How Do Banks Trade Currency?

Banks are involved in more than 80 percent of foreign currency exchange transactions.

Banks dominate the international currency exchange market. About 40 percent of the $3.2 trillion in daily foreign exchange currency transactions are between banks, and roughly another 40 percent are between banks and institutional investors, such as insurance companies and pension funds, according to a 2007 report by the Bank for International Settlements. Banks include private financial institutions and central banks that act as the financial arms of their governments.

How

Banks employ a large number of foreign exchange traders who conduct the actual transactions, the Federal Reserve Bank of New York's website reports. The traders use telephone and computer networks to gather market information and arrange transactions directly with another bank. Sometimes, they arrange trades through a broker, who acts as an intermediary between the buyer and seller of a currency in return for a commission on the transaction. Banks' foreign exchange traders try to predict the behavior of other market participants. If they predict correctly, they can seize profit opportunities or prevent losses.

Transaction Types

Banks may exchange currencies in a spot transaction in which two parties agree on an exchange rate and make an immediate currency trade. Or they may agree to a forward transaction in which they will trade currencies at a specific future time. They agree on an exchange rate and make the trade at that rate on the future date, regardless of what market rates are then.

Currency Swaps

The most common type of forward transaction is the currency swap, in which two parties agree to exchange currencies at a specific exchange rate now and then reverse the transaction at that same exchange rate on a specific future date.

Why

Banks trade international currencies to make a profit from changes in exchange rates, obtain currency for direct foreign investments or secure currency needed by the banks' customers. Banks make money from foreign exchange rate changes when they can sell a currency for more than they paid to get it, or by selling a currency today at a high price and buying it back later at a lower price.

Risks

Banks can suffer significant financial loss from poor foreign exchange decisions. Banks and other market participants can minimize trading risks through tactics such as buying foreign currency options to protect against adverse market turns. With an option, the bank buys the right, but not the obligation, to buy or sell a currency at a specific price on or before a specific date. The option costs a small fraction of the currency's actual price. If things move as expected, the bank simply allows the option to expire. If there is an adverse market turn, the bank can exercise the option and minimize its losses.

References

• New York Federal Reserve Bank: Foreign Exchange
• Bank for International Settlements: Forex Market Summary