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Foreign Exchange

Payment involving the transfer of bank deposits from the buyer’s account to the seller’s account is very simple if both buyer and seller share the same bank.  The process is only a little more complex when they have different banks if both banks are part of the same clearing system.  If the two banks are in different clearing systems, payment is substantially more complex. 

A Case of Different Clearing Systems 

Consider a U.S. importer who buys a shipment of Swiss watches.  Assume the exporter requires payment in francs to his 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 a Swiss bank.  The details of this transaction are handled by his own bank.  A check can then be drawn on the Swiss bank in payment to the exporter.  When the exporter deposits the check in his Swiss bank, it will clear in the 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 does business in foreign exchange, it may maintain a deposit of its own at a Swiss bank.  If not, it can buy the francs in the interbank market in foreign currencies where the ownership of deposits in different currencies is traded.  Small banks may need the services of a correspondent bank that has trading facilities. 

Use of a Forward Contract 

If the importer’s payment is not due for say three months, he can buy a forward contract with his bank for delivery of francs at that time.  This locks in the dollar price and thus protects him against changes in the exchange rate before actual payment is required.  If the amount were large enough, the bank would hedge its own risk with a currency swap in the foreign exchange market. 

A currency swap consists of two simultaneous transactions.  In this example, one would be the purchase of francs for 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 that time the francs would be delivered as required.  The currency swap locks in the exchange rate and thus protects the bank.  The bank makes its profit as a markup in the forward contract bought by the importer. 

The Foreign Exchange Market 

Because so much of world trade is conducted directly in US dollars, foreign exchange between non-U.S. currencies usually involves conversion into and out of U.S. dollars.  The foreign exchange 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 on computer screens around the world their bid and ask prices for currencies relative to the U.S. dollar.  Quotes are offered for both the spot market and the forward market. 

Foreign exchange trading has grown rapidly since 1971.  That is the year Nixon ended gold backing for the U.S. dollar in international payments, thus leaving the exchange rates of the world’s currencies to float at market prices.  The volatility of those rates has increased dramatically since the mid-1970s, creating investment risk as well as opportunities for speculative gain.  Foreign exchange trading in support of commerce is now just the tip of the iceberg, probably less than 5% of the total.

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