Money (including transfer of money) and related services: foreign exchange (forex): how do businesses conduct forex transactions?
Essentially the way forex can be transacted is either with “cash”, “spot” or “forward” transactions. The way the businesses benefits from such transactions is either from a “spread” or “commission”. Forex deals are not traded on an exchange and are referred to as “over the counter - OTC” deals.
What is cash forex?
These are purchases (physical) of foreign currency transacted by the exchange of cash (or other immediate payment methods, i.e. cheques, debit cards, credit cards, etc) generally through an MSB.
What is a spot?
A spot transaction/deal is a straightforward exchange of one currency for another. The spot rate is the current market rate.
For market makers, brokers or other forex dealers etc, the ‘spot’ value date is, by convention, on the second business day (a valid business day is a normal working day in the financial centres for both currencies in the transaction) after the trading/deal date. These deals are sometimes referred to as “spot next” deals, i.e. deals starting on the spot date and maturing on the next working day.
What is a Market Maker?
A market maker is someone (generally a large bank) who will quote at all times for other banks and their customers both a rate at which they are willing to buy (the bid) and a rate at which they are willing to sell (the offer, or, ask), a “two way quote”, agreed amounts of any currency for which they are making a market.
Market makers will typically have a dealing room or trading floor where deals will be struck by telephone or by electronic means. Such dealing rooms will be equipped with a range of monitors supplying global information on the movements in financial markets that will influence positions market makers will want to take.
What is a spread?
A spread is the difference between the bid rate and the sell (offer) rate and it is from this difference that someone dealing in forex will look to make their profit.
The spread is most obvious when looking at the exchange rates displayed at an MSB, but for the major dealers the bid and offer quotes for most currencies are carried down to the fourth decimal point. On more volatile currency markets the spread can be small; convention on the spot GBP/US$ market will be as narrow as 3 “pips”, i.e. 1.9477 - 1.9474.
What is a forward?
A forward transaction differs from a spot transaction in that the delivery and sale of currencies are completed only on a future value date, with the amounts, however, being fixed by reference to the rates of exchange agreed on the deal date. They are quoted as “forward points” referenced to the spot rate at the time that the trade is fixed.
Historically forward forex contracts came about as a means of giving some certainty in commercial terms to both producers and buyers of commodities and for wider trading reasons but have evolved as a tradable financial instrument in their own right and an integral part of the forex market.
Whilst in any contract there is an exchange of currencies, each party will tend to see themselves in a ‘buy’ or ‘sell’ position depending on what each is seeking to achieve commercially or how each might be speculating as to how the forex market will move.
A basic example would be a business that knows it will need to settle a supplier’s account in USD in say, three months time. If the USD is expected to strengthen against sterling (GBP), the business knows that in three months its costs will be higher in GBP terms. By entering now into a forward purchase of USD, it can limit any additional costs that might result from that adverse currency fluctuation.
What are ‘open’ and ‘closed’ positions?
These terms can used in relation to both spot and forward transactions but are more readily understood in relation to forwards.
In the basic example at the previous paragraph, our business holds an ‘open’ position as it will allow the transaction to run to maturity in order to gain the benefit of the position taken and receives the dollars it needs at an advantageous rate to that which it might otherwise have been obliged to pay against the spot rate of the day.
If however our business at the end of the first month saw the USD start to rapidly weaken against GBP, it might conclude that if it retained its open position it would be disadvantaged against what the eventual spot price might be when it was due to settle its USD liability. It would then take out a sale for the same amount of USD to mature at the same time as its buy contract. This would ‘close out’ its position at some cost in terms of the forward points difference but would have the effect of limiting that cost of the reversed currency fluctuation.
If the currency market was particularly volatile during the three month period described above, our business might enter into a series of forward contracts, constantly changing it’s open or closed position. Such activity can be referred to as ‘hedging’.
A major forex dealer during it trading time zone, will be constantly monitoring its holding of different currencies, its position on forwards and what its sees as its risk or exposure to currency movements. It will often at the close of business, look to lock in profit, restrict any loss, or, limit its overnight exposure by closing its various positions through further spot or forward deals. Again this activity can be described as ‘hedging’.
What about fees or commission?
Fees or commissions will be levied by forex broking companies and are clearly linked to pre-agreed charging scales.
This is not a common practice for banks. Sometimes banks will apply a fee or commission because there is a particular added value to a bespoke service or it is seen as having some boutique or exotic nature.