Overview of Japan’s Interbank Foreign Exchange Markets
Japan’s interbank foreign exchange markets are predominantly in Tokyo, Osaka, and Nagoya. Tokyo is the largest hub, processing about 70% of all transactions, while Osaka handles most of the remaining activity, and Nagoya contributes a smaller share. Despite the advanced communication systems in place, these markets function separately rather than as a unified whole. This separation is primarily attributed to the pivotal role of foreign exchange brokers in each city, who efficiently align supply with demand. Although broker-mediated trades are the norm, there are instances of direct trading between banks. Over time, a consolidated interbank market is expected to develop, with Tokyo becoming the central point of focus.
Role of Foreign Exchange Brokers
Foreign exchange brokers are not permitted to hold foreign exchange and are integral to the market's equilibrium. They liaise between commercial banks and their clients, earning a brokerage fee. At the start of each business day, brokers are tasked with reconciling buying and selling offers from various banks. These transactions are executed through the Bank of Japan’s Banking Department, and it is the brokers’ responsibility to notify the Bank’s Foreign Department immediately after each transaction is confirmed. Should there be a lack of demand at the initial offering rate, brokers facilitate negotiations to adjust either the rate or the amount until a mutually agreeable transaction is established.
In these markets, banks trade their excess or acquire additional foreign exchange through brokers before considering the Bank of Japan as a final option. The market’s supply includes surplus funds from export bills, short-term capital from Euro-dollar deposits, long-term capital from loans and bond issues, and royalties from abroad. Conversely, the demand encompasses the need for foreign exchange to cover import bills, short-term capital withdrawals to European markets, and long-term capital loans to overseas subsidiaries. Trade-related transactions have traditionally dominated these markets, although occasional fluctuations in short-term capital have impacted market stability.
Market Dynamics in Foreign Exchange Trading
Banks manage their foreign exchange surpluses or deficits through broker-mediated trades before resorting to the Bank of Japan in Japan's foreign exchange markets. Various sources feed the market's supply side, including excess funds from export transactions, short-term capital from Euro-dollar deposits, long-term financing from loans and bond issuances, and international royalties. On the flip side, the demand for foreign exchange is driven by the requirements to settle import invoices, transfer short-term capital to European financial centers, and provide long-term loans to foreign-based subsidiaries. While trade-related exchanges have been the mainstay of these markets, stability is occasionally challenged by the ebb and flow of short-term capital movements.
Monitoring and Intervention in the Interbank Market by the Bank of Japan
The Bank of Japan’s Foreign Department constantly monitors the activities in the interbank market. Brokers inform the bank’s specialized operators about all the finalized contracts and the exchange rates agreed upon between commercial banks. The Bank of Japan is prepared to intervene in the market whenever there are abnormal movements in exchange rates.
In situations like those outlined in the previous paragraph, where the inflow and conversion of short-term capital from abroad into yen could potentially disrupt exchange rates and undermine the effectiveness of the Bank of Japan’s monetary policies in the domestic yen markets, the Foreign Department may collaborate with the Banking Department. They might attempt to dissuade commercial banks from importing short-term capital into Japan solely to finance yen requirements.
Interbank Transactions and Swap Operations
In interbank transactions, banks engage not only in spot and forward exchanges but also in swap operations. These swaps are broker-mediated deals between banks that need immediate foreign exchange but have future exchange commitments and vice versa. For example, Bank A may agree to a spot sale. At the same time, Bank B commits to a corresponding purchase, and simultaneously, Bank A agrees to a future purchase, with Bank B committing to a future sale, typically for the same amount and delivery date. Such swap agreements are joint among banks with mismatched foreign exchange timelines, like Japanese commercial banks and local branches of international banks. While there’s no formal restriction on the duration of forward exchange deals, including swaps, they are generally not set for periods beyond six months. These contracts often stipulate a one-month delivery or leave the date unspecified.
Just as trading firms’ activities in customer markets are influenced by their current and anticipated foreign exchange positions, banks’ operations in interbank markets are similarly driven by these positions and the pursuit of profit.
At the close of a business day, a bank may find itself with a net surplus (an “overbought position”) or deficit (an “oversold position”) in its combined spot and forward foreign exchange transactions. Banks strive to balance their positions by aligning their exchange assets and liabilities, minimizing the risk of uncovered positions. However, maintaining perfect balance is challenging. In collaboration with the Bank of Japan’s Foreign Department, banks establish limits for these net positions, which are considered temporary and minor. Exceeding these limits prompts banks to rebalance by trading in the interbank market.
Banks sometimes engage in interbank market operations primarily to fulfill their financial obligations, with exchange risk being a secondary concern. They may need to secure forward exchange to meet a future payment request from a trading firm or sell foreign exchange in anticipation of a significant yen demand due to a long-term foreign loan conversion by an industrial company. Banks aim to provide optimal service to their clients by quickly meeting exchange needs at favorable rates. Banks might accept an uncovered position up to the agreed maximum limit in such scenarios. These adjustment practices by foreign exchange banks periodically impact the daily interbank exchange rates.
Interbank Markets and Short-Term Transactions
Interbank markets are conduits for various transactions, including foreign exchange related to the current operations of trading companies or other clients and long-term loans from private corporations. They also facilitate short-term transactions, such as Euro-dollars, short-term foreign currencies accepted by commercial banks via their European branches, primarily in London, as deposits from clients or correspondent banks in Europe. These markets also handle minimal volatile (hot) money from overseas.
The acceptance and usage of Euro-dollars abroad for loans and other short-term credit purposes, whether they remain uncovered on the bank’s books or are transferred and converted into Japanese yen in domestic interbank markets, is entirely dependent on each bank's policy. The interest rate differentials between the Japanese and foreign money markets and the overall yen liquidity requirements in the domestic markets influence this decision.
When yen liquidity is tight in these markets, banks tend to transfer some of these short-term funds to their head offices in Japan and sell them in the interbank markets to boost their domestic yen liquidity. This can tighten the liquidity position of other banks and trigger a domino effect of further transfer and selling of Euro-dollars.
The unexpected influx of foreign currencies into the domestic interbank markets for sale can potentially disrupt the exchange rate or, more significantly, the money supply. However, the volume of such disruptive short-term capital flows has not exceeded the volume of foreign exchange transactions resulting from regular trade transactions.