What is the Purpose of the Interbank Market?
The interbank market is a global financial market for exchanging currencies. It is the largest and most liquid financial market globally, with over $5 trillion worth of currency changing hands daily.
The interbank market ensures that banks have easy access to foreign exchange at all times to provide their customers with accurate rates and prices. This article will give you insight into what this large-scale marketplace does and how it operates.
Understanding the Interbank Market: How Does it Operate?
The interbank market is a global marketplace that operates 24 hours a day, five days a week. This means there are always traders trading in this market, and it is never closed during the working days of the week.
This marketplace has no physical location or central counterparty to oversee the transactions within its borders.
That said, you can think of the interbank market as an extensive auction where banks and other financial institutions are selling their currency to the highest bidder.
The interbank FX market is an over-the-counter (OTC) marketplace that operates under no central authority or governance.
The interbank market helps to ensure that all of the major currencies are traded regularly. This is true even when trading activity is low in other markets like the stock exchange or commodities exchanges.
With no central authority governing transactions, there would be a liquidity crisis if this were not the case, making it impossible for businesses and individuals who require foreign currencies to operate.
Leading Currencies Traded at the Interbank Foreign Exchange Market
One of the most popular currency pairs traded on this platform is the US Dollar (USD) against the Euro (EUR). This makes up just over 50% of all trades.
Why this pair? Simply because the US is a significant trading country and Euros are needed to purchase items imported from Europe, such as oil, food, and clothing.
Most interbank foreign exchange transactions occur in London, but exchanges take place at all hours of day and night worldwide. Therefore, even if you have an unusual request, there is a good chance that someone will fill it.
Other major currency pairs traded on at the interbank market include:
The Benefits/Role of the Interbank Market
The most important thing to remember is that the interbank market exists as a method for banks and currency traders to buy/sell currencies at any hour of the day. This makes it much easier than dealing with an exchange bureau closed during non-business hours.
Here are some of the critical benefits of the interbank market:
Acts as a Source of Funds for Banks
The interbank market allows banks to maintain liquidity when the normal times for making exchanges are not in their favour. A bank that wants to exchange currencies but is currently out of season or lacks enough capital can turn to this market and take advantage of these opportunities that would typically go to waste.
Allows for Liquidity between Banks and Central Banks
Sometimes, the interbank market will use central banks to facilitate transactions. This is helpful in countries that don't have a strong currency.
It can also be an intermediary when conducting foreign exchange within international trade deals between two currencies.
Allows for Liquidity between Central Bank and Commercial Banks
Similar to the central banks using the interbank market for transactions, commercial or retail banks can use it when they need liquidity between each other.
It is not necessarily limited to these circumstances; if a bank lacks enough liquidity in its reserve account and needs more money, this will be available.
Promotes Fractional Reserve Banking Model
The interbank market also promotes the fractional reserve banking model. Because it is a short-term loan, it allows banks to continue operating with less liquidity in their reserves and still meet customer needs (such as withdrawals).
This type of transaction would not be possible without an intermediary like the interbank market since it provides flexibility to the banks.
Allows for Transmission of Monetary Policies
Monetary policies can also be more easily transmitted through the interbank market since it is so large. This gives banks access to low-cost funds, allowing easier monetary policy transmission that can hopefully spur economic growth and recovery.
It Funds Liquidity Risks
A country’s central bank can fail to service its liabilities. Once this happens, it’s the duty of the central bank to find additional sources of funds.
One way the central bank funds liquidity risk is through interbank lending. They can use the additional funds to settle their matured debts, thus reducing liquidity risks. The good thing with interbank liquidity loans is that they’re available quickly and at a lower cost.
It Acts as a Benchmark for Short-Term Lending Rates
When the pricing of a majority of financial instruments like Adjustable Rate Mortgages (ARMs), Floating Rate Notes (FRN) and syndicate loans are made, a lot is borrowed from the unsecured interbank lending system.
The conditions in the unsecured interbank lending markets can have far-reaching effects on the financial system of a country by shaping the investment decisions of households and firms.
Challenges with the Interbank Market
Countries trading in the interbank market do so with some risks and challenges. Some of these challenges are:
Diverse Risk Tolerances of Banks
Banks' risk tolerance is very diverse, which can cause some adverse effects on the market. Suppose a bank decides to take more risks with its portfolio. In that case, it could start getting low-quality interbank loans, which would negatively affect the transmission of monetary policies through the economy.
Another way in which risk tolerance can affect the interbank market is by making it more volatile. Suppose banks do not have diverse risk tolerance. In that case, they will all start taking risks to make money, and this would cause volatility because of over-speculation in these high-risk assets, which could lead to losses during times of increased uncertainty.
Another challenge that central banks face when managing the interbank market is limited liquidity. This means that if people started withdrawing their money at once, the bank would not have enough liquid assets to cover these withdrawals.
The interbank market is a primary factor in the global economy, and it has helped countries preserve the value and stability of their currencies. A country must weigh the benefits of trading in the interbank market before taking action. Trading well in the interbank market could save millions of dollars in the long term.