When a person wants to exchange one currency for another, they can go to a currency exchange and buy the desired currency at a slightly higher rate than the official exchange rate. This is a common experience and is to be expected. For example, if a person wants to buy US dollars, they may have to pay a few extra rupees to the money changer in order to obtain the dollars.
The official exchange rate, also known as the interbank rate, is the rate at which banks buy and sell currencies to each other. This rate is used as a reference point for the general foreign exchange market. Money changers, on the other hand, operate in the open market, where they buy and sell currencies to the general public at a slightly higher rate than the interbank rate. This difference in rate is known as the open market rate.
In Pakistan, the interbank and open market rate for the dollar has increased significantly in recent times, leading to a difference of up to Rs 10 between the two rates. The reasons for this increase are not clear, but it could be due to various economic factors such as supply and demand, inflation, and monetary policy.
Before we delve into the reasons behind the spread between the interbank and open market rates of exchange, it is important to understand how these two markets function.
Interbank vs Open market Comparison
The interbank market is a platform for financial institutions to trade currencies and currency derivatives with each other on an international level. These transactions can be conducted on behalf of third parties, but they are primarily conducted for the banks themselves. The interbank market is a network between banks and operates 24 hours a day, five days a week. It serves as a reference point for the general foreign exchange market and is influenced by various economic factors such as supply and demand, inflation, and monetary policy.
The interbank market is a platform for banks to trade currencies and currency derivatives with each other directly. It is the most important segment of the foreign exchange market and can be thought of as a wholesale market for currency transactions. The interbank market operates 24 hours a day, five days a week and is influenced by various economic factors such as supply and demand, inflation, and monetary policy. It serves as a reference point for the general foreign exchange market.
The interbank market emerged after the Bretton Woods Agreement was no longer in effect. The Bretton Woods Agreement, which was in place from 1944 to 1971, established a fixed exchange rate system in which the value of currencies was pegged to the value of gold. The US dollar, in particular, was pegged to the price of gold, and other currencies were pegged to the value of the US dollar. The Bretton Woods Agreement fell through following US President Richard Nixon’s decision to take the USA off the gold standard in 1971. This led to the development of the interbank market, which serves as a platform for banks to trade currencies and currency derivatives with each other.
After the Bretton Woods Agreement was no longer in effect, currencies were allowed to float freely, meaning that their value was determined by supply and demand rather than being pegged to the value of another asset. In the early days of the interbank market, voice brokers used telephones to connect buyers and sellers of foreign exchange.
These brokers were eventually replaced by computerized systems such as Reuters and Bloomberg, which facilitated the trading of currencies in a more efficient and accurate manner. The interbank market developed as a platform for banks to trade currencies and currency derivatives with each other, and it continues to play a crucial role in the global financial system.
Pakistan has been using a market-based flexible exchange rate system since May 1999, which means that the value of the Pakistani rupee is determined by supply and demand in the foreign exchange market. Under this system, the interbank rate applies to all foreign exchange receipts and payments for both the private and public sectors in Pakistan.
The exchange rate is determined by the demand and supply conditions in the domestic interbank market. This means that the value of the Pakistani rupee is influenced by various economic factors such as inflation, monetary policy, and trade balances.
The demand for foreign exchange in Pakistan consists of various factors such as imports, services, and debt repayments. These foreign exchange requirements are met by authorized dealers who participate in the interbank market.
These authorized dealers are allowed to release foreign exchange for various purposes without needing to approach the State Bank of Pakistan (SBP). They also do not have to surrender the foreign exchange to the SBP after it has been released. This system allows for a more efficient and flexible foreign exchange market in Pakistan.
The demand for foreign exchange in Pakistan is made up of various factors such as imports, services, and debt repayments. This demand is met by authorized dealers who participate in the interbank market.
As authorized dealers, they are able to release foreign exchange for various purposes without needing to seek approval from the State Bank of Pakistan (SBP) and do not have to surrender the foreign exchange to the SBP after it has been released. This system allows for a more efficient and flexible foreign exchange market in Pakistan.
The demand for foreign exchange in Pakistan is made up of various factors such as imports, services, and debt repayments. This demand is met by authorized dealers who participate in the interbank market.
As authorized dealers, they are able to release foreign exchange for various purposes without needing to seek approval from the State Bank of Pakistan (SBP) and do not have to surrender the foreign exchange to the SBP after it has been released. This system allows for a more efficient and flexible foreign exchange market in Pakistan.
Where does the money in the interbank and open market come from?
The interbank market in Pakistan is fed by various inflows such as imports, remittances, grants, aid, donations, foreign direct investment, and the repatriation of profits. These funds enter the country through official channels, such as commercial banks, and are used to facilitate foreign exchange transactions for their clients. This helps to sustain the interbank market and keep it running smoothly.
Outflows in the interbank market in Pakistan also occur through official channels such as commercial banks. The State Bank of Pakistan (SBP) can influence the liquidity in the interbank market by buying or selling foreign currency as needed.
The open market in Pakistan gets its inflows from various sources such as remittances, travelers exchanging currency, and individuals exchanging saved currency. It is worth noting that remittances can be an inflow in both the interbank and open market, as customers have the option to choose which channel they want to use to send their remittance. This allows them to choose the channel that offers the most favorable exchange rate and fees.
Why is the rate different for both exchange rates?
While the interbank and open markets may seem independent from each other, they are actually interconnected in certain ways. Foreign exchange companies, which operate in the open market, often deposit or surrender their net inflows to the interbank at the end of trading days. This means that the open market is indirectly linked to the interbank market.
There is usually a spread or differential between the interbank and open market rates, with the open market rate being slightly higher due to the exchange companies’ profit margin. However, in times of volatility, this spread may increase. On rare occasions, the interbank rate may be higher than the open market rate. This is unusual but has happened in the past.
Why is the differential so high these days?
In many countries, people only go to currency exchanges when they are traveling and need the local currency of their destination. People do not typically buy and hoard physical notes of other currencies. In the open market, the exchange rate goes up when there is a demand for foreign exchange, such as when people are traveling more, going abroad to study, or trying to dollarize their savings.
However, it is worth noting that the open market in Pakistan operates somewhat differently. In Pakistan, it is common for people to buy and hoard physical notes of foreign currencies, particularly the US dollar. This can contribute to an increase in the open market exchange rate for these currencies.
In recent times, the demand in the open market in Pakistan has been driven by people looking to make a quick profit in the foreign exchange market when the Pakistani rupee depreciates. This demand has been further amplified by individuals trying to dollarize their savings. Additionally, with travel picking up, there has been an increase in demand for foreign currency at currency exchanges.
On the other hand, the demand in the interbank market has calmed down due to controls on outflows such as restrictions on Letters of Credit (LCs) and the closing of open accounts.
In the past, the interbank market struggled with processing large LCs and had difficulty providing sufficient liquidity to process these payments. With these issues now being resolved, the interbank market has seen a decrease in demand and an increase in inflows. As a result, the interbank rate is currently significantly lower than the open market rate.