>> Major players in the foreign exchange market
After a brief understanding of the trading tools, who are the main players in this market? The figure below shows the statistics of the BIS Bank for International Settlements in 2019.
Red represents forex traders or market makers. Mainly some big international banks. Accounted for 38% of the transaction volume.
Yellow represents some other financial institutions, most of which are small and medium-sized banks or hedge funds, as well as non-bank and non-financial institutions, including some large companies engaged in trade or import and export. Accounting for 55% of the transaction volume, the average daily transaction volume is 3.6 trillion US dollars.
Blue represents non-financial institutions and corporations.
It can be clearly seen from this picture that red and blue together account for 93% of the transaction volume. They are the most important vested interests. The transaction volume of non-financial institutions and large companies only accounts for 7%.
Among the small and medium-sized banks and financial institutions that account for 55% of the transaction volume, another 24% is the foreign exchange transaction volume provided by small and medium-sized banks for corporate customers and individual customers.
12% of institutional investors, insurance company pension funds.
9% are hedge funds and ETFs.
Another 1% is some official reserves or official sovereign funds, which account for a very small proportion.
Speaking of which, everyone knows who are the main players in the foreign exchange market and where is the main center of the foreign exchange market. In general, I have a preliminary impression, and also have an overall understanding of the logical structure of the formation of the US dollar exchange rate.
>> Five major trading tools
After talking about the players in the foreign exchange market, next, let's talk about the five major trading tools.
When talking about the logical framework of the U.S. dollar exchange rate above, we introduced five trading tools: foreign exchange swaps, forward contracts, currency basis swaps , foreign exchange spot and options.
Among them, the first three are the most commonly used tools. Among these three types of instruments, the most important is foreign exchange swaps.
Let me say something in advance here. It is of course best to understand the three major tools that will be discussed next. It doesn’t matter if you don’t understand or have a little knowledge, because there will be pictures + detailed explanations later, which can help everyone understand simply and rudely. But you must understand that this is the most important thing, otherwise it will affect the next reading.
1. Foreign exchange swap
What is the concept of foreign exchange swap? In fact, foreign exchange is used as collateral for mortgage loans. For example, if you want to borrow U.S. dollars, you can use Japanese yen as collateral to borrow U.S. dollars, and then agree on what exchange rate will be used for settlement on a certain day in the future.
Therefore, foreign exchange swap is essentially a kind of mortgage loan. Use currency as collateral to borrow another currency. It is similar in nature to a repo.
Foreign exchange swap is currently the most active trading tool in the foreign exchange market, accounting for half of the total foreign exchange transaction volume - 49%. Its trading mode is OTC mode (over the counter trading mode).
One sentence summary: foreign exchange swap is to use one currency as collateral to borrow another currency. It is a kind of foreign exchange mortgage financing, which is essentially a mortgage loan, similar in nature to repurchase.
Of course, this involves the currency exchange rate issue. Still confused? Still do not know? It doesn't matter, let's give a chestnut.
For example, if I have 1 US dollar, the exchange rate against RMB is 1:6.82. Forex swap contracts are 1 month. The specific operation is that I first convert the US dollar into RMB according to the current exchange rate. After the contract expires (after 1 month), the RMB will be exchanged for US dollars. At what exchange rate? When the contract is signed, it is agreed in advance, assuming it is 1:7.0. Then on the day when the contract expires, even if the exchange rate becomes 1:100, it will be exchanged at 1:7.0.
The advantage of this is that future risks can be effectively locked.
Therefore, foreign exchange swaps should remember five key points: local currency, foreign currency, spot exchange rate (current exchange rate), future forward exchange rate, and contract.
2. Forward contracts
Foreign exchange swaps, as mentioned earlier, are mortgage loans, while foreign exchange forward contracts are essentially a kind of exchange rate insurance.
To put it simply, the party that needs to protect the exchange rate risk is called the hedging party, and must make an agreement with the insurer. At some point in the future, one currency will be exchanged for another currency at the agreed exchange rate. There is no margin requirement, and we will pay in one lump sum on that day.
Forward contracts account for 15% of the total foreign exchange transaction volume, and the transaction mode is also OTC mode (over the counter transaction). Foreign exchange swaps + forward contracts accounted for 64% of the total transaction volume, the absolute main force in the market, the main tool.
It seems that it is no different from foreign exchange swaps? Don't worry, I'll make it clear later.
3. Currency basis swap
Currency basis swap, to understand it simply, is to lock in the exchange rate at the beginning and end of the contract, and settle at the current exchange rate. After one or two years, the settlement will still be at the current exchange rate. Then add the basis.
For example, the ratio between RMB and US dollar is 1:6.82, so we agree to make a swap now, I will exchange one US dollar for 6.82 RMB, and we will exchange it back at the same exchange rate 10 years later, still at 1:6.82 Change it back.
Isn't this equal to a fixed exchange rate?
But in addition to this, the interest must be exchanged within 10 years, that is to say, after I exchange the US dollar for the RMB, I am equivalent to borrowing the RMB, and I have to pay the counterparty the RMB interest, labor interest rate plus other Yes; the other party also has to pay interest like me, but the payment is in US dollars.
Swap interest is the crux of the matter and the core of currency basis swaps.
Its transaction volume is not high, accounting for only 2%, but its period is very long, often for 10, 20 or even 30 years for large companies and large financial institutions. For this kind of long-term investment, speculative funds generally rarely enter this market, and it is also an OTC model (over the counter).
4. Foreign exchange spot
In fact, the trading performance of foreign exchange spot has been declining recently, and the trading volume has shrunk from 33% in 2016 to 30% in 2019. In terms of importance, the spot is not very important anymore.
5. Options and other products
There are other products in options, and the transaction share is getting smaller and smaller, from 5% to 4%. So neither of these are the focus of our attention.
Spot, in fact, is very simple, that is, buying and selling.
Options are generally used less, especially in the most active areas of the foreign exchange market. The first three are the core tools of the foreign exchange market, because of its large scale and fast growth, so we will focus on these three core tools.
Some people here may wonder, the trading volume of foreign exchange spot is much larger than the trading volume of currency basis swap, why is it not important? Don't worry, look down. In addition, those who do not understand the first three tools will be described in detail below.
>> Main functions of core tools
The importance of the three tools is not determined by market share. but their functionality.
The three core tools correspond to corresponding functions: foreign exchange financing, exchange rate hedging, and interest rate arbitrage. These are three different functions and properties, and different tools are used for different purposes.
1. Application of foreign exchange swap --- foreign exchange financing
The following picture can help you understand.
For example, ultra-short-term financing is none other than foreign exchange swaps. Look at the left one in the picture below, the left side is the party that owns the US dollar, and the right side is assumed to be the party that owns the RMB. The timeline starts with a top-down contract.
1.1 Operation of foreign exchange financing
For example, a real estate company in China wants to invest in real estate overseas, how can it obtain foreign currency? There is 682 million RMB in the account, which needs to be exchanged for 100 million US dollars. How to do it? At the beginning of the contract, after you find the risk counterparty (a company or institution that is willing to switch with you), then make an exchange with the other party. I will give you 682 million yuan, and you will give me 100 million US dollars. We will exchange, which is The spot exchange rate is 1:6.82.
The validity period is one month, and we will change it back after one month. But what is the forward exchange rate in exchange? It is necessary for us to negotiate the forward exchange rate when signing the contract.
Maybe the forward exchange rate will be higher or lower than what we agreed one month later. But we have negotiated it now, so we don't have to worry about market fluctuations. So when signing the contract, it completed the spot and forward at the same time.
Foreign exchange swap is equal to a spot transaction, plus a forward transaction, carried out at the same time. That is, both the proximal and the distal occur at the same time.
Foreign exchange swaps generally have a term of less than 7 days. Is there any one that is longer than 7 days? Yes, but very few. The proportion of less than 7 days is 64%, and its daily trading volume reaches 2.1 trillion US dollars, so most people use ultra-short-term foreign exchange financing less than 7 days.
Since the term is very short, generally less than 7 days, this kind of contract must be continuously rolled, similar to short-term and long-term loans. We know that the biggest problem with different terms is the risk of term mismatch.
For example, the money I raise is short-term financing within 7 days, but the projects I invest in are the development of the Three Gorges Dam or real estate companies, which can range from a year or two to several years. Good guy, I rely on 7 days of fund rolling, which is a bit too tiring, so the contract must be rolled in the middle. And that comes with certain risks.
The main role of foreign exchange swaps is short-term financing. Small and medium-sized banks are widely involved because they lack sources of U.S. dollar deposits, and must use market makers in the foreign exchange market or major international banks to help matchmaking to obtain short-term financing in U.S. dollars.
Foreign exchange swaps traded as much as $404 billion a day, accounting for half of the new volume.
1.2 Synthetic financing and direct financing
Why find large companies or financial institutions to use foreign exchange swaps to obtain short-term financing? Can't you go directly to the bank?
To give a simple example: a European company needs dollars to develop its business, it can use a local European bank to make a euro loan at a very low interest rate there. Then use the euro as collateral to exchange for dollars in the foreign exchange swap market, and at the same time lock in the future exchange rate. I already know what price I will exchange for it a month later, so I probably know how much the cost and risk are. This is called synthetic dollar financing.
There is synthetic dollar financing, and of course there is direct dollar financing. For example, this European company can directly ask the bank to borrow dollars, right? This is direct dollar financing , with borrowing costs. Moreover, you may not be able to get a loan.
Which of these two ways is cheaper? In many cases, synthetic financing is cheaper, and it is for this reason that foreign exchange swaps have developed greatly. Let alone whether you can borrow money, the cost of borrowing is high and troublesome.
1.3 Arbitrage
Or give a simple example: the euro and the yen. The yen is after the 1990s, and the euro is after the European debt crisis. They have easier monetary policy and lower interest rates.
At this time, hedge funds can go to Japan and Europe to borrow yen or euro at a low price, and then exchange it for US dollars through foreign exchange swaps, while locking in the exchange rate risk of future exchange. Then invest the obtained U.S. dollars in higher-yielding U.S. dollar assets, such as U.S. 10-year treasury bonds, and the yields on ten-year treasury bonds in Germany and Japan are too low.
Therefore, after obtaining euros at a very low cost, they can be exchanged for dollars and invested in high-yield varieties in the United States (relatively speaking). Knowing the exchange rate at which the contract expires, you can still make money after deducting the cost. This is called arbitrage financing without any exchange rate risk.
Of course, there are still risks in the bond market, but the national debt is still 10-year, which is relatively stable.
2. The application of foreign exchange forward --- exchange rate hedging
The function of exchange rate hedging is mainly realized by foreign exchange forward.
As can be seen from the figure, what is the biggest difference between foreign exchange forward and foreign exchange swap? There is no spot rate.
That is to say, when signing the contract, we agree on the transaction price of the future exchange rate and that's it.
For example, when signing the contract, it is agreed that the ratio of USD to RMB is 1:6.8, and the contract period is half a year. When the time is up, it will be sold at this price. This is called a forward contract.
The main purpose of the forward contract is to carry out exchange rate hedging, and the term is mainly in the mid-term of a few months or less than a year. Where is it used? Mainly used in trade.
For example: A Chinese export company sells goods to the United States, and it takes half a year to receive payment for the goods. If within 6 months, the RMB appreciates from the current 6.82 to 6.0, that is to say, the value of the dollar has already been severely depreciated when the dollar is received, and the export company is equivalent to a loss. In this case, export companies must carry out risk hedging.
That is the foreign exchange forward. After signing the contract, no matter how the exchange rate changes, it will not affect me. In addition to trade, the financial sector also accounts for the majority of foreign exchange forwards. But the gameplay is different. For example, the exchange rate hedging company accepts this order, is it really just for the handling fee? How is it possible, the water is deep here. More on that later. Now it's just a matter of figuring out the basics.
3. Application of currency basis swap---interest rate arbitrage
Currency basis swaps are generally used in the long term, how many years? It can be as short as 1 year or a few years, and as long as 10, 20 or even 30 years.
Currency basis swaps look similar to foreign exchange swaps, but they are actually very different. It can be seen from the figure that, in addition to the swap between the local currency and the U.S. dollar (once when the contract is signed and once when the contract is terminated), when the contract is signed, it is exchanged in cash, and at the end of the contract, it is also exchanged in cash. The current exchange rate (that is, the exchange rate at that time) is tantamount to fixing the exchange rate. This is the first difference from foreign exchange swaps.
For example, suppose we sign a contract on September 21, 2020 for a period of 20 years. Then after the expiration, the exchange rate on September 10, 2020 will still be used for settlement.
So what's the point of this tool? Interest. For example, if you use Japanese yen (local currency) to borrow US dollars, then you need to pay Libor interest in US dollars; similarly, for the US dollar side, it is equivalent to exchanging US dollars for foreign currency (Japanese yen), so you also need to pay Libor interest in Japanese yen+ basis. This is the second difference from foreign exchange swaps. (Don’t understand? Don’t worry, this paragraph will be explained in detail later)
In short, the currency basis swap fixes the exchange rate, and the rest is the transaction of interest. Therefore, currency basis swap is not a derivative of foreign exchange. The first two are foreign exchange derivatives, but currency basis swap is not. It is a derivative of interest rate, which is different from others.
currency basis swap
Currency basis swaps deserve a special mention. It is actually equal to: currency basis swap = spot transaction + forward transaction + interest rate swap.
Currency basis swap is mainly used for foreign exchange financing of interest rate arbitrage. For example, the interest rate difference between Japan and the United States is higher in the United States than in Japan, so of course American companies are willing to go to Japan to take advantage of Japan's low interest rates to borrow money. How to do it?
For example: when Japan engages in zero interest rates, and the United States (not now) raises interest rates and shrinks its balance sheet,
Interest rates are significantly higher than in Japan. The background is explained.
Suppose the United States is 2%, and Japan is 0. GE of the United States plans to set up a factory in Japan; Toyota of Japan is also preparing to establish a business in the United States. GE's operations in Japan definitely need yen; while Toyota's operations in the United States need dollars, and they need each other's currency for at least 10 years. You need Japanese yen, and I need US dollars, so let's exchange them, and we will hit it off immediately, and we will be in trouble.
GE can easily obtain low-interest dollar loans in the U.S. money market or banks; Toyota can also borrow cheap yen in the Japanese financial system. I believe there is no doubt about this, and large companies have such advantages.
Then the two parties choose a 10-year term to carry out the currency basis swap. GE exchanged 100 million US dollars for Toyota's 10.6 billion yen at a spot exchange rate of 1:106. It is agreed that after 10 years, they will still be exchanged back to their respective currencies at a rate of 1:106. This is a basis swap.
During the term of the contract, Toyota pays the US dollar Libor interest rate to GE, because Toyota borrows in US dollars; while GE borrows in Japanese yen, it needs to pay the Japanese yen Libor interest rate to Toyota, plus the basis difference.
What is basis? We can understand it as an additional fee for borrowing US dollars. After the financial crisis in 2008, in the international foreign exchange market, the dollar was more scarce than the yen, so the basis was negative.
If the negative value is larger, it means that the dollar is more scarce than the yen, so the borrower of the dollar should be reversed. For example, -50 basis points means that Toyota will subsidize GE by 50 basis points. So what is GE paying Toyota for? Yen Libor rate minus USD scarcity fee.
Therefore, although the US dollar side pays Libor+ basis in the figure. If this is a negative number, it actually subtracts a negative value. The interest rate of the yen is already very low, and if it is reduced by 50 basis points, it will be tantamount to disappearing.
Therefore, GE does not need to pay interest to Toyota or only pays a little bit. Even in some special cases, GE does not pay interest to Toyota, but charges fees. Then the situation will become that Toyota has to pay GE the US dollar Libor interest rate, and has to pay GE a US dollar scarcity fee.
Regarding this point, it can be simply understood as the overnight interest when we place orders. For example, if you put a long order overnight, you give money to the bank; if you leave an empty order overnight, the bank gives you money. Almost the same meaning.
Through this method, GE can realize the financing of long-term interest rate arbitrage. Interest rates in Japan are low and interest rates in the U.S. dollar are high, so the difference between the interest rates of these two countries is used for arbitrage.
Finally, to sum up: Currency basis swap is to exchange one currency for another under the condition that the exchange rate is locked. Both parties then give the Libor interest rate of the borrowed currency. Which party's currency is more scarce, then the other party needs to pay an additional scarcity fee (basis).
In Hong Kong, Singapore or Japan, there are a large number of financial companies that can provide such services. In China, it is estimated that you can only find banks. The advantage of this set of tools is that it can greatly reduce the financing costs of domestic enterprises. I can borrow Japanese yen and then exchange it for RMB through foreign exchange swaps and other tools, and in the end I will exchange it back to Japanese yen and give it to others in the sea.
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