.
The outright forward contract, like the spot exchange contract, but to a considerably greater degree, is subject to credit and political risks. Once the forward contract matures into a spot contract (this occurs two days before delivery), its credit and political risks are identical to those discussed earlier. There are additional dangers. The bank's customer may become bankrupt prior to the forward contract maturing into a spot contract. If, at the date of bankruptcy, the customer's forward position was showing a large loss (because the mark had fallen steeply in the exchange market), then the bank would suffer a loss due to its customer's default; for the bank would either have a matching forward obligation to another customer, or itself have assumed a matching open position. Another danger is that during the lifetime of the forward contract one of the currencies may become non-convertible. For example, Deutsche marks may have their convertibility into foreign monies restricted, and the customer may not be able to use the marks delivered to him for their intended purpose.
The swap contract is a hybrid spot and forward transaction. In a swap deal two currencies are exchanged in the spot market, and simultaneously they are exchanged in the opposite direction in the forward market. For example, a customer in a swap transaction in dollars against marks with his bank could sell $100,000 spot for marks, and simultaneously buy back $100,000 against marks forward for delivery in three months. The swap rate is a price difference — it is the premium or discount at which the parties agree to reverse the spot deal at the given date in the future. After the spot component of the swap deal has been completed — that is, when sight deposits in the respective currencies have been exchanged — then both parties are left with simple outright forward positions outstanding, with their associated credit and political risks as already described.
Swap dealing is very common in exchange markets and there is a much greater volume of swap than of outright forward transactions. The concept of swap dealing and the relationship of the swap market to the other two exchange markets — the outright and spot — are complex, and are the subject of Chapter 2, with further development in later chapters.
Making the Markets in Foreign Exchange
Exchange markets for the major currencies are highly liquid. It is possible to deal instantaneously during the business day in the spot, swap or forward markets, for maturities of up to one year. The cost of dealing is extremely low and is not much reduced by spacing the deal over a period of time rather than acting immediately. The effective business day is a long day, with the foreign exchange market embracing cities spread throughout the major time zones. There are two main types of agent who contribute to the creation of liquidity in exchange markets — the market-maker and broker. The broker is found in a wide range of markets, extending from money and commodity markets at one extreme to labour, humans and houses at the other. The market-maker, in contrast is found only in high-volume financial markets.
The market-maker is prepared to deal continuously through business hours, and deals for his own inventory. He quotes a two-way price (a buying and a selling price) and is prepared to deal at these prices up to a conventional maximum (around $10 million equivalent in the contemporary exchange market). On obtaining a quote from the market-maker, the customer expects to be able to deal instantaneously in either direction. In consequence, the market-maker must accept inventory positions — long or short — in currencies. He cannot keep his customer at bay whilst he tries to find another customer wishing to deal in the opposite direction at the other side of his two-way price.
On a normal day in the foreign exchange markets, the spread between the bid and offer rate on marks against dollars (spot) — the busiest exchange market in the world — is around 10 pips (for example, 2.2230-2.2240 DM/$). It is the spread which is the source of the market-maker's revenue. Out of the revenue he must expect to meet the operating costs of the foreign exchange department plus make a net return sufficient to compensate for risk. It may be argued that over a period of months the cu...
