Inside Story: The Money Trade: Foreign exchange dealers have changed the course of our economy. Who are they? How do they make their profits? And can anyone have a go? A plain person's guide to the currency market

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The Independent Online
Q Who are those young men see on television?

A They are dealers, employed by banks to buy and sell currencies as part of their day-to-day business. Most are probably interbank dealers, who trade with other banks. In a big bank each interbank dealer will specialise in a specific trade, such as sterling against the German mark, or the dollar against sterling.

Other employees in the dealing rooms are called customer dealers, because they talk to the bank's corporate customers - from manufacturing companies to pension funds to travel agencies - and take orders from them to buy or sell foreign exchange.

Interbank dealers work only for banks - foreign as well as British banks such as Midland and Barclays - and those based in London must obey rules set by the Bank of England. Some financial institutions have dealing rooms, and banks also sometimes ask specialised brokers to find out what prices other banks are offering.

Q Where do dealers work? How many are there?

A The ones we see on television are in London, which is the biggest foreign exchange trading centre in the world, followed by New York and Tokyo. These three centres, and dozens of smaller ones, operate in different time zones, so that during the week currency trading never ceases. This is the 'foreign exchange market'. The amount of money changing hands each day on this market adds up to about dollars 1,000bn ( pounds 590bn), vastly more than the value of world trade.

In London, about 360 banks, domestic and foreign, trade foreign exchange. Other financial institutions and very large companies sometimes have their own dealers. The dealers work in large, open-plan offices called dealing rooms, most of them in and around the City of London. Dealing rooms vary in size. One leading British bank employs 30 interbank dealers. Estimates for the City as a whole range from 3,000 to about 11,000.

Q What qualifications do dealers have?

A Interbank dealers come from a wide range of backgrounds, and do not need a university education. They must be able to stay cool under pressure and not get flustered by huge amounts of money. They must be able to calculate mentally their currency position at all times - how much of the various currencies they have bought or sold - and be able to anticipate what might happen in the market so that they can react in a split second. Most dealers are in their twenties or thirties.

A typical foreign exchange dealer might make a salary of pounds 60,000 a year plus bonuses of (in a good year) as much again. These usually relate to how the whole department has performed - it is unusual for an individual dealer to be paid on a commission basis.

Q What are those screens they watch all the time?

A The dealers need a great deal of information to operate, and they get this mainly from their screens, which have several functions:

1 They are constantly updated with the latest prices at which banks are buying and selling currencies.

2 The screens are fed by Reuters, Telerate and other agencies with the latest news from around the world. This can be about financial matters such as the latest trade figures, or it may be political, such as opinion polls or speeches by ministers - anything that might influence decisions to buy or sell. The agencies also describe developments on other markets and report dealers' comments on trade - market gossip. And they carry graphs and charts that are constantly updated to show price trends. Many dealers use the patterns of these graphs as guidance for future currency movements.

3 On some screens, the dealers keep track of their own trading position and the bank's overall position in the foreign exchange markets. These screens are private to the bank, and cannot be seen by other banks.

4 Many dealers now have screens that allow them to do deals directly with other screen users. They type in prices and quantities, push a button and the transaction is recorded at both ends.

Q With all this technology, why do they need to shout?

A Because it is quick. For example, at certain times, dealer A will need to know the prices being quoted by as many other banks as possible in as short a time as possible. He will stand up and shout what he wants, and his dealing room colleagues will immediately ask other dealers on the phone for their prices. They will shout these out. Dealer A will instruct them whether to do deals at those prices, and how much to buy or sell. When he has traded the sum he intended, the dealer sits down. In a busy day, this happens often; it is not a sign of chaos. If everyone involved in the process typed every number into screens to communicate, instead of shouting, it would take much longer. For the same reason, dealers often prefer to deal with other banks by telephone, rather than through the dealing screens.

Q Why are they in such a hurry?

A In a busy property market, if you want to buy a house you think is going cheap, you move quickly. If you are selling and prices are going down, you sell as quickly as possible. The same pressures apply in the currency market, but amplified enormously. The dealers all have access to the same information at the same time; when some market-moving development occurs, the dealer must react quickly or he may lose his bank hundreds of thousands of pounds.

Q What is the purpose of the foreign exchange market?

A As long as countries have dif ferent currencies, people will need to swap one for another. Tourism, the trade in goods and international investment require people, companies and governments to change cash from one currency to another. If Marks & Spencer buys Golden Delicious apples from a French farm co-operative it needs to pay the seller in French francs. Banks and other businesses with international clients buy and sell currencies as a service for such customers.

Another form of investment abroad is very important here. Banks, companies and financial institutions usually have a great deal of money on their hands from day to day, and they like to make it work. One way of doing this is to look around for the highest interest rates. Often, those rates are to be found in foreign countries, and to take advantage of them the money must be changed into the relevant currency before it can be deposited.

Q Why do prices go up and down?

A Prices of currencies move up and down to reflect changing levels of demand. These changes can come about because of alterations in the patterns of trade between countries - if country A imports more from country B, then demand for country B's currency will grow and the price will probably rise. Changes in investment prospects and in interest rates will also affect the flow of money, and the price. The economic performance of a country, and its monetary policies, are among the most important factors in determining the price of its currency. Another is speculation.

Q What is speculation, and who does it?

A Speculation comes about be cause of the very fact that prices move up and down. A speculator is someone who places bets on those movements. Although the word is often used pejoratively, almost anyone who trades in currency nowadays engages in speculation to some degree. That includes all our high street banks, many unit trusts, insurance companies, pension funds and some big industrial companies.

If you were to change your pounds into dollars tomorrow for a holiday in the United States that you plan to take in November, you too would be speculating. You would be betting that the pound will be weaker against the dollar then than it is now. Interbank dealers do the same thing, but they are betting, very often, on the pound being weaker or stronger against the dollar in a couple of hours, or even in a few minutes.

Q How do the dealers sell and buy currencies?

A Let's say a customer, a widget importer, phones the customer dealer desk to ask what's happening on the currency markets. The dealer sees the pound falling and tells his customer that the pound will probably fall further. So the importer decides to sell sterling and buy Belgian francs, which he needs because he buys a lot of Belgian widgets.

The customer dealer shouts to the interbank dealer to obtain a price at which he can sell sterling and buy a certain amount of Belgian francs. The interbank dealer then phones another bank, or several banks, for a price quotation and might yell the best price across to the customer dealer, or execute the order over the phone right then, depending on the customer's instructions.

The deal is done and the papers will be cleared in two days, just as personal cheques are cleared. The widget importer's account is adjusted accordingly.

Q How do the dealers make a profit? And who loses?

A If you sold pounds and bought marks recently when sterling was priced at 2.80 German marks, you would have received DM2.80 for pounds 1. If you then bought sterling back after it left the exchange rate mechanism and was much weaker against the mark, say DM2.50, you would only have had to give back DM2.50 in exchange for pounds 1. In that case you would have made a 30 pfennig profit. Or take another example. Last week, many dealers sold French francs at Fr3.42 to the mark, betting that the franc would continue falling against the mark, as the pound had done. Those dealers would have lost money because the franc stopped falling and began heading back up at the end of the week. By Friday, they would have lost three centimes on each mark.

These differences, of 30 pfennigs or three centimes, are enormous by market standards. Dealers usually expect to make their profits on movements of a fraction of a pfenning or a penny. When these fractions are multiplied by the enormous sums of money involved, they turn into substantial profits and losses.

Q Is this money only figures on a screen?

A It is real money. The huge amounts circulating in the foreign exchange markets come from the bank accounts of institutions and corporations that are exchanging currencies. If banks do not have immediate access to the money, they can borrow on the overnight money markets, which lend for very short periods at very high rates.

The sums traded in the currency markets are electronically debited from banks' accounts when they agree to make a transaction, just as your account is debited when you use your Switch card or your cash machine card. Banks hold accounts in the various currencies in which they deal, in many world financial centres, so that, at the end of each day the trades are settled - meaning the right amounts of money go to the accounts of the right banks or institutions.

Q Why do dealers speculate against a currency?

A Dealers decide to sell a cur rency when they believe the only direction it can go is down. Two weeks ago most people in the currency markets held the view that sterling should fall - because of the weak economy, because other currencies were more attractive and, bluntly, because they did not believe that the Government, or its European partners, had the will or means to bolster the pound successfully.

This is not primarily a scientific, or a mathematical business, although banks employ economists and statisticians. Markets often take a collective view of where a currency is going. This is known, oddly, as sentiment, and sentiment is usually self-fulfilling. Once the feeling was established that the pound was in trouble, most dealers sold, and invevitably it soon was in trouble. Then anybody who was not selling was missing a chance of profit - almost as bad, in market terms, as making a loss.

Q Can anybody speculate in the market?

A It is a game for big players who have experience and up-to-the-minute information. But if you wanted to try your hand, you could. You would need to have pounds 1,000 to gamble at the very least, and be prepared to lose your shirt. An investment company that caters to personal customers would give you advice.

Buying and selling currencies at high street banks is not usually profitable in the short term, even if you forecast the market correctly. The 'tourist rates' include heavy bank charges which could cancel out your profits on most short-term currency movements.

Q How does raising interest rates protect a currency?

A Like a company trying to make itself more attractive to shareholders by raising its dividends, a country can raise its interest rates to increase the appeal of its currency. Higher interest rates increase the amount of money investors can earn by depositing money in a given country. For instance, when interest rates were 15 per cent in Britain from 1989 to 1990, this attracted overseas investment. When that happens, overseas investors convert whatever currency they hold to pounds to deposit in Britain or buy British bonds. That helps the pound to rise.

It is not a sure-fire recipe for a strong currency, as Norman Lamont found when he put rates up to 15 per cent and the pound still fell. This is because interest rates are only one of many factors affecting the market.

Q What is central bank intervention?

A Central bank intervention is another way in which governments manipulate the operation of the market. Central banks buy or sell the national currency to stimulate demand or reduce it. This can smooth short-term fluctuations in the currency, but cannot solve the economic problems that may lie behind them. The central bank buys or sells foreign exchange like any other bank customer: its dealers call bank dealers, or brokers, for prices and then place their order.

Central banks use the nation's foreign currency reserves, which are built up over many years. The Bank of England keeps the currency reserves invested in liquid assets, so that it can have access to them at a moment's notice.

Sometimes central bank intervention successfully influences the currency by conveying a message to the markets about the government's stance on exchange rate policy. But this month the Bank of England intervention was not successful because of the strong views held in the market that the pound should go still lower. At the end of August the Bank of England held dollars 45bn in reserves, but dealers estimate that it spent from one-third to one-half of total reserves the week before last.

Q Are things getting out of control?

A Foreign currency trading has become especially active since the 1970s. Before then, technology was less advanced, many countries had exchange controls and governments were able to fix rates. Since then there have been many upheavals in the markets - too many to list. This one has caught our attention because it is particularly intense, and because it has hit sterling at a time when the Government set great store by the pound's value.

It may appear as though 'speculators' have taken control and perverted the true purpose of the market - the supply of currency for trade and investment. But those who use the markets believe that the huge growth in currency trading - in London, it has risen by 62 per cent in value since 1989 - has enabled the markets to do business more effectively. Speculation, they argue, oils the wheels of the market and makes non-speculative dealing easier and fairer.

It is often said that currency movements are 'exaggerated', and it is true that they are more sudden than the economic changes they are supposed to reflect. Britain's economic position relative to Germany, for example, did not alter in a matter of days. But the truth about markets - house markets as well as money markets - is that it is impossible to identify a 'proper' price; there is only the price that someone is prepared to pay.

Q Should we, could we, limit currency speculation?

A Exchange controls can be used to ensure that money can only be transferred into or out of a country with the approval of regulatory authorities. They can then refuse to allow a transfer unless it is for 'genuine' investment purposes. Britain used to have such controls but, like many other nations, dismantled them in the late 1970s; Spain, Ireland, and Portugal, have tried to use them in an attempt to take the heat out of the current crisis.

Controls limit the ability of speculators to buy and sell a particular currency. But there are serious doubts about how effective they can be, especially with a currency such as sterling: large numbers of pounds already outside the country would be the subject of unregulated dealing. Also, since Britain last had controls, the financial world has become much more sophisticated and ways would probably be quickly found to get round them.

There are also big disadvantages to exchange controls. They cost a lot of money to put in place and increase bureaucracy; forms have to be filled in and civil servants employed to process them. That makes businesses less efficient. Also, the City of London, which is the world's leading currency market, would lose a lot of business because people would be less inclined to deal here.

As well as making it more difficult to take money out of a country, controls discourage people from making investments in it. A country such as Britain, which spends more abroad than it earns, needs to attract money from outside to make up the difference.

Q Would it help to have a single world currency?

A The idea is Utopian. Judging by the difficulties the 12 European Community countries are having on agreeing to move toward a single European currency, it is hard to imagine that the nearly 160 countries in the world would ever be able to manage it.

Besides, currency fluctuations provide safety valves for the financial system, by reflecting differences in economic performance and political stability of different countries.

If we had one world currency, we would have to have a single monetary authority - a mega- Bank of England - making decisions on interest rates and prices that would apply equally to Switzerland and Bangladesh, the United States and Albania. It is hard to see how any economy would benefit.

Answers by Lisa Vaughan and Gail Counsell with technical advice from David Simmonds, economist at Midland Montagu.

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