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The global financial system (GFS) is a financial system consisting of institutions and
regulations that act on the international level, as opposed to those that act on a national or
regional level. The main players are the global institutions, such as International
Monetary Fund and Bank for International Settlements, national agencies and
government departments, e.g., central banks and finance ministries, and private
institutions acting on the global scale, e.g., banks and hedge funds.
International institutions
The most prominent international institutions are the IMF, the World Bank and the WTO:
Government institutions
Governments act in various ways as actors in the GFS: they pass the laws and regulations
for financial markets and set the tax burden for private players, e.g., banks, funds and
exchanges. They also participate actively through discretionary spending. They are
closely tied to central banks that issue government debt, set interest rates and deposit
requirements, and intervene in the foreign exchange market.
Private participants
Players acting in the stock-, bond-, foreign exchange-, derivatives- and commodities-
markets and investment banking are
Commercial banks
Pension funds
Hedge funds and private equity
Managing foreign exchange
Foreign exchange market and management of exchange rate of a country’s currency are
two key areas that influence the economic well-being of the general public. The exchange
rate of a country’s currency is the value of its money for international trade in goods,
services and finance and, therefore, it is part and parcel of the monetary condition of a
country. Therefore, the central banks being the monetary authorities have been given
discretionary powers under the relevant statutes to decide appropriate foreign exchange
policies along with its monetary, financial and economic development policies. In
macroeconomic perspective, foreign exchange policies are instrumental in mobilization
of foreign savings and capital to fill the domestic resource gap and expand investments.
Various public views are often expressed as to how the central banks should decide
exchange rate policies and what factors should be taken into consideration. Therefore,
this article is intended to educate the public on the background how the central banks
manage or regulate exchange rates and foreign exchange markets.
An exchange rate is a price of a currency stated in units of another currency, i.e., Rs 108 a
US Dollar (US $), US$ 1.5 a Euro or Chinese Yuan 7 a US$. The exchange rate between
two currencies can be stated in two ways, domestic currency price of foreign currency or
foreign currency price of domestic currency, i.e., Rs. 108 a US$ or US$ 0.01 a Rupee.
Exchange rates exist because countries have to exchange their national currencies with
foreign currencies to engage in trade and financial transactions with other countries. For
example, when a Sri Lankan garment manufacturer exports garments to a buyer in US,
Sri Lankan exporter receives the payment for his export in US$. Therefore, if the Sri
Lankan exporter is to use his US$ income in Sri Lanka, he has to sell his US$ proceeds to
a bank for Sri Lanka Rupees. Similarly, Sri Lankan importers have to buy currencies of
the exporting countries for payments to suppliers in those countries. Accordingly, any
foreign receipts to a country involve supply of foreign currencies (or foreign exchange) in
exchange for domestic currency. On the other hand, any payments to foreign countries
involve purchase (demand for) of foreign currencies by paying in the domestic currency.
In addition, certain authorized parties undertake dealings (buying and selling) in foreign
currencies seeking various kinds of financial gain. Since international transactions are
conducted in major foreign currencies such as US$, Sterling Pounds, Yen and Euro,
market participants and policymakers are concerned about the exchange rates of such
major currencies. In Sri Lanka, the Central Bank
(CBSL) monitors mainly the exchange rate for US$ as the Base Exchange rate in the
foreign exchange market. However, CBSL has designated several foreign currencies for
international transactions by the public through banks.
What determines the exchange rates?
Exchange Rates are determined by supply and demand side factors. For example,
increased demand for sterling will cause an appreciation in the Sterling exchange rate.
These are some of the most significant factors in exchange rate determination:
1. Interest Rates.
If interest rates increase in the SL then it becomes relatively more attractive to save
money in banks and in bonds. Therefore, there is higher demand for SL rupee (to be able
to buy the securities). This causes an appreciation. - It is known as hot money flows.
If SL inflation was to become higher than other countries, SL goods would become less
competitive. Therefore, there would be less demand for SL goods and SL rupees, causing
depreciation. General productivity and competitiveness will also have an influence on
the exchange rate.
3. Balance of Payments.
If a country has a large current account deficit it means it is importing more goods and
services than it is exporting. This means more foreign exchange is leaving the country
than going in. Therefore, (assuming it has difficulties in attracting a surplus on the
financial account) a large current account deficit will usually cause depreciation.
4. Speculative buying.
Foreign currencies are heavily traded and some investment banks try to make profit from
buying and selling. If investors lose confidence in an economy and therefore the
currency, the exchange rate will fall. This can depend on political as well as economic
factors. At times currency movements can be unpredictable to say the least.
5. Public debt
Countries will engage in large-scale deficit financing to pay for public sector projects
and governmental funding. While such activity stimulates the domestic economy, nations
with large public deficits and debts are less attractive to foreign investors. The reason? A
large debt encourages inflation, and if inflation is high, the debt will be serviced and
ultimately paid off with cheaper real dollars in the future.
Foreign investors inevitably seek out stable countries with strong economic performance
in which to invest their capital. A country with such positive attributes will draw
investment funds away from other countries perceived to have more political and
economic risk.
The changes in exchange rates will have both favorable and unfavorable impacts on
economic activities and living standard of the public because of the largely globalised
trade and finance involving exchange of currencies. In general, appreciation of a
country’s currency will have the following effects whereas depreciation will have the
opposite effects.
• Lowering the domestic prices of imports because the cost of imports in domestic
currency will be less due to higher value of the domestic currency, i.e., to pay for
any given foreign price of imports will require less units of domestic currency. As
a result, inflation will be lower depending on the extent of the imports in the
domestic consumption and production activities.
•
• Country’s outstanding foreign debt equivalent of domestic currency will be lower
and, therefore, burden on foreign debt repayment will less.
• One unfavorable effect will be that the lower import prices will encourage imports
and worsen the country’s trade balance (net position between exports and
imports).
•
• Another unfavorable effect will be that exporters will be discouraged by reduction
in their income in domestic currency which will adversely affect the export
industries. However, if domestic inflation will be lower due to reduced import
prices, there will be higher foreign demand for exports which will off-set the
initial reduction in exporters’ income.
The foreign exchange market is where currency trading takes place. FX transactions
typically involve one party purchasing a quantity of one currency in exchange for paying
a quantity of another.
Today FX market is one of the largest and most liquid financial markets in the world, and
includes trading between large banks, central banks, currency speculators, corporations,
governments, and other institutions. The average daily volume in the global foreign
exchange and related markets is continuously growing. Traditional daily turnover was
reported to be over US$ 3.2 trillion in April 2007 by the Bank for International
Settlements. Since then, the market has continued to grow.
The purpose of FX market is to facilitate trade and investment. The need for a foreign
exchange market arises because of the presence of multifarious international currencies
such as US Dollar, Pound Sterling, etc, and the need for trading in such currencies.
The large number of, and variety of, traders in the market,
Its geographical dispersion,
Its long trading hours: 24 hours a day except on weekends
The variety of factors that affect exchange rates.
The low margins of profit compared with other markets of fixed
income The use of leverage
Market participants
Banks
The interbank market caters for both the majority of commercial turnover and large
amounts of speculative trading every day. A large bank may trade billions of dollars
daily. Some of this trading is undertaken on behalf of customers, but much is conducted
by proprietary desks, trading for the bank's own account.
Until recently, foreign exchange brokers did large amounts of business, facilitating
interbank trading and matching anonymous counterparts for small fees. Today, however,
much of this business has moved on to more efficient electronic systems.
Commercial companies
An important part of this market comes from the financial activities of companies seeking
foreign exchange to pay for goods or services. Commercial companies often trade fairly
small amounts compared to those of banks or speculators, and their trades often have
little short term impact on market rates. Nevertheless, trade flows are an important factor
in the long-term direction of a currency's exchange rate. Some multinational companies
can have an unpredictable impact when very large positions are covered due to exposures
that are not widely known by other market participants.
Central banks
National central banks play an important role in the foreign exchange markets. They try
to control the money supply, inflation, and/or interest rates and often have official or
unofficial target rates for their currencies. They can use their often substantial foreign
exchange reserves to stabilize the market. Milton Friedman argued that the best
stabilization strategy would be for central banks to buy when the exchange rate is too
low, and to sell when the rate is too high — that is, to trade for a profit based on their
more precise information. Nevertheless, the effectiveness of central bank "stabilizing
speculation" is doubtful because central banks do not go bankrupt if they make large
losses, like other traders would, and there is no convincing evidence that they do make a
profit trading.
About 70% to 90% of the foreign exchange transactions are speculative. In other words,
the person or institution that bought or sold the currency has no plan to actually take
delivery of the currency in the end; rather, they were solely speculating on the movement
of that particular currency. Hedge funds have gained a reputation for aggressive currency
speculation since 1996. They control billions of dollars of equity and may borrow billions
more, and thus may overwhelm intervention by central banks to support almost any
currency, if the economic fundamentals are in the hedge funds' favor.
There are two types of retail brokers offering the opportunity for speculative trading:
retail foreign exchange brokers and market makers. Retail traders (individuals) are a
small fraction of this market and may only participate indirectly through brokers or
banks. Retail foreign exchange brokers, while largely controlled and regulated by the
CFTC and NFA might be subject to foreign exchange scams. At present, the NFA and
CFTC are imposing stricter requirements, particularly in relation to the amount of Net
Capitalization required of its members.
Other
Non-bank foreign exchange companies offer currency exchange and international
payments to private individuals and companies. These are also known as Foreign
Exchange Brokers but are distinct from Foreign exchange Brokers as they do not offer
speculative trading but currency exchange with payments. There is usually a physical
delivery of currency to a bank account.
Financial instruments
Spot
Forward
One way to deal with the Foreign exchange risk is to engage in a forward transaction. In
this transaction, money does not actually change hands until some agreed upon future
date. A buyer and seller agree on an exchange rate for any date in the future, and the
transaction occurs on that date, regardless of what the market rates are then. The duration
of the trade can be a few days, months or years.
Future
Foreign currency futures are exchange traded forward transactions with standard contract
sizes and maturity dates. Futures are standardized and are usually traded on an exchange
created for this purpose. The average contract length is roughly 3 months. Futures
contracts are usually inclusive of any interest amounts.
Swap
The most common type of forward transaction is the currency swap. In a swap, two
parties exchange currencies for a certain length of time and agree to reverse the
transaction at a later date. These are not standardized contracts and are not traded through
an exchange.
Option
A foreign exchange option is a derivative where the owner has the right but not the
obligation to exchange money denominated in one currency into another currency at a
pre-agreed exchange rate on a specified date. The FX options market is the deepest,
largest and liquid market for options of any kind in the world.
Main currencies used in foreign exchange:
The United States dollar is the world's main currency. All currencies are generally quoted
in U.S. dollar terms. Under conditions of international economic and political unrest, the
U.S. dollar has been the main safe-haven currency, which was proven particularly well
during the Southeast Asian crisis of 1997-1998.
The U.S. dollar became the leading currency toward the end of the World War II and was
at the center of the Bretton Woods Accord, as the other currencies were virtually pegged
against it. The introduction of the euro in 1999 reduced the dollar's importance only
marginally.
The major currencies traded against the U.S. dollar are the euro, Japanese yen, British
pound, and Swiss franc.
The Euro
The euro was designed to become the premier currency in trading by simply being quoted
in American terms. Like the U.S. dollar, the euro has a strong international presence
stemming from members of the European Monetary Union. The currency remains
plagued by unequal growth, high unemployment, and government resistance to structural
changes. The pair was also weighed in 1999 and 2000 by outflows from foreign
investors, particularly Japanese, who were forced to liquidate their losing investments in
euro-denominated assets. Moreover, European money managers rebalanced their
portfolios and reduced their euro exposure as their needs for hedging currency risk in
Europe declined.
The Japanese yen is the third most traded currency in the world; it has a much smaller
international presence than the U.S. dollar or the euro. The yen is very liquid around the
world, practically around the clock. The natural demand to trade the yen concentrated
mostly among the Japanese keiretsu, the economic and financial conglomerates.
The yen is much more sensitive to the fortunes of the Nikkei index, the Japanese stock
market, and the real estate market. The attempt of the Bank of Japan to deflate the double
bubble in these two markets had a negative effect on the Japanese yen, although the
impact was short-lived
The British Pound
Until the end of World War II, the pound was the currency of reference. Its nickname,
“cable”, is derived from the telex machine, which was used to trade it in its heyday. The
currency is heavily traded against the euro and the U.S. dollar, but has a spotty presence
against other currencies. The two-year bout with the Exchange Rate Mechanism, between
1990 and 1992, had a soothing effect on the British pound, as it generally had to follow
the Deutsche mark's fluctuations, but the crisis conditions that precipitated the pound's
withdrawal from the ERM had a psychological effect on the currency.
Prior to the introduction of the euro, both the pound benefited from any doubts about the
currency convergence. After the introduction of the euro, Bank of England is attempting
to bring the high U.K. rates closer to the lower rates in the euro zone.
The Swiss franc is the only currency of a major European country that belongs neither to
the European Monetary Union nor to the G-7 countries. Although the Swiss economy is
relatively small, the Swiss franc is one of the four major currencies, closely resembling
the strength and quality of the Swiss economy and finance. Switzerland has a very close
economic relationship with Germany, and thus to the euro zone. Therefore, in terms of
political uncertainty in the East, the Swiss franc is favored generally over the euro.
Typically, it is believed that the Swiss franc is a stable currency. Actually, from a foreign
exchange point of view, the Swiss franc closely resembles the patterns of the euro, but
lacks its liquidity. As the demand for it exceeds supply, the Swiss franc can be more
volatile than the euro.
Bills of Exchange
The most common and yet most complex form of negotiable instrument used for business
transactions is known as the draft, or the bill of exchange. A bill of exchange can be used
for payment, credit, or security in a financial transaction. The term comes from the
English and is defined as an unconditional order in writing that is addressed by one
person to another and signed by the person giving it. Bills of exchange, also referred to as
commercial bills, were initially developed in inland trade by merchants who wished to
resell goods before making a payment on them. Later they came to be used as a type of
IOU in international trade.
In a bill of exchange transaction, a person, or the drawer, agrees to pay to another, also
known as the drawer , a sum of money at a given date, usually three months ahead. In
principle, the bill of exchange operates much a like a postdated check in that it can be
endorsed for payment to the bearer or any other person named other than the drawer.
If the person accepts the bill of exchange by signing his name, or his name with the word
"accepted," across the face of the paper, he is called an acceptor. The person to whom a
bill is transferred by the acceptor's endorsement is called the endorsee. Any person in
possession of a bill, whether as payee, endorsee, or bearer, is termed a holder. The basic
rule applying to bills of exchange is that any signature appearing on a bill obligates the
signer to pay the specified amount drawn on the bill.
A bill of exchange can also be passed beyond the drawer, drawee, and creditor. For the
purposes of payment or borrowing, the creditor may transfer the bill of exchange to a
fourth party, who in turn may pass it on and on through endorsement or signature of the
transferor. Endorsement transfers the rights of the endorser to the new holder and also
creates a liability of the endorser for payment of the amount of the draft if the drawee
does not meet payment when the draft is due. A failure to pay a draft must be more or
less formally recognized, and the draft holder may claim payment from any endorser
whose signature appears on the instrument.
In English laws, bills of exchange were defined in the Bills of Exchange Act of 1882. The
act later influenced American legislation, particularly the passage of the United States
Negotiable Instruments Act, which was eventually adopted throughout the United States.
However, English law of what constitutes a bill of exchange is somewhat different than
bills of exchange laws in Europe and Asia. In 1988, the United Nations Commission on
International Trade Law (UNCITRAL) began working to synchronize these laws through
the "United Nations Convention on International Bills of Exchange and International
Promissory notes." With the development of other means of credit, the use of bills of
exchange has declined.
Incorporation
Incorporation means that the obligation is incorporated in the instrument. In other words,
who owns the document owns the right, meaning that it is enough to be the legitimate
holder upon a continuous series of endorsements to have the right to claim and receive
payment. This is so important because the good faith holder of the bill prevails over a
previous holder that unfairly lost its possession
Literality
Literality means that the existence and content of the obligation is defined by the
document. This is another dimension of incorporation of the credit in the bill. But it goes
further to justify the protection of the good faith holder in terms that several defects of
will cannot be opposed to him, thus making circulation easier.
Abstraction
Abstraction means that the causal or underlying business is separated from the bill of
exchange. In fact, the defects of the causal or underlying transaction cannot be opposed to
subsequent good faith holders of the bill. However, in case they are in bad faith those
defenses can be opposed to them.
Autonomy
Autonomy means that exceptions of the causal transaction cannot be opposed to
subsequent holders in good faith (appraised at the moment of acquisition of the bill, and
that the legitimate holder of the bill has an autonomous right, and therefore a previous
holder that unfairly lost its possession cannot oppose to the legitimate holder the
illegitimacy of the prior holder of the bill who has transmitted the bill to him. In this
context, gross negligence means bad faith, for example, in case the holder gets the bill
from someone well known to be a thief or an indigent person.
Forfeiting
Forfeiting and factoring are services in international market given to an exporter or seller.
Its main objective is to provide smooth cash flow to the sellers. The basic difference
between the forfeiting and factoring is that forfeiting is a long term receivables (over 90
days up to 5 years) while factoring is shorttermed receivables (within 90 days) and is
more related to receivables against commodity sales.
Definition of Forfeiting
The terms forfeiting is originated from a old French word ‘forfait’, which means to
surrender ones right on something to someone else. In international trade, forfeiting may
be defined as the purchasing of an exporter’s receivables at a discount price by paying
cash. By buying these receivables, the forfeiter frees the exporter from credit and the risk
of not receiving the payment from the importer.
The exporter and importer negotiate according to the proposed export sales contract.
Then the exporter approaches the forfeiter to ascertain the terms of forfeiting. After
collecting the details about the importer, and other necessary documents, forfeiter
estimates risk involved in it and then quotes the discount rate.
The exporter then quotes a contract price to the overseas buyer by loading the discount
rate and commitment fee on the sales price of the goods to be exported and sign a
contract with the forfeiter. Export takes place against documents guaranteed by the
importer’s bank and discounts the bill with the forfeiter and presents the same to the
importer for payment on due date.
Documentary Requirements
• Invoice: Forfeiting discount, commitment fees, etc. needs not be shown separately
instead, these could be built into the FOB price, stated on the invoice.
•
• Shipping Bill and GR form: Details of the forfeiting costs are to be included along
with the other details, such FOB price, commission insurance, normally included
in the "Analysis of Export Value "on the shipping bill. The claim for duty
drawback, if any is to be certified only with reference to the FOB value of the
exports stated on the shipping bill.
Benefits to Exporter
100 per cent financing: Without recourse and not occupying exporter's credit line
That is to say once the exporter obtains the financed fund, he will be exempted
from the responsibility to repay the debt.
Improved cash flow: Receivables become current cash inflow and it is beneficial
to the exporters to improve financial status and liquidation ability so as to
heighten further the funds raising capability.
Reduced administration cost: By using forfeiting, the exporter will spare from the
management of the receivables. The relative costs, as a result, are reduced greatly.
Advance tax refund: Through forfeiting the exporter can make the verification of
export and get tax refund in advance just after financing.
Risk reduction: forfeiting business enables the exporter to transfer vary risk
resulted from deferred payments, such as interest rate risk, currency risk, credit
risk, and political risk to the forfeiting bank.
Increased trade opportunity: With forfeiting, the export is able to grant credit to
his buyers freely, and thus, be more competitive in the market.
There is, presently, no legal framework to protect the banker or forfeiter except
the existing covers for the risks involved in any foreign transactions.
High country and political risks dissuade the services of factoring and banking to
many clients.
The order 37 of Civil procedure code should be amended to clarify that factor
debts can be recovered by resorting to
Letters of Credit
Letters of credit accomplish their purpose by substituting the credit of the bank for that of
the customer, for the purpose of facilitating trade. There are basically two types:
commercial and standby. The commercial letter of credit is the primary payment
mechanism for a transaction, whereas the standby letter of credit is a secondary payment
mechanism.
Beneficiary
The beneficiary is entitled to payment as long as he can provide the documentary
evidence required by the letter of credit. The letter of credit is a distinct and separate
transaction from the contract on which it is based. All parties deal in documents and not
in goods. The issuing bank is not liable for performance of the underlying contract
between the customers and beneficiary. The issuing bank's obligation to the buyer is to
examine all documents to insure that they meet all the terms and conditions of the credit.
Upon requesting demand for payment the beneficiary warrants that all conditions of the
agreement have been complied with. If the beneficiary (seller) conforms to the letter of
credit, the seller must be paid by the bank.
Issuing Bank
The issuing bank's liability to pay and to be reimbursed from its customer becomes
absolute upon the completion of the terms and conditions of the letter of credit. Under the
provisions of the Uniform Customs and Practice for Documentary Credits, the bank is
given a reasonable amount of time after receipt of the documents to honor the draft.
The issuing banks' role is to provide a guarantee to the seller that if compliant documents
are presented, the bank will pay the seller the amount due and to examine the documents,
and only pay if these documents comply with the terms and conditions set out in the letter
of credit.
Advising Bank
An advising bank, usually a foreign correspondent bank of the issuing bank will advise
the beneficiary. Generally, the beneficiary would want to use a local bank to insure that
the letter of credit is valid. In addition, the advising bank would be responsible for
sending the documents to the issuing bank. The advising bank has no other obligation
under the letter of credit. If the issuing bank does not pay the beneficiary, the advising
bank is not obligated to pay.
Confirming Bank
The correspondent bank may confirm the letter of credit for the beneficiary. At the
request of the issuing bank, the correspondent obligates itself to insure payment under the
letter of credit. The confirming bank would not confirm the credit until it evaluated the
country and bank where the letter of credit originates. The confirming bank is usually the
advising bank.
Factoring
In finance factoring, a business will sell off its accounts receivable, which are the
invoices that the company has coming in, at a discounted rate. By doing this, the
organization or business is able to obtain cash, or capital, that is readily available to them
rather than waiting for the accounts receivable to actually come in to them. In many
situations, this helps to keep the organization afloat and helps them to pay debts they may
have.
There are several differences between finance factoring and a business loan that may be
obtained from a bank, for example. First, when considering this type of finance, the value
of the receivables is the ultimate important number. This is in contrast to the credit
worthiness of the business, which is what would happen in a business loan. Secondly,
another area the two differ is that the factoring does not offer a loan to the business.
Rather, it is more of a purchase of an asset that the business has.
There is a third way in which finance factoring is different from a business loan. That is
the structure of it. Whereas with a business loan involves just two parties, the bank and
the borrower, the factoring system involves three parties. This includes the receivable
clients, the business owner and the company that purchases the receivables
In finance factoring, the business will sell their receivables to a third party who pays the
business a fraction of what those receivables are worth. The customers of the business
then pay the receivables to the third party at full price. In this transaction, any defaulting
on the behalf of the receivables is not dealt with by the business any longer.
There are many situations in which finance factoring becomes an important part of the
business and therefore is used often.
How factoring can benefit your business
• Up to 90% of the value of your invoices can be advanced by the next working day
• Flexible finance – Factor some or all of your sales ledger
• The Factoring company can take over management of your sales ledger
• The facility is easy to set up through Simply Business
•
2. Deposit Intermediaries
Deposit intermediaries include the following institutions:
a) Banks
b) Credit Unions
c) Mortgage and loan companies.
d) Mortgage and loan agencies.
3. Contractual savings intermediaries
Contractual savings intermediaries are in the form of the following:
a) Life insurance companies.
b) Pension funds.
c) Property and casualty insurance companies
d) Government pension plans.
4. Investment intermediaries
Investment intermediaries include:
a) Mutual funds companies,
b) Investment dealers.
c) Consumer loan companies.
d) Business finance companies.