Markets run our daily lives. We cannot live without them. What would our lives be like if there were no markets for, say, fruits or vegetables? Our friend Johnny agrees that markets play a role in making our lives more comfortable. But he is not sure how different markets actually work. One morning, he is busy thinking about one of the most complicated markets: the foreign exchange market. He has no idea how the foreign exchange market operates and so, as usual, he asks his trusted friend, Jinny.
Johnny: Sometimes, even the most obvious things seem so confusing. A few weeks ago, you talked about raining dollars causing a problem of plenty for our economy. I was just wondering why the foreign exchange market exists at all. Can’t we do without one? If there was no foreign exchange market, there would be no problem of inflows or outflows causing rise and fall in the exchange rate of the rupee, right?
Jinny: Wrong. Have you tried to imagine what our lives would be like if there was no foreign exchange market? Let us first try to understand why the foreign exchange market exists. You may be aware that each country has its own domestic currency, which serves as a medium of exchange within its domestic market. You purchase fruits and vegetables and pay your vendor the price in terms of the Indian rupee. But, suppose you want to purchase a shirt made in the US. How would you pay for that? Your Indian rupees can’t be used as a medium of exchange in the US market. The seller in the US will let you purchase only if you pay the price in terms of his domestic currency, that is, the US dollar. So, you will now have to exchange your Indian rupees for US dollars. You can exchange one currency for the other only if there is a foreign exchange market. If there were no such market, all our foreign trade, travel and business would come to a halt. Imagine what it would be like if you were to barter shiploads of your goods for shiploads of goods from another country. This is how your foreign trade would work if there was no market for foreign exchange.
Shailaja and Manoj K. Singh
Johnny: But, how exactly does the exchange of one currency for the other take place in a foreign exchange market?
Jinny: Well, small transactions by individuals take place face to face. You might have seen a foreign tourist approaching an authorized moneychanger with his domestic currency for changing it to the domestic currency. In such small transactions, the physical exchange of one currency with the other takes place.
However, large foreign exchange transactions by importers or exporters, or by different firms, governments and central banks take place through banking channels. In such large transactions, no physical exchange of currencies takes place.
Johnny: What? No physical transfer? Then how does the trading in the foreign exchange market take place?
Jinny: There can be two types of participants in the foreign exchange market: retail and wholesale. Retail participants are mainly individuals, importers, exporters and firms that may require foreign exchange for their own use. Retail customers do not directly trade in the foreign exchange market. Instead, they purchase and sell foreign exchange mainly through wholesale participants such as commercial banks and financial institutions. Actual trading in the foreign exchange market takes place between different wholesale participants. There are also foreign exchange brokers and agents who act as market intermediaries.
Let us understand how the wholesale participants trade in the market: Suppose your bank is interested in purchasing US dollars and someother foreign bank is interested in purchasing Indian rupees. Both the banks can directly talk over the phone or through any other electronic means for exchanging rupees with dollars.
Johnny: What will happen if the banks are not directly in touch with each other?
Jinny: In that case, they can approach foreign exchange brokers or dealers. These intermediaries play a very important role in bringing the buyers and the sellers together. All the participants in the foreign exchange market—such as buyers and sellers, and dealers and brokers—keep on obtaining exchange rate quotes from each other. These foreign exchange transactions between the wholesale participants involve huge amounts of money. It would be very cumbersome if you were required to make physical delivery of one paper currency for exchanging it with another paper currency. So, the transactions are completed only through debit and credit of accounts.
That is, in case you are purchasing dollars, the foreign bank will make arrangements for getting your account credited with the dollars. You, in turn, will ensure that the account of the foreign bank is credited with the rupees. How many rupees are exchanged for how many dollars depends upon the exchange rate of the two currencies.
Johnny: Exchange rate? How is that decided?
Jinny: Good question! Let it be your food for thought till we meet next week.
What:The foreign exchange market is the largest financial market in the world.
Who: The main participants in the foreign exchange market are individuals, firms, foreign exchange brokers/dealers, commercial banks, central banks and governments.
Why: We need the foreign exchange market for carrying out transactions denominated in different currencies.
How much: According to the Bank of International Settlements triennial survey 2007, the average daily global turnover of the foreign exchange market is around $3.2 trillion (Rs125.76 trillion).
Shailaja and Manoj K. Singh have important day jobs with an important bank. But Jinny and Johnny have plenty of time for your suggestions and ideas for their weekly chat. You can write to them at firstname.lastname@example.org