Interbank trading refers to the direct exchange of currencies or other financial instruments between banks and financial institutions. It is the core mechanism of the global foreign exchange (forex) market and involves high-volume trades that facilitate liquidity, price discovery, and currency exchange across the world.

Understanding interbank trading

The interbank market is a decentralised network where banks and large financial institutions trade directly with each other, bypassing exchanges. Transactions in this market are typically conducted over-the-counter (OTC) through electronic communication networks (ECNs), dealing platforms, or via phone.

Interbank trading allows institutions to manage currency needs, hedge risks, and facilitate global trade and investments. The prices negotiated in this market set the benchmark rates for the broader forex market, influencing currency valuations globally.

How interbank trading works

1. Participants
   The primary participants in the interbank market include:
   • Central banks
   • Commercial banks
   • Investment banks
   • Hedge funds and institutional investors (via prime brokers)
2. Trading platforms
   Interbank trading occurs on sophisticated electronic platforms such as:
   • EBS (Electronic Broking Services): Popular for EUR/USD and USD/JPY trades.
   • Reuters Matching: Common for GBP/USD and other less traded currency pairs.
   • Proprietary platforms: Banks also use their own systems for direct trades.
3. Trading process
   • Banks quote bid (buy) and ask (sell) prices for various currency pairs to one another.
   • Once a trade is agreed upon, it is settled either on a spot basis (typically within two business days) or via derivatives like forwards or swaps.
4. Liquidity provision
   Large banks act as liquidity providers, quoting two-way prices and facilitating trades for smaller banks or financial institutions.
5. Settlement
   Most interbank forex transactions are settled through systems like CLS (Continuous Linked Settlement) to reduce settlement risk.

Functions of interbank trading

Liquidity creation: The interbank market supplies the liquidity required for global forex transactions.
Price discovery: Currency prices in the interbank market serve as benchmarks for retail and institutional markets.
Hedging and risk management: Banks use interbank trades to hedge their currency exposures.
Facilitation of international trade: Interbank trading supports global commerce by ensuring efficient currency exchanges.

Features of the interbank market

High volume: Interbank trading involves large transaction sizes, often millions or billions of dollars per trade.
Decentralisation: The market operates globally, 24 hours a day, across various time zones.
Tight spreads: Due to the volume and competition, interbank trades typically feature minimal bid-ask spreads.
Exclusive access: The interbank market is primarily accessible to banks and large financial institutions, not retail traders.
OTC nature: Trades occur directly between participants without a central exchange.

Advantages of interbank trading

Deep liquidity: Large transaction sizes can be executed without significant price disruptions.
Efficient pricing: Tight spreads and competitive quotes ensure optimal pricing.
Global connectivity: The market operates seamlessly across time zones, supporting international trade and finance.
Flexibility: Participants can trade a wide range of instruments, from spot forex to forwards and swaps.
Risk mitigation: Banks can use interbank trading to hedge exposures and reduce currency risks.

Challenges of interbank trading

High capital requirements: Only institutions with substantial capital can participate due to the large trade sizes and credit demands.
Credit risk: Banks rely on counterparties to honour agreements, which can create exposure to default risk.
Regulatory oversight: Stricter regulations, such as those introduced after the 2008 financial crisis, have increased compliance requirements.
Complexity: Interbank trading involves sophisticated systems and strategies that require expertise and advanced infrastructure.

Examples of interbank trading in action

• A multinational bank trading billions of dollars in EUR/USD to hedge currency exposure from international loans.
• Central banks intervening in the interbank market to stabilise their currencies.
• Two commercial banks exchanging USD for JPY to meet liquidity needs for client transactions.

FAQs

What is interbank trading?
Interbank trading is the direct exchange of currencies or other financial instruments between banks and large institutions in a decentralised market.

Who participates in interbank trading?
Participants include commercial banks, central banks, investment banks, hedge funds, and institutional investors.

How does interbank trading differ from retail forex trading?
Interbank trading involves large transaction sizes and is exclusive to banks and institutions, while retail forex trading is accessible to individual traders via brokers.

What platforms are used in interbank trading?
Popular platforms include EBS, Reuters Matching, and proprietary trading systems developed by banks.

Why is the interbank market important?
It provides liquidity, facilitates global trade, and sets benchmark currency prices for other markets.

What instruments are traded in the interbank market?
Instruments include spot forex, forwards, swaps, and options.

What are the risks in interbank trading?
Risks include credit risk, market risk, and operational risk due to the large trade sizes and reliance on counterparties.

What role do central banks play in the interbank market?
Central banks use interbank trading to influence currency values, manage reserves, and implement monetary policy.

How is interbank trading settled?
Trades are typically settled through systems like CLS to minimise settlement risk.

Can retail traders access the interbank market?
Retail traders cannot access the interbank market directly but benefit indirectly through brokers who source liquidity from it.

Conclusion

Interbank trading is the backbone of the global forex market, enabling banks and financial institutions to trade currencies efficiently and at scale. By providing liquidity, determining prices, and supporting global commerce, the interbank market plays an indispensable role in the functioning of the world economy. While its exclusive nature limits access to retail participants, its influence permeates every level of the forex market.