Primary dealers quote two-way prices and are willing to deal either side, i.e. they buy and sell the base currency up to conventional amounts at those prices. However, in interbank markets this is a matter of mutual accommodation. A dealer will be shown a two-way quote only if he / she extends the privilege to fellow dealers when they call for a quote.
Communications between dealers tend to be very terse. A typical spot transaction would be dealt as follows:
BANK A : “ Bank A calling. Your price on mark – dollar please.”
BANK B : “ Forty forty eight.”
BANK A : “ Ten dollars mine at forty eight.”
Bank A dealer identifies and asks himself for B’s DEM/USD. Bank A is dealing at 1.4540/1.4548. The first of these, 1.4540, is bank B’s price for buying USD against DEM or its bid for USD; it will pay DEM 1.4540 for every USD it buys. The second 1.4548, is its selling or offer price for USD, also called ask price; it will charge DEM 1.4548 for very USD it sells. The difference between the two, 0.0008 or 8 points is bank B’s bid – offer or bid – ask spread. It compensates the bank for costs of performing the market making function including some profit. Between dealers it is assumed that the caller knows the big figure, viz. 1.45. Bank B dealer therefore quotes the last two digits (points) in her bid offer quote viz. 40 – 48.
Bank A dealer whishes to buy dollars against marks and he conveys this in the third line which really means “ I buy ten million dollars at your offer price of DEM 1.4548per US dollar.”
Bank B is said to have been “hit” on its offer side. If the bank A dealer wanted to sell say 5 million dollars, he would instead said “Five dollars yours at forty”. Bank B would have been “hit” on its bid side.
When a dealer A calls another dealer B and asks for a quote between a pair of currencies, dealer B may or may not wish to take on the resulting position on his books. If he does, he will quote a price based on his information about the current market and the anticipated trends and take the deal on his books. This is known as “warehousing the deal”. If he does not wish to warehouse the deal, he will immediately call a dealer C, get his quote and show that quote to A. If A does a deal, B will immediately offset it with C. This is known as “back-to-back” dealing. Normally, back-to-back deals are done when the client asks for a quote on a currency, which a dealer does not actively trade.
In the interbank, market deals are done on the telephone. Suppose bank A wishes to buy the British pound sterling against the USD. A trader in bank A might call his counterpart in bank B and asks for a price quotation. If the price is acceptable they will agree to do the deal and both will enter the details- the amount bought/sold, the price, the identity of the counter party, etc.-in their respective banks’ computerized record systems and go to the next transaction. Subsequently, written confirmations will be sent containing all the details. On the day of the settlement, bank A will turn over a US dollar deposit to bank B and B will turn over a sterling deposit to A. The traders are out of the picture once the deal is agreed upon and entered in the record systems. This enables them to do deals very rapidly.
In a normal two-way market, a trader expects “to be hit” on both sides of his quote amounts. That is in the pound – dollar case above. On a normal business day the trader expects to buy and sell roughly equal amounts of pounds / dollars. The bank margin would then be the bid – ask spread.
But suppose in the course of trading the trader finds that he is being hit on one side of hiss quote much more often than the other side. In the pound – dollar example this means that he is buying many more pounds that he selling or vie versa. This leads to a trader building up a position. If he has sold / bough t more pounds than he has bought/ sold he is said to have a net short position / long position in pounds. Given the variability of exchange rates, maintaining a large net short or long position in pounds of 1000000. The pound suddenly appreciates from say $1.7500 to $1.7520. This implies that the banks liability increases by $2000 ($0.0020 per pound for 1 million pounds. Of course pound depreciation would have resulted in a gain. Similarly a net long position leads to a loss if it has to be covered at a lower price and a gain if at a higher price. (By covering a position we mean undertaking transactions that will reduce the net position to zero. A trader net long in pounds must sell pounds to cover a net short must buy pounds. A potential gain or loss from a position depends upon the size of the position and the variability of exchange rates. Building and carrying such net positions for a long duration would be equivalent to speculation and banks exercise tight control over their traders to prevent such activity. This is done by prescribing the maximum size of net positions a trader can build up during a trading day and how much can be carried overnight.
When a trader realizes that he is building up an undesirable net position he will adjust his bid ask quotes in a manner designed to discourage on type of deal and encourage the opposite deal. For instance a trader who has overbought say DEM against USD, will want to discourage further sellers of marks and encourage buyers. If his initial quote was say DEM/USD 1.7500 – 1.7510 he might move it to 1.7508 – 1.7518 i.e offer more marks per USD sold to the bank and charge more marks per dollar bought from the bank.
Since most of the trading takes place between market making banks, it is a zero – sum game, i.e. gains made by one trader are reflected in losses made by another. However when central banks intervene, it is possible for banks as a group to gain or lose at the expense of the central bank.
Bulk of the trading of the convertible currencies. Takes place against the US dollar. Thus quotations for Deutschemarks, Swiss Francs, yen, pound sterling etc will be commonly given against the US dollar. If a corporate customer wants to buy or sell yen against the DEM, a cross rate will be worked out from the DEM/USD and JPY/USD quotation. One reason for using a common currency (called the vehicle currency) for all quotations is to economize on the number of exchange rates. With 10 currencies 54 two-way quotes will be needed. By using a common currency to quote against, the number is reduced to 9 or in general n – 1ss. Also by this means the possibility of triangular arbitrage is minimized. However some banks specialize in giving these so called cross rates.