Interbank Rate
The interbank lending market is a market in which banks lend funds to one another for a specified term.
The interbank rate is the interest rate at which a bank charges another bank interest on the short-term loans exchanged between them.
These rates help the banks borrow and lend money from each other to maintain reserve requirements and liquidity. These kinds of loans are usually repayable within a week or even overnight.
Banks that have an extra amount residing in their reserves can earn interest over it by lending the amounts to the banks that may need the funds. Thus these transactions are done in the interbank lending market, where these interest rates are decided.
The interbank rate, which is also sometimes mentioned as the federal funds rate, is of little significance to the customers who avail of loans from the bank. Rather, it's a bank-to-bank or, say, financial institution-to-financial-institution rate.
It is also defined as the foreign exchange rate that the banks pay while exchanging currencies with other banks.
The interbank exchange rate is a non-stationary, fluctuating rate that varies with time. This interbank rate is used when two currencies are to be exchanged with one another.
The interbank exchange rate is not used when the customers require to exchange foreign currencies.
Like the stock market, interbank currency trading occurs from 5:00 p.m. EST to 4:00 p.m. EST, Sunday to Friday.
Let us now look into the working of these rates in the lender and borrower market that results from interactions between the banks and financial institutions.
- Interbank Rates are a medium for us to choose the best foreign exchange option to suffice individuals' needs depending on their requirements.
- They depict the exchange rate between your home currency and the foreign currency that the bank or the financial institution is interested in exchanging their money for.
- Banks most often deploy this rate to maintain a minimum amount of funds with them as set by the guidelines of the Central Bank in their home country. Thus they can often be required to borrow money to maintain the minimum required level of assets.
- It is, thus, the interest rate charged on short-term loans between banks. Banks borrow and lend their money to each other in the interbank market.
- The interbank exchange rate is the rate at which the value of any two currencies can be compared at their current value. It depends on the availability of the particular currency in the market.
- In short, the supply and demand forces acting in the market impact the interest rates between currency exchanges. Thus, it varies from time to time, more often than not, even within seconds.
The working of the interbank rate
One should be careful that the interbank rates differ from the regular foreign exchange rates. Instead, they are the foreign exchange rates that are set when a bank decides to engage in the trading of various currencies with another bank.
Let us take an example here. Assume the foreign exchange rate of Euros from US dollars is 0.91 euro. That means you can only get 0.91 euros in return for 1 USD. Thus, it will not be like an American bank borrowing from a European bank to fund its reserves.
There are many characteristics on which the banks depend while dealing in the interbank market. Let us talk about a few of them.
A. The market conditions in the foreign exchange market
The interbank market is almost the same as the stock market, where the prices of the currencies are impacted by the demand and supply or the buying and selling of the currencies.
So, for instance, if the euros are expected to rise, say in Germany, then the British bank would want to buy a large number of euros from another bank, leading to a rise in the price of euros owing to its high demand.
B. Interbank affinity
Interbank trading platforms also enable banks and financial institutions to interact with each other and find the best deal in a limited time. In addition, these platforms allow banks to set prices according to what is best for their understanding.
This discretion leaves the banks to maintain interbank relations with other banks, a vital element while dealing.
Banks must strive to avoid an irrational business to better stand in the market.
C. Fees charged by banks
The interbank rates could sometimes be higher than usual due to the high business fees. This could be explained by one of the most common reasons to have a high fee; there may be a possibility that the bank holds a limited amount of that specific currency.
Consequently, the banks may charge a very high fee owing to this reason. There may be other reasons, like a bank may only charge high prices for a particular bank for doing business with that particular bank.
This briefly explained the working of the interbank rate and how it occurs between various banks and financial institutions. First, however, let us keep exploring the subject by dwelling on the international aspects of the rate.
The Interbank Rate in the Foreign Exchange Market
The interbank rate or the interbank exchange rate is the rate at which the value of any two currencies can be compared at their current value. The rates can differ even by points or fractions in seconds.
This happens because of the demand and supply forces that act upon the currencies according to their demand and supply at a particular time.
In this market, most of the trading is done by the banks mainly to maintain their forex reserves, control their exchange rate, and shield themselves from the interest rate risk.
Nevertheless, it is a crucial component of the foreign exchange market globally, mostly used by bankers for trading purposes. The main segments of the market are:
1. Spot market: Here, the currencies are exchanged on the spot. The delivery occurs in cash for the exchange of the financial instrument. Some examples of spot markets are commodity markets, currency markets, and stocks.
Paces providing spot trading facilities are called exchanges and over-the-counter (OTC) markets. The settlement date of most of the transactions is T+2 days.
2. Forward market: This segment is used by risk-averse people who want to avoid market uncertainties by signing a predetermined forward contract. These contracts can be bought from the point of view of selling or buying a particular asset in the future.
3. SWIFT (Society for Worldwide Interbank Financial Telecommunications): A Belgian cooperative society that helps monitor and execute financial transactions and services among a few banks worldwide. It started in 1973, and since then, it has been operating in over 200 countries, recording around 42 million messages a day as of 2021.
It provides every institution with a transaction code that is made up of either eight or eleven characters.
For example, UNCRITMM is the code for an Italian bank called UniCredit Banca.
Here, UNCR stands for UniCredit, the name of the bank. IT in the code refers to the country code, Italy, and MM specifies the location or the city code, which is Milan.
Why are Interbank Rates important?
There is no other way we can see these rates to be other than their importance. They show the actual worth of the currency the bank or the financial institution wants to deal in. All in all, they are a very important tool deployed by players in the foreign exchange market.
Their primary role is to determine the currency exchange rates for so many currencies that are traded worldwide, and that enables you and, in fact, all the people, the brokers, and the institutions, along with other players, to exchange money throughout the world for different currencies.
However, the speed or the frequency at which these rates change could differ from entity to entity. There may be a time gap between when you order your currency exchange from your bank and when you finally receive it.
Thus, it is impossible to anticipate the exact exchange rate when your current currency will be exchanged for the international currency you desire to obtain through the process of foreign currency exchange.
Due to having a magnificent foreign exchange market, there is a lot of competition among the forex service providers, and there are various applications where you can perform a currency exchange.
Therefore, you may also be charged a certain amount above the deal that will cost you already or even an amount less than the marketing you delay your order fulfillment time.
When you finally receive your money, you can carry your transactions through the most effective payment method that suits you.
Frequently Asked Questions (FAQs)
The interbank exchange rate is not static at all. It changes from time to time and even from second to second. The interbank rate changes due to the supply and demand of different currencies by different banks.
As we know, banks borrow and lend money regularly in the interbank lending market to maintain the appropriate amount of liquidity to fulfill the reserve requirements.
The interest rate can, thus, be affected by the amount of money that is currently available in the market and the rates that are currently displayed, as well as by the terms of the contract between the two given financial institutions.
The interbank rate is a crucial component for banks worldwide that assures the banks that they never run out of money reserves and earn interest on the excess lying around cash in their reserves.
This ensures they maintain enough liquidity in their reserves for their immediate money requirements, borrow for the same reason, and lend the excess money to earn interest on the excess money.
As mentioned above, the interbank rate is the rate at which banks borrow and/or lend short-term borrowings and are charged the interbank rate.
The interest rate, however, is the rate at which the bank lends the money to the public and the rate of return on the deposits that the public receives.
The interbank transfers usually take around one to three business days. However, the time gap required to complete a transfer can vary across financial institutions and banks depending on the countries they belong to.
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