The interbank rate, also known as the federal funds rate, refers to the interest charged on short-term loans made between large financial institutions, such as US banks. These loans are generally short term and don’t last for longer than a week. It is common for banks to borrow money from other banks during times when they need more liquidity or lend out money when they have an excess in cash.
The interbank exchange rate, on the other hand, refers to foreign exchange rates that banks pay when they trade currencies with each other. These rates are reserved for big banking institutions only with very low fees.
In this article, we will take a closer look at how both the interbank rates and the interbank exchange rates work and who the major participants are.
How Do Interbank Rates Work?
Federal authorities in the US mandate that banks keep enough cash on hand to cover regular customer withdrawals on a daily basis. These liquidity requirements are often met by borrowing to make up for any shortfalls and lending to profit from any excess by charging a moderate interest rate.
The current federal funds rate is used to determine the interest rate paid on the money held by the banks. This rate, commonly referred to as the overnight rate or interbank rate, is established by the banks themselves. It is not ‘set’ by the Federal Reserve, but it is influenced by the one rate that the Fed does set: the discount rate. The Fed does not actually set the goal range that it attempts to keep the Fed Funds within. That decision rests with the banks taking part in the transaction.
The Federal Reserve utilises the federal funds rate as a tool to alter the overall amount of cash in the system. While a higher rate inhibits such activities, a low rate encourages banks to borrow more.
During times of economic crisis, such as a recession, the Fed will likely cut the federal funds rate to stimulate investment and borrowing.
This does not imply that customers will automatically benefit from a reduction in rates. Only the biggest and most creditworthy financial institutions have access to the interbank rate. The key federal funds rate, however, determines the interest rates for borrowing and saving money. As a result, the interest rate for a home loan or credit card, for example, will be calculated using the federal funds rate plus an additional fee.
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How Do Interbank Exchange Rates Work?
The current value of one currency in relation to any other currency is known as the interbank exchange rate, which is determined by the interbank foreign exchange market. The primary market makers such as big banks are responsible for the majority of the volume traded on the foreign exchange market (forex).
Other market participants include forex brokers, institutional investors, retail investors, hedge funds, large corporations, central banks and governments. The forex market is by far the largest market in the world, with an average trading volume of $5tn per day.
Markets such as stocks and commodities, for example, are traded on physical exchanges such as the New York Stock Exchange or the Chicago Board of Trade, to name but a few. All the trading that happens on these exchanges can be traced back to one particular location and often have a centralised network of market makers.
The forex market, however, is a decentralised market with no single physical exchange where all trades are recorded.
Trading occurs everywhere in the world and on many different exchanges with no clearinghouse for FX transactions. Instead, each financial institution or market maker keeps track of and records its own trading activity.
What Are Interbank Bid-Ask Prices?
On the foreign exchange market, all currencies are quoted in pairs with a bid and ask price, the bid price being the quote you would receive for selling and the asking price for buying the currency. The difference between the bid and ask prices is referred to as the bid-ask spread, which is where the costs come in when trading currencies.
The biggest banks in the world are the key market makers that determine the bid and ask spreads in the currency market. These banks frequently transact with one another, either for themselves or on behalf of their clients.
With so much volume traded on the foreign exchange market on a daily basis, the resulting competitiveness between the largest interbank players leads to tight bid and ask spreads and fair pricing.
Retail Forex Traders and Interbank Rates
Most retail or individual traders do not have access to the pricing available on the interbank forex market because their transaction size is not big enough to be traded by the larger interbank participants.
That being said, interbank participation is crucial to retail investors because the more players there are, the more liquidity the market has, which in turn leads to price fluctuations and more trading opportunities.
An added benefit of a market with a lot of volume is that it allows retail investors to easily enter and exit their trades.
Who Are the Major Interbank Participants?
Well-known banks such as Deutsche Bank, Citigroup, UBS and HSBC are responsible for most of the transacted forex volume. Although some government and central banks have their own systems for forex trading, they regularly use these large institutional banks to transact.
In general, banks can conduct business with one another directly or through online trading platforms. More than 1,000 banks are connected by Electronic Brokering Services (EBS) and Reuters Dealing 3000 Matching, which are the two main competitors in the electronic brokering platform market.
The forex interbank market functions on a credit approval system, where banks will trade solely based on the credit relationships they have. Although all banks can see the best market rates at any given moment, each bank needs to have an authorised relationship to trade at those rates.
Banks trade in the currency interbank market based solely on their credit relationships. Despite the fact that all banks can see the best market rates at all times, each bank needs an authorised relationship in order to trade at those rates.
The larger a bank is, the more credit relationships it gets, which in turn relates to better rates. The same holds true for retail forex brokers – the more capital they have available, the better pricing they will get.
Conclusion
In this article, we discussed what both interbank rates and interbank exchange rates are. We also looked at who the biggest market participants are that drive this massive global market that literally dwarfs all other financial markets.
Although we might never have the ability as retail traders to trade the same amounts of volume that large institutional banks do, or get access to their reduced interbank fee structures, they play an especially important role in providing liquidity for the currency markets.
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