Thursday, September 3, 2009

The role of banks in the foreign exchange market (1)

The central institution in modern foreign exchange markets is the commercial bank. Most transaction in foreign currency of any size represent merely an exchange of the deposit of one bank for the deposits of another bank. That is, if an individual or business firm needs foreign currency, it will contact a bank, which in turn will secure a deposit denominated in foreign money or actually take delivery of foreign currency if the customer requires it. If the bank is a large money-center institution, it may hold inventories of foreign currency just to accommodate its customers. Smaller banks typically do not hold stocks of foreign currency or foreign-currency-denominated deposits. Rater, they will contact larger correspondent banks, who in turn will contact bank and nonbank foreign exchange brokers or dealers.
The largest money-center banks headquartered in New York, London, Zurich, Tokyo, Frankfurt, and other financial capitals of the world not only maintain large inventories of key foreign currencies but trade currencies with each other simply through an exchange of deposits. For example, if a major U.S. bank needs to acquire pounds sterling, it can contact its correspondent bank in London and ask that bank to transfer an additional amount of sterling to the U.S. bank‘s correspondent account. In turn, the U.S. bank will increase the dollar deposit held with it by the London bank. In this way money never really leaves the country of its origin; only its ownership does, as deposits denominated in various currencies are moved from one holder to the next.

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