International Finance

AN INTRODUCTION TO EXCHANGE RATESEXHIBIT 2.2 AN EXCHANGE ON THE EXCHANGE: A CONVERSATIONBETWEEN MARKET-MAKERS IN THE FOREIGN EXCHANGE MARKETThe following account of an exchange betweencurrency traders is an updated, slightly revisedversion of a description of a typical conversationthat appeared in the Review of the Federal ReserveBank of St. Louis: updating is required to reflectthe fact that Germany has replaced the Deutschmarkwith the euro. In this account, Mongobank and Loans’n Things are two market-making banks. Interpretationsof jargon are given as the jargon is used. Forexample, we are told that ‘‘Two mine’’ means topurchase two million units of a currency. ‘‘One bytwo’’ means being willing to buy one million units ofa currency and sell two million units of the samecurrency.In the direct market, banks contact each other.The bank receiving a call acts as a market-makerfor the currency in question, providing a two-wayquote (bid and ask) for the bank placing the call. Adirect deal might go as follows:Mongobank: ‘‘Mongobank with a dollar-europlease?’’(Mongobank requests a spot marketquote for the euro (EUR)against US dollars (USD).Loans’n Things: ‘‘20–30’’(Loans’n Things will buy euros at1.1520 USD/EUR and sell eurosat 1.1530 USD/EUR – the 1.15part of the quote is understood.The spread here is ‘‘10 points.’’)Mongobank: ‘‘Two mine.’’(Mongobank buys EUR 2,000,000for USD 2,306,000 at 1.1530USD/EUR, for payment twobusiness days later. The quantitytraded is usually one of a handful of‘‘customary amounts.’’)Loans’n Things: ‘‘My euros to Loans ‘n ThingsFrankfurt.’’Mongobank:(Loans n’ Things requests that paymentof euros be made to their accountat their Frankfurt branch. Paymentwill likely be made via SWIFT.) a‘‘My dollars to Mongobank New York.’’(Mongobank requests that paymentof dollars be made to them in NewYork. Payment might be made viaCHIPS.) bSpot transactions are made for ‘‘value date’’ (paymentdate) two business days later to allow settlementarrangements to be made with correspondents orbranches in other time zones. This period is extendedwhen a holiday intervenes in one of the countriesinvolved. Payment occurs in a currency’s home country.The other method of inter-bank trading is brokeredtransactions. Brokers collect limit orders from bankmarket-makers. A limit order is an offer to buy(alternatively to sell) a specified quantity at a specifiedprice. Limit orders remain with the broker untilwithdrawn by the market-maker.The advantages of brokered trading include therapid dissemination of orders to other marketmakers,anonymity in quoting, and the freedom not toquote to other market-makers on a reciprocal basis,which can be required in the direct market. Anonymityallows the quoting bank to conceal its identity andthus its intentions; it also requires that the brokerknow who is an acceptable counterparty for whom.Limit orders are also provided in part as a courtesy tothe brokers as part of an ongoing business relationshipthat makes the market more liquid ...A market-maker who calls a broker for a quote getsthe broker’s inside spread, along with the quantities ofthe limit orders. A typical call to a broker mightproceed as follows:Mongobank:‘‘What is sterling, please?’’(Mongobank requests the spot quotefor US dollars against British pounds(GBP).)39 &