Intermediation In The Foreign Exchange Market

Besides financial intermediation, credit creation and global cash management, the other major function of international banks is the intermediation in the foreign exchange market, which is often known as off-the balance sheet activities.  In the foreign exchange market, banks play the role of a middleman between the buyer and the seller of foreign currency.  Suppose a person having a British pound likes to exchange it with the US dollar.  There is another person who likes to buy the British pound for his dollar.  The bank helps in this exchange.  The spread between the buying and the selling rate is the income to the bank.  The role of international banks goes even further.  Banks are the market-maker.  They take a position in a particular foreign currency for a specified period so that they make sell it when its price goes higher in future.  This way they influence the supply of and demand for a particular currency and thereby determine the shape of the foreign exchange market.  The foreign exchange market is spread globally.  But the banks bring remote locations to proximity.  They transact business on telephones and encourage spot transactions between distantly located customers.  They have both the forward and backward linkages-with the customers as well as with other banks.  The arbitrage operation of the international banks in the foreign exchange market is one of the most important functions.  They buy cheap and sell costly.  The process brings in equality in foreign exchange rates.  The forward transactions are done through banks.  The banks play a vital role in the market for currency options.  For the purchaser of options, they act as a seller of options.  For the seller of options, they act as a purchaser of options.  It is because of the increasing role of the international banks that over-the-counter options market accounts for a large segment of the currency options transactions.