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Thursday, July 3, 2014

Forex Markets: Dealing Room Operations

Forex market operations are essentially transacted through banks’ dealing rooms. A relatively small proportion of these transactions actually finances cross-border purchases of goods and services. Instead, it is the investors seeking the highest return on their funds by investing around the globe that are known to generate most of the currency trading. The cross border capital movements have accelerated since the 80s offering unparalleled personal and financial freedom to make money as well as lose it in no time. Let us now examine how dealing rooms operate to facilitate trading in foreign currencies/exchange of currencies.

 1. Dealing Room – What is it all about?
A dealing room is a centralised establishment, usually of a commercial bank, which is willing to make/offer a two way dealing price for different currencies at all times, even when they may not wish to deal, but all during prescribed business hours. Banks trading actively in the forex market and offering variety of products usually segregate their dealing room functions into two or three (which has become the current trend in large dealing rooms): One, front office – that undertakes the actual dealing/trading operations in the interbank market; two, mid office – if established, is entrusted with the job of risk management and accounting policies, MIS; market research, etc; and three, back office – which is made accountable for settlement of transactions, reconciliation and accounting. Today, dealing rooms of major banks are known to house as many as 50 to 100 dealers, all operating simultaneously from the same dealing room on different currencies/markets/ products. The current trend is towards integrated dealing rooms that are capable of offering foreign exchange services along with derivatives such as swaps, options etc. Indeed, major banks have moved a step further by establishing integrated dealing rooms which are imultaneously operating in forex, derivatives and money markets. Such integration is believed to afford better ‘real-time’ interaction between all the three markets, which is felt necessary to take well-informed trading decisions for maximizing profit.

 1.1  Front Office
It is the very hub of the dealing activities – the nerve center from where dealers trade in the Forex market. A large Dealing Room will be controlled by a Chief Dealer, who may not actually undertake dealing activities by himself. He would be responsible to implement management policies. He leads morning discussions with his junior Dealers on forecasts and strategies for the day, before dealing begins. He is also responsible to assess the effectiveness of Dealers working under him as also to guide them in their day-to-day business transactions. Under the Chief Dealer, there can be Senior Dealers being individually responsible for a group of currencies/a major currency/spot forward trades, etc. Dealers are freed from undertaking accounting work of any kind, as otherwise they would not be able to concentrate on the market.

Currency trading is a game of good judgment of markets and the psyche of the counter party calling in the dealing rooms. Hence, a forex dealer must be good at understanding the changing nature of markets; quick to react to new opportunities and situations; quick in reversing a previous stance; able to overcome the natural tendency to salvage something from a loss-making situation; full of hunches as to which market will do better next rather than sticking to his own view, and be able to work under stress. To be effective, a Dealer must establish himself in the market as “trust worthy”, as he needs all the friends he can get in the market for obvious reasons and hence needs to be fair and honest in his dealings with others. It is only individuals having such quick reflexes and steel nerves that are chosen and trained as dealers to operate from the dealing rooms.

Front Offices are provided with many supporting gadgets: real-time financial data providers such as Reuters monitor services/Bridge/Blombergs which provide real-time bid and offer quotations of contributing banks; other market information that has a bearing on currency movements. The latest version of Reuters is not only capable of functioning as a dealing system but also acts as an electronic broker by matching the quoted rates of the subscribing banks. Electronic Data Processing systems ensure automatic recording of trading date, time and transaction serial number with no scope for the Dealers to alter. These systems usually are of multi-user type so that consolidation of various dealers’ positions and results can be obtained. The Chief Dealer enjoys the facility of logging on to any part of the system to see overall totals – the net positions under various currencies and quotes, at any given time.

In India, interbank market deals are done on the telephone. Dealers maintain “deal slips” indicating the name of the broker, if any, the counterparty bank, currency, amount, time, rate and due date under his signature as soon as the deal is struck and pass it on to back office for further processing. However, in an automatic system, separate “deal slips” are redundant. Some Dealing Rooms do maintain gadgets like voice recorders, etc., to record the Dealing Room conversations for such taped conversations hasten resolution of differences, if any, that may arise at a later date. Non-bank customer transactions are entertained during normal banking business hours while interbank transactions are carried on up to 5 PM.

1.2 Back Office
Striking a deal with a counter party from a dealing room to buy and sell a certain currency is not the end of forex transaction. There is a lot more to be done after that: details of the trade have to be processed; amounts agreed to be exchanged must be debited and credited, etc. It is the back office that undertakes all these activities silently from behind the front office. These two offices are physically separated.

     The back office comprises various sub-sections with specifically assigned functions:

·    Merchant desk: It has two key functions: one, it receives and consolidates the various foreign exchange transactions put through from different centers of the bank and arranges appropriate cover by forwarding them to the dealing room; and two, analyzes the pattern of the foreign exchange usiness of the bank and makes use of this analysis to frame merchant rate for the customers.

·   Contract desk: It processes the interbank contracts booked by the dealing room and ensures that no contract remains in the bank’s books that is not backed by a counter part Confirmation. In fact, it is the ‘trade ticket’ that initiates accounting action at the back office. The trade tickets bear serial numbers into which every single foreign exchange trade undertaken by every dealer is entered. It basically consists of two sets of information: one, that which caters to the needs of the dealer himself such as name and amount of the base currency, exchange rate and the side of the deal; and two, the information for back office for accounting purposes, such as the name and city location of the counter party, transaction date, maturity date, name and amount of the base currency, relevant exchange rates, buying or selling of the base currency, other foreign currency name and amount, name of the trader, method of execution and payment and received instructions. name of the trader, method of execution and payment and received instructions.

  As a part of its accountability in handling these trading tickets, back office undertakes: obtaining confirmation of contracts for all deals from counterparties; checking contents of contracts and signatures thereon, and rectification of defects if any, on the same day; and obtaining stamped agreements from the counter parties and keeping on record wherever computer generated confirmation slips are forthcoming.

·      Funds settlement desk: It ensures that the funds have been received and paid out at both the foreign and Indian centers in accordance with the deals concluded. The identification and follow-up of the discrepancies, collection of over-due interest thereof are the key functions of this desk.

·      Funds/pickups desk: It monitors the Nostro accounts and ensures that Nostro balances are maintained at optimum levels.

·       Messaging desk: Inter-bank messages about the deals struck, modalities of transfer/payments style etc., through SWIFT and other means of communication are handled by this disk.

·      Reconciliation desk: Monitors entries in the Nostro and Vostro accounts of different banks and follows up reconciliation of entries.

As a part of its overall responsibility, back office undertakes additional jobs such as: monthly evaluation of profit and loss; submission of daily currency position; maintenance of positions and funds registers; and preparation of rates can reports and enquires into wide variations, if any, in the deals struck from the on-going market rates.

1.3 Mid Office
Big dealing rooms have of late created another segment in the dealing rooms calling it mid office and entrusted it with the responsibilities of – control functions; drafting management policies, and management information systems that generate daily and weekly reports for management use etc. Another key function that the mid office undertakes is to constantly monitor, analyze and interpret macroeconomic indicators that have an impact on exchange rate movement.

Dealing rooms function essentially with three objectives: one, to give the best possible service to customers; two, to manage the bank’s position so that inventory in each foreign currency is kept at the desired level; and three, to produce profit for the bank while accomplishing the first two objectives.

1.4 Who knocks at the dealing rooms and why?
Essentially, it is all those who are in need of exchange requirement that call on the dealing rooms either through their bank branches or directly. Normally, in India, every customer calls on a bank branch/branches with whom they transact their banking operations for all such conversions. Individuals of high networth/corporates with large requirements are today known to call on the dealing rooms directly and “ask for the market”.

·     Corporates, Firms, Individuals: For payment towards Imports, conversion of export receipts, hedging of receivables and payables, payment of interest and principal of foreign currency loans. Giant multinationals, of course, do take speculative positions purely for profit generation through their own well-established treasury/dealing rooms (our exchange regulations do not permit such speculative trading).

·    Commercial Banks: Around 90% of world Forex Trade is accounted for by interbank transactions. They are mostly to meet client requirements. Merchant transactions are less than 2%. They also buy and sell on their own account and carry inventory of currencies for speculative purposes since foreign exchange trading profits have become an important source of revenue for commercial banks.

·    Central Banks: Central banks of many countries intervene in the exchange markets to arrest volatility in exchange rate movement or to give a direction to its movement. Such interventions could be in the spot or forward markets, but mostly such interventions are carried out surprisingly and intermittently.
1.5 Currencies
Multinational banks deal, in large number of currencies:

·       Major currencies: US Dollar, Euro, Yen, Pound Sterling, Swiss Franc.

·       Minor currencies: Australian $, Singapore $.

·       Widening domestic forex market is slowly catapulting leading banks, particularly of Mumbai, to trade in all major currencies.

In the Dealing Room parlance, major currencies are denoted by abbreviations-

EUR             –          Euro
US $             –          US Dollar
GBP             –          British Pound
Ch S             –          Swiss Franc
BeF              –          Belgian Franc
DKk              –          Danish Kroner
A$                –          Australian Dollar
Jap Y           –          Japanese Yen
The trading at each center is predominantly confined to a single pair of currencies – say, for example, in Mumbai it is confined to dollar/rupee. It is from this market rates, that dealers work out cross-rates for other currency prices like, Rupee/Yen or Rupee/Euro, etc.

2. Dealers Offer Two-way Quotes
In forex market, it is customary for a dealer to quote both the prices at which he is willing to buy and sell foreign currency, which in usual parlance known as two way quote/bid and offer rate e.g. US $ Vs. Rupee =59.6950/7050. While offering a two-way quote, a trader will always ensure some profit margin by fixing buying and selling prices differently. It is needless to say that a dealer, while quoting a bid and offer rate, would always work on it from bank’s point of view i.e., desires to give less units of home currency while purchasing foreign currency and give less units of foreign currency while selling it against rupees. So, in a direct quotation, the market dictum would be “buy low, sell high” or “give less, take more”.

2.1 Dealers are Market Makers
Dealing rooms of major commercial banks act as ‘Market Makers’ in most of the major currencies by offering “two-way” quotes. In a normal two-way market, a Dealer expects “to be hit” on both sides of his quotes in roughly equal amounts. But it is not necessary to happen always that way. He may suddenly find “being hit” on one side of his quote, much more often than on the other side. It means that he is either buying many more dollars than he is selling or vice versa. This leads to the trader building up “a position”:

·       If he has sold more $ than he has bought, he is said to have a “short position”;
·       If he has bought more $ than he has sold, then he is said to have a “long position”.

In a highly volatile Forex market a long or short position that, too, for long can be risky. For instance, net short position may lead to loss if it is to be covered at an appreciated price or gain if currency depreciated. Similarly, a net long position may lead to loss if it is to be sold at a lower price or gain if it is to be sold at a higher price. Therefore, a Dealer, realising that he has built up an undesirable net position, quickly adjusts his bid offer quote in such a manner that it discourages one type of deal (which has already landed him in a over bought/sold position) and encourages the opposite deal or at least the counterparty who asked for the quota may walk away.

2.2 Foreign Exchange Brokers
They act as middlemen between two market-users. They provide information to market-making banks about prices at which there are firm buyers and sellers in a pair of currencies. They carry out bank’s instructions to buy or sell a specific amount of currency at a specified rate and collects commission on the conclusion of the deal. Banks also use brokers to acquire information about the general state of the market.

In the Indian context, brokers are prohibited from acting as principals and maintaining positions in foreign currencies. Brokers’ notes should be received promptly by the dealers before close of the day’s business. Nomination of brokers for deals not done through them is not permitted. It is desirable to have a panel of brokers and shuffle the business among them. Dealers are required to maintain separate broker-wise records of transactions carried out, payment of brokerage claims, etc.

2.3 How Exchange Rates are Quoted
·      A currency dealer in Mumbai starts his day with a look at the New York closing prices of major currencies like Dollar, Euro, etc. of the previous day and opening rates in Tokyo, Hong Kong and Singapore. He would then elicit information from the local dealing rooms/brokers about the current market rates, their momentum, market mood, etc. and also looks at his own position of the previous night and makes up his mind as to what should be his quote.

·      A dealer usually calls another dealer and “asks for the market”. The caller does not say whether he wants to buy or sell, nor does the caller state the amount to be traded. Normally, the caller says – “your market in dollar please”. This means, “at what price are you willing to buy and at what price are you willing to sell dollars for rupees”. While replying, the dealer attempts to assess if the caller wants to buy or sell and relates it with his current position in that particular currency and accordingly, offers his quotes, all within a fraction of a second.

·   Simultaneously, a dealer would be looking for a rate at which he can remain “squared”. Here, “Squared” means, covering every large purchase with a matching sale in every currency so that no gaps are left that are vulnerable for rate fluctuations. Such disposals are usually made at the ruling interbank spot rate that gives no profit or loss. Such a rate is known as “cover rate”.

·     Now, based on the interbank spot rate/cover rate and adding a little cushion to the “cover rate” for remaining on the safer side, a Dealer arrives at his “base rate”. To make it more explicit, let us look at this example. Suppose, an export customer calls on a bank for selling his export proceeds that are in dollars. Say, at that moment interbank US dollar INR spot rate is 59.6950/7050. It means that there are Banks/Dealers, who are prepared to buy dollars @ Rs.59.69 and sell dollars @ Rs.59.70. As seen already, these are the rates at which dealers can square their currencies and are known as “Cover Rates”. Since the dealer has to quote a rate for purchasing dollars from the customer, he has to base his quote on the cover rate i.e. the rate at which other banks are willing to buy dollars from the market. However, as Rupee is freely floating In the interbank market, a Dealer would always wish, of course, depending on the market trend/mood, to add a little cushion to these cover rates to guard himself from adverse movement in rates, while formulating his base rates/quotes to his customers.

·       There are thus two kinds of rates in the forex market: one, “interbank spot rate” that is meant for wholesale transactions, and the other, known as “base rate” for working out rates for retail market.


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