This jourbaney begins as a traveler removes foreign currency from an ATM machine in Istanbul. The author guides us from the periphery of the market into its neural centers in financial hubs such as London and New York. Currency traders, market analysts, money managers and payments systems architects show their workplaces and reveal their day-to-day experiences in this unpredictable and rapidly evolving world.
The experts interviewed may use unfamiliar terms, but the logical progression of the chapters and participants' stories told in workplace settings bring abstract concepts down to earth. After completing the tour, the reader will have a clear picture of the geographical and structural organization of global currency markets and the people who run them. This vision of a volatile, evolving structure will provide a useful framework for deciphering the complex causes of yet unforeseen financial events.
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About the Author
Robert G. Williams is Voehringer Professor of Economics at Guilford College, North Carolina.
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The Money Changers
A Guided Tour Through Global Currency Markets
By Robert G. Williams
Zed Books LtdCopyright © 2006 Robert G. Williams
All rights reserved.
Back in the States: a glance at foreign exchange
The radio blares from the kitchen: 'The dollar fell against the yen in heavy Tokyo trading today, closing at 105.75 yen, down two yen from Friday's close. In early European trading, the dollar is mixed against the euro and the pound.'
I look at the Wall Street Journal's website (online.wsj.com) and select 'currencies' to pull up a table that lists about sixty foreign currencies from the Argentine peso to the Venezuelan bolivar. I select about a dozen currencies and download them to see what can be learned from this listing (see figure 1.1). I underline the first thing that catches my eye at the top. These must be the wholesale market rates in New York, because these quotes are for trades 'among banks in amounts of $1 million and more'; the fine print warns 'retail transactions provide fewer units of foreign currency per dollar.' So, as the trip to Turkey taught, the money-changing business is like any other. The middleman collects a profit.
The next thing that catches my eye is that for every currency they show two ways of quoting the exchange rate, one they call the 'US$ Equivalent' and the other 'Currency per US$.' To compute the difference I go down to the Japanese yen, and see that a yen was worth less than a penny on Friday, or about nine-tenths of a cent. So, if I were in Japan and was charged a thousand yen for this breakfast, I would know that the bagel and coffee were costing me a little over 9 bucks. The second way they're quoting it is from a Japanese point of view, the price of the dollar or how many yen it takes to buy a dollar. From Friday to today, the dollar fell in value from 107.74 yen to 105.75 yen. So for a Japanese tourist visiting New York, a $9 breakfast would have gotten a little less expensive over the weekend, since $9 would convert back into fewer yen on Monday than on Friday.
I see that the yen is like the UK pound and most of the other currencies listed; their values fluctuate from one day to the next. Two exceptions appear to be the Hong Kong dollar and the Chinese renminbi, which at this time look like they might be pegged to the US dollar since they traded at the same values on Thursday and Friday, both of them valued at more than twelve cents. Also, it looks as though on 11 September 2000, Ecuador eliminated its currency and adopted the US dollar.
Also I see the banks are quoting I-month, 3-month and 6-months forward rates for the Canadian dollar, the British pound, and the Japanese yen, in addition to the rates for the day. I highlight these and note that the pound looks slightly less expensive to buy forward, while the Canadian dollar and the yen look more expensive forward. Are the currency traders predicting the pound will fall a bit, and the yen and Canadian dollar will strengthen against the dollar?
I note the euro fell slightly against the dollar and the Australian dollar rose from Thursday to Friday, so they are floating currencies. And then there's the Turkish lira, which appears to be falling.
This is about all that can be seen just looking at the table from the Wall Street Journal. There are two ways to express the same exchange rate. Some currencies float against each other; some are fixed. Some move more quickly than others. Some have developed forward markets, others maybe not. Banks are at the center of the currency markets, and there's a wholesale market for large blocks at a time in New York. Trades between banks are for sizeable amounts, but retail amounts to customers would cost more. But this little snapshot of two days' worth of foreign exchange trading raises more questions than it answers.
What exactly is being exchanged on the currency markets? Who are the major banks involved in this business? Who are their customers, and how much are they charged? How do customers buy currencies from the banks? How do the banks buy and sell currencies with each other? What makes some currencies float and others stay fixed? What are forward rates about, and why are they higher or lower than current rates?
I thumb through the telephone book and find a nearby bank that has a listing for foreign exchange. I need an introduction, so I call a former student who works there. Alice tells me she'll call the head of the department. She says the small group of traders are known at the bank for working hard and having a good time. In ten minutes, Alice calls back and gives me the go-ahead to contact the head of the foreign exchange (FX) department.
Mr Roberts says his schedule is filled for the rest of the week, but if I could get there in an hour he'll be able to work me in for about forty-five minutes. 'If you're interested, I'll introduce you to my people in the trading room, who'll show you what they do. Bring a photo ID You'll need it to sign in at the lobby.'CHAPTER 2
A visit to a local bank: what do money changers buy and sell?
Mr Roberts tilts back in a leather chair behind a large desk.
'Have you always had all the security check-points?' I ask.
'No, they were put in after September nth.' He describes some of the other changes at the bank, which was for most of its history a town bank but in the 1950s expanded to other towns and cities in the state. Then in the 1990s the bank began acquiring banks and opening branches in other states. These acquisitions were done cautiously and turned out to be profitable. 'Now we're a target for a takeover, if we don't successfully negotiate this merger.'
A senior vice-president and head of the foreign exchange department, Mr Roberts has worked for the bank for more than thirty years, most of that time in foreign exchange. He describes what it was like under fixed exchange rates. 'Back when I started, foreign exchange was a no-brainer, but in 1972, when Bretton Woods broke down,' Mr Roberts's blue eyes light up, 'we had to mobilize. There hasn't been a dull moment since.'
'How has your currency business evolved over this time?'
'Our foreign exchange operations have always been simply an extension of corporate banking services we offer customers.' Before the expansion into other states, he served the customer base with a staff of four; prior to that he and two women ran the show; and it began with him and one clerk. 'The entire time we had a very high profit-to-expenses ratio. Then we acquired a bank in another state that had a foreign exchange department with fifteen people. They did a larger volume business but with a much lower profit-to-expenses ratio.'
'Did the acquired bank keep its foreign exchange department after the merger?'
'No.' He explains that the costs of outfitting a state-of-the-art trading room are high, and to cut down on staffing and other duplications, they decided to centralize their operations at company headquarters here. 'We kept the "niche" business. We offer competitive rates and a highly personalized service to our corporate customers, and we've combined it with a moderate dealing business.' He says proudly, 'We're doing all this with a staff of only ten people, including me.'
'And with a merger in the works?' I ask.
'Depending on who gets us. The bidders are much larger than we are. One has a trading room with three hundred stations, sixty of them devoted to foreign exchange, the rest to stocks, fixed-income securities, and money market instruments. Our department — though highly profitable — will soon be dissolved. Of course, I'm retiring before that happens.' Melancholy crosses his face.
I decide to shift to a happier past. 'Why, for the last few decades, have companies chosen to do business with you instead of going through a big New York bank?'
He brightens. 'First, they know they won't get a better deal with the big guys. Second, most of our customers already use us for cash management and payrolls. We know them and their creditworthiness, and they know us. They realize our account executives will spend just as much time on a $20,000 transaction as they would for a $20 million one. That doesn't happen in New York. Several years ago, we were attracting accounts from some of the big New York banks.'
'How did you do that?'
'It became known that we separated our corporate service section, which carries out orders for customers, and our dealer section, which trades to make profits for the bank.' He says that back then the typical New York account executive also made money from dealing — a conflict of interest in his view. 'You'll see in the trading room that we keep the two positions — account executive and dealer — separate, so our account executives work for the customer and try to get as good a price as possible from our dealers. The big banks saw this and copied us.'
'Mr Roberts, you've worked in this business for more than thirty years and know it inside and out. I've got some beginner questions for you if you don't mind. First of all, when I think of currencies being traded, I picture myself in a foreign land, at the airport or train station, changing my $20 bills for their money.'
Mr Roberts smiles. 'That's the picture most people have.'
'How relevant is this picture for today's world?'
'It's just the retail fringe.' He says that direct exchange of notes happens in every country, especially around tourist attractions. In Eastern Europe and developing countries, where there is little faith in the banking system, it takes on a more important role. He recalls a customer who did business in Russia. 'Before leaving, he would come in and get stacks of $100 bills. His man in St Petersburg would use the money for investment deals.' He explains that the center of the currency markets, where wholesale rates are set, bank account money is traded, not physical units of currency. 'Everyone else who trades in those currencies, even the money changer at the airport, watches these wholesale rates and adjusts buy and sell rates according to the wholesale changes at the center of the currency market.'
'How might the image of physical currency changing hands be misleading about the actual workings of currency markets?' I ask.
'People get confused by this all the time.' He explains that when physical currency is traded, there is an exchange of money from one country to the next. When bank account money is traded, it doesn't cross a border. 'It just moves between accounts inside the two banking systems.'
'Can you give an example?'
'Well, let's say I buy Swiss francs with dollars. On delivery day, funds from my dollar account in the US are sent to their dollar account in the US, and they'll send Swiss francs from their account to ours at a correspondent bank in Switzerland. Then they can make dollar payments and we can make Swiss franc payments.'
'When you say "send," do you mean you write them a check?'
'No. The funds are wired — electronically sent. Only the tiniest fraction of foreign exchange involves the trade of physical currencies, and practically none of the delivery instructions are made through checks.'
'You mentioned "on delivery day." Is there a gap between when you agree to trade a currency and when the funds are finally delivered?'
'There are two gaps: When and where.
I ask him to explain, and he says that only with physical currency are there no gaps. You show how many dollars you want to change, the money changer writes down an amount of local currency you will get, you pass your dollars through the window and the money changer passes the local currency back. 'The deal and the delivery are in the same place at the same time.'
'And when the deal involves account money?' 'Account money deals can be struck anywhere.' He gives the example of someone in Timbuktu agreeing to trade US dollars for British pounds with someone in Machu Picchu. All they need is a secure communications line and assurance that the other will actually deliver the funds. After the deal is made, they instruct their banks in the US and in the UK to send the amounts agreed on to the other's bank account. 'The delivery of dollars and pounds to the correct accounts may take a few days, depending on the settlement systems used by the banks to complete the transfers.'
'A few days — you mean two?'
'Yes, for most currencies, the standard contract is for delivery two days after the deal is struck.' He says that this standard convention is called a 'spot' contract, and the two days between the 'trade date' and the 'value date' is to give ample time for banks to arrange for the movement of funds.
'You said "for most currencies." Are there exceptions?'
'Yes, for trades involving the US dollar and the Canadian dollar, the standard 'spot' contract is for next-day delivery.' He explains that the time zones are the same and the settlement systems closely linked, so next-day delivery gives ample time.
'But hasn't information technology speeded up funds transfer between banks, so same-day delivery can happen?'
'True. Technology has supported innovations that speed funds transfers, so same-day delivery is more likely now than five years ago. (Mr Roberts gives the example of Continuous Linked Settlement Bank, whose entire purpose is to settle currency transactions quickly and safely. See appendix to Chapter 11 for more details on CLS Bank.) Also with banks consolidating across borders, "cash" or same-day delivery is happening more often.' Mr Roberts gives the example of JPMorgan Chase, with branches worldwide. If both parties use accounts at the same bank, the electronic funds transfer takes place on the internal payments system of the bank. The delivery can happen the same day, because banks don't have to settle up with each other. 'But, despite possibilities for faster delivery, the standard "spot" contract is pretty much like it was twenty years ago, a promise to deliver funds two days after a trade.'
'What about the listings for "one month", "three months," and "six months" forward?'
Mr Roberts explains that "outright forwards" are deals to deliver funds one or more days after the "spot" value date. A one-day outright forward would be for delivery within three business days after the trade date, or spot plus one. The one-month, three-months, and six-months forward contracts are commonly listed in newspapers because they correspond to the duration of typical loan contracts. Because credit markets in different countries are linked through foreign exchange, those dates are heavily traded. He says they call these 'straight dates.' 'So much action happens for these dates that the entire market uses them as benchmarks for valuing customized forwards.'
'Often our clients know exactly when they want to make a payment abroad or when they will be receiving payment in a foreign currency, and they'll want to convert it back into dollars, so we can tailor deliveries for specific dates that aren't traded much.'
I ask why his customers ask for forward contracts, when they could just wait and use a spot contract.
'It's insurance against currency markets moving against them.' He says that many of his customers are manufacturers. If they have to make foreign currency payments in six months for parts or raw materials they've ordered, they don't want to be surprised to find the cost in dollars to have risen because of the currency markets. 'So they call us — sometimes several days in a row — to check on forward rates. When they get a forward rate that's inexpensive enough to assure them of a profit, they'll enter into a forward contract with us for the delivery of the foreign currency close to the time they have to pay the supplier. They're buying insurance against the dollar declining in value, which might otherwise drive up their costs and squeeze their profits.'
'But what if the dollar rises in value over that time?'
'In that case, if our client had waited until two days before the payment is due, he could have entered a spot transaction that would have cost the company fewer dollars for the foreign currency needed. But the company is in the manufacturing business, not the business of currency speculation, so our client's eye is on locking in manufacturing profits. We provide a service that allows the company to do that.'
'So when the bank takes on a forward contract on behalf of a customer, does the bank then absorb the currency risk?'
Mr Roberts smiles, 'Not for long. This is where our dealers come in. If an action for a customer gets the bank's currency exposure out of balance, we'll quickly counteract it with a reverse deal. That neutralizes our foreign exchange risk.'
'So, how do you make money on this? Do you charge a commission?'
'No, we don't charge a commission. We make a profit through spreads.'
He says a 'spread' is the difference between the price a currency dealer is willing to 'offer' to sell a currency for and the price they'll 'bid' to buy it for. 'At the wholesale center of the market, deals are in large blocks, trading is brisk, and there's plenty of competition so bid/offer spreads are thin. We have good credit with major currency dealers, so we can trade with them at wholesale rates. If a customer calls and wants to buy a particular currency, we first find out how much we could buy the currency for on the wholesale market, and then we adjust the "spread," which translates into a retail markup over what we can buy it for. Then our dealer, who watches the wholesale market carefully, finds the best deal to cover our exposure.'
Excerpted from The Money Changers by Robert G. Williams. Copyright © 2006 Robert G. Williams. Excerpted by permission of Zed Books Ltd.
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Table of Contents
Introduction: Encounter with a Moneychanger 1. A Glance at Foreign Exchange at Breakfast 2. A Visit to the Local Bank: What Do Money Changers Buy and Sell? 3. How Do Money Changers Arrange Deals? 4. Who Are the Actors in the World's Biggest Market? 5. Where Deals are Made: Historical Geography of Money Changer Enclaves Why Do Money Changers Cluster Where They Do? Paradox of Clustering in a Computer-linked World 6. Professor Smith Gets FX'd in Tokyo: Could He Have Profited from a Currency Forecast? 7. Inside the Trading Room: Philosophies behind Trading Strategies Vision No. 1: It's All Supply and Demand Vision No. 2 : It's All Fundamentals Vision No. 3: It's All Technical 8. Behind the Fish Tank: What Causes Rates to Change? 9. How Currencies are Delivered: Snapshot of an Evolving System A Visit with a Payments Systems Expert Appendix to Chapter 9: Diagrammatic Notes on Currency Delivery Channels 10. The Big Apple: Electronic Dollar Deliveries through CHIPS 11. Time to Settle Up: CHIPS Closes the International Dollar Day at the New York Fed 4:30-5:00 pm CHIPS Upgrades to Real Time Final Settlement 2001 Finally, a Delivery System Safe from Foreign Exchange Settlement Risk: Continuous Linked Settlement Bank begins in 2002 Lessons of September 11, 2001 for Global Payments 12. In the City of London after the Russian Default: Anatomy of Currency Storms of the 1990s? 13. The Euro in its Infancy Prologue The Potential of the Euro as a World Currency The Euro-Revolution in Stocks and Bonds The Transition of the Real Economy to Euro 14. Doubts about the Euro and the new Central Bank A European Central Banker Waits on the Sidelines Doubts about TARGET, the Official Euro Payments System Reflections on the Future of the World Monetary System Wrap-up Session with Walter Blass Update Appendix: Euro Developments after the 1999 London Interviews 15. Testing the Dollar's Hegemony: Will the Adjustments be Smooth? Source of the Dollar Doubts: How long will Foreigners Finance US Overspending? Dollar Testing Episodes and the Evolution of Market Stories Episode 1: Spring and Summer 2002 Episode 2: The Buildup to War Episode 3: Fall of 2003 Episode 4: 2004 Presidential Elections and their Aftermath Relief for the Dollar: Spring and Summer 2005 A Smooth or Turbulent Adjustment: Greenspan vs Volcker The Run on the Dollar in the Late 1970s The Political Economy of Sterling's Decline as Global Currency Long-run Lessons for the Dollar's Loss of Hegemony A Hopeful Conclusion