Payment involving the
transfer of bank
deposits from the buyer’s account to the seller’s account is very
both buyer and seller share the same bank. The process is only a
more complex when they have different banks if both banks are part of
clearing system. If the two banks are in different clearing
payment is substantially more complex.
A Case of
Consider a U.S.
importer who buys a shipment
of Swiss watches. Assume the exporter requires payment in francs
account at a Swiss bank, which of course is in a different clearing
system. Normally the importer will go to the foreign exchange
desk of his
own bank and pay the dollars required to buy the francs as a deposit in
bank. The details of this transaction are handled by his own
A check can then be drawn on the Swiss bank in payment to the
When the exporter deposits the check in his Swiss bank, it will clear
normal fashion through the Swiss banking system.
Where does the U.S.
bank get the Swiss
francs to sell to the importer? If the bank is large enough and
business in foreign exchange, it may maintain a deposit of its own at a
bank. If not, it can buy the francs in the interbank market in
currencies where the ownership of deposits in different currencies is
traded. Small banks may need the services of a correspondent bank
has trading facilities.
Use of a Forward
If the importer’s
payment is not due for say
three months, he can buy a forward contract with his bank for delivery
francs at that time. This locks in the dollar price and thus
against changes in the exchange rate before actual payment is
If the amount were large enough, the bank would hedge its own risk with
currency swap in the foreign exchange market.
A currency swap
consists of two simultaneous
transactions. In this example, one would be the purchase of
dollars for immediate delivery in the spot
market. The other would be a
contract in the forward market
allowing the bank to sell
francs for dollars at an agreed upon price three months hence. At
time the francs would be delivered as required. The currency swap
in the exchange rate and thus protects the bank. The bank makes
profit as a markup in the forward contract bought by the
Because so much of
world trade is conducted
directly in US dollars, foreign exchange between non-U.S. currencies
involves conversion into and out of U.S. dollars. The foreign
market is an international market, active around the clock. London has by far the largest market, followed by
New York, Tokyo, and Singapore.
Large banks and security dealers maintain trading rooms where they post
computer screens around the world their bid and ask prices for
relative to the U.S. dollar. Quotes are offered for both the spot
and the forward market.
trading has grown rapidly
since 1971. That is the year Nixon ended gold backing for the
in international payments, thus leaving the exchange rates of the
currencies to float at market prices. The volatility of those rates has
increased dramatically since the mid-1970s, creating investment risk as
opportunities for speculative gain. Foreign exchange trading in
of commerce is now just the tip of the iceberg, probably less than 5%