Foreign exchange and correspondent banking bleg

What are the best things to read on this topic?  How does it work?  Why is it difficult and expensive (to the extent it is)?  How might current institutions be improved?  And what determines bid-ask spreads in the relevant trading markets?

I thank you all in advance for your wisdom and counsel.

Comments

What do you mean? The topic of "foreign exchange" is well covered in financial literature, and I have no idea what you mean by expensive. Forex markets are readily accessible to most retail investors, and bid-ask spreads are incredibly tight. Often forex-traders use large amounts of leverage, but the US government sets an upper limit for most investors. Correspondent banking is accomplished using the SWIFT network, which provides secure communication between financial institutions, allowing for the determination of a suitable correspondent bank for transfers between financial institutions. Simply put, a correspondent bank is an agent. What determines the bid-ask spreads is largely a function of the future expectations of currency demand/supply, as in equity and bond markets. Overall you will see larger bid-ask spreads in less liquid markets, but forex generally doesn't experience this to the same degree that you'd find in other financial markets, due to the nature of the product.

For the average person who travels, using the local bank or exchange desk is really expensive, even more with the local merchants and hotels. You pay the rough equivalent of a local sales tax just to convert currency. The bid/ask spread you talk about is for traders, yes? For some reason this spread does not make its way to the regular person.

The reason the spread is so high for people looking to exchange a piece of paper for another piece of paper is due to the cost of maintaining secure conditions for pieces of paper and establishing processes and infrastructure to facilitate that exchange of pieces of paper. The exchange rate is quite good for the consumer (almost exactly market) when credit cards are used, or other information systems that aren't from the 1800's.

'The exchange rate is quite good for the consumer (almost exactly market) when credit cards are used'

The key word there is 'consumer,' that is, a one way transaction. However, try having two companies pay each other using two currencies in two countries (outside of the EU common market), and one quickly enters a different world, where 'fee' is not a foreign concept, even though it predates the 1800s.
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Check into SEPA to see how straightforward transactions between nations and currencies can be handled in a way that benefits other people than the middlemen.

Of course, with a no-deal Brexit, British citizens and companies will (very likely) lose the benefits of an inexpensive and smooth flowing international payments system, and will return to a system where the banks make as much money as the market will bear. The City is not going to go gently into the night by following regulations it hates, after all.

When trading the markets, financial traders tend to act more rationally, maximizing their gains and obviously minimizing their losses. Loss aversion plays an important role. The market makers are quick when it comes to locking-in their profit for making the transaction happen, the bid-ask spread in this case is evident for calculation matters.
Loss aversion does not play the same role when you consume things like shoes or clothes. This, I believe, is consistent to why a customer walks in a clothes store trying to purchase a pair of pants for 99usd but there's a spread of 1usd which he is not aware of and it is baked in the price so later it becomes a commission to the salesman. Other things similar, buying a car and the salesman also get a commission for the sale but this bid-ask spread is not evident.
The level of accountability in financial markets is extreme and spreads have to be visible.
Traders are engaging in routine transaction and the market-making systems created by them are just a representation of how they would perform specific trades themselves but in a computational manner.
The degree of liquidity presented by each commodity defines in most cases the bid-ask spread size. A trade pair like USDJPY which is the most liquid forex pair has also the lowest spreads in the market. Contrary to a less liquid pair like USDMXN which has relatively high spreads
More participants in the market, in any particular market, will inevitably lower the arbitrage profit opportunities. This point raises the question to why some markets get more liquidity providers (market makers)
I would attempt to say the quality of the commodity they are holding has a higher demand by investors which naturally makes it more tradable. The Japanese currency is more stable, investors have more credibility on it and the purchasing power of investors in Japan is higher compared to Mexico in this example. The available quantity is higher as well. More speculators and more participants, population size might affect I believe

Good reading I would include
https://www.aqr.com/Insights/Research/Working-Paper/Trading-Costs

I'm a FOREX day trader, so if that's the segment of FX you're wondering about then this might be a start.

Best things to read: about the inner workings of it, such as what market makers are, what brokers do, how leverage works? I'm not too sure, but there's a very corny guide/introduction to FX here https://www.babypips.com/learn/forex and you might be interested in going through the 'Preschool' and 'Kindergarten' sections, where you can read about the basic structure of the FX market.

Why is it difficult/expensive (to the extent it is) : It's not expensive. Transaction costs are very low (about one pip, which is 1/100th of 1%), hence it's been heavily democratized and regular people with a computer and an internet connection can do it.

What determines spread: brokers widen the spread as a result of liquidity drying up. Banks withhold their liquidity in times of excessive volatility to protect their assets. So whenever impactful events occur, such as banks dropping CPI numbers or interest rates, you see a jump in spread around 10 or so seconds before the event takes place. Liquidity dries up, and spreads widen during rollover as well. Rollover happens around 11pm CEST; it's when the new trading day begins and its when daily interest is charged for leveraged positions.

the BIS is the most authoritative source of data for this AFAIK

https://www.bis.org/cpmi/paysysinfo/corr_bank_data.htm

Hi Tyler we are an independent think tank in South Africa and have done quite a lot of research on remittances in sub-Saharan African. In this research we have touched a lot on foreign exchange (one of, if not the biggest driver of cost) and the impact of AML\CFT regulation on corresponding banking challenges. I read most of your work and think you may find some of the way we think about it interesting. You can read our specific series on barriers to remittances here: https://cenfri.org/publications/exploring-barriers-to-remittances-in-ssa/ or all our work on the topic here (https://cenfri.org/research-themes/remittances/) and here (https://cenfri.org/research-themes/integrity-amlcft-and-illicit-flows/). I hope it helps!

Here's a paper from 2018 that provides a historical perspective on the high cost of remittances: https://www.moneyandbanking.com/commentary/2018/2/18/the-stubbornly-high-cost-of-remittances

There's a chart showing the increase in the total volume of remittances from 1970 to 2018, which gives one an appreciation for the potential profits banks and other providers can make from remittances. As pointed out in the paper, one would think that the enormous increase in volume would promote cost-reducing advances in technology, but costs have lowered gradually and not by much. Over the last decade, the average cost has fallen from 9.8% to 7.1%. To provide one a sense of the scale of remittances, the total cost per year is about $30 billion.

Money changing was the one thing that made Jesus flip his lid and go full SJW like an eat-the-rich socialist occupying Wall Street. I wonder what he would have thought about Bitcoin. Or Libra for that matter.

In the UK, this space seems like one where FinTech startups have very quickly created an obviously superior service. CurrencyFair and TransferWise are huge improvements over what the banks offered for retail customers.

Tyler - this paper does a nice job of explaining payment fundamentals: http://euro.ecom.cmu.edu/resources/elibrary/epay/crossborder.pdf

It also might be worth looking into how corrisponditti relationships were built during the Renaissance - for example, here: https://opensiuc.lib.siu.edu/cgi/viewcontent.cgi?article=1007&context=pn_wp

Essentially though, currency markets are a series of disconnected liquidity "pools" - separated by national borders, regulatory regimes, differing standards, and varying levels of interconnectedness with other pools. Demand and supply for a currency within a pool determines overall liquidity and drives overall spreads - so that many emerging market units will trade at wider spreads relative to the dollar, for example. Highly restricted currencies almost always cost more to trade. But at a micro level, spreads are also determined by transaction size, the sophistication of the trading entity, the number of available counterparties, and things like credit risk.

For more, the BIS and the foreign exchange committees run by most central banks are good resources for high-level market statistics and research.

Hope that helps!

As some have already mentioned, Bank Secrecy Act/Anti-Money Laundering and Office of Foreign Assets Control probably account for a disproportionate share of the costs. Specifically, banks are required to conduct enhanced due diligence for certain foreign correspondent accounts.

Hey Tyler - had been writing something related to this, and this pushed me to finish it, so thanks: https://shanelennox.xyz/2019/07/17/crypto-remittances/

Happy to chat, I work at a money transfer business.

Correspondent banking is expensive because getting access to a central bank's RTGS is so burdensome. Few US banks are set up to self clear Canadian dollars. Even those that can often end up relying on nostros to meet currency cutoff times.

You should differentiate FX trading (no cross-border money movement) from FX payments (generally cross-border money movement*):
- FX trading: bid-ask spread is narrow. Obviously, this depends on the currency pair, and the pair's liquidity, but these are usually measured in pips (pip = 0.01%)
- FX payments: this is where correspondent banking comes in, the margins are much bigger here. Karl Schamotta (above) recommended a few papers that explain why

*few exceptions when for example an EU company bills an EU company in US dollars, but let's ignore those for now

No,I don't know. What's the meaning of banking bleg?

it is a correspondent banking bleg...these are the banks on the other side of the world, in different nations, dealing in their nations' currencies. All banks have them.

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