Forex Trading and Money

CONTROL OF MONEY MARKET

We have shown in the previous paragraph the value of the liquidity report to limit cumulative positive or negative cash flows and to control different Forex operators in their adherence to established limits. There is an additional advantage associated with this report. In many cases, the liquidity report will reflect fundamental funding techniques of a specific country. This information can be useful to review personnel in the headquarters of international banks. A positive cash flow in one- to three-month local currency (DM). This is not surprising because a German branch naturally makes loans in German marks which it expects to collect a few months later; the collections create the positive cash flow in the DM column. We also see negative cash flows for U.S. dollars in Block I. They can only be the result of dollar deposits received which must be repaid over the next few months, thus creating the negative cash flows in the US$ column. At this point, the examiner of the liquidity report may be concerned because the German branch is apparently lending marks and borrowing dollars, which would make it necessary to maintain a very sizable net overbought position in marks against dollars.

Foreign Exchange Operations

However, as we study Block 2, we recognize an outflow of marks in the one- to three-month area and an approximately corresponding inflow of dollars. These cash flows are the result of forward Forex trading exchange transactions. Now the whole report begins to make sense.
The branch made loans in marks, borrowed dollars, converted these dollars into marks in the spot exchange market, and covered in the forward exchange market view, i.e., sold forward marks and purchased forward dollars. This means that the branch has no net exchange position and a cumulative cash flow position which results, by and large, from demand deposits. The cash flows from assets and liabilities and exchange purchases and sales are almost balanced. The explanation for this funding approach must be that the branch finds it cheaper to borrow dollars and swap them into marks than simply to borrow marks.

Miscellaneous Controls Aggregate Limit

We have described tools to limit and control the credit, rate, and liquidity risks. The aggregate limit proposed here does not control any particular risk which would not be controlled already by one of the above-mentioned limits. The aggregate limit is a limit for total unliquidated exchange contracts outstanding with all other banks, corporations, and individuals. It is strictly a volume indicator and functions as a red flag whenever there is an increase in unliquidated exchange contracts. For example, if the aggregate contracts outstanding increase without a corresponding increase in earnings and without any other good explanation, and if this increase in volume is accompanied by a general increase in operating costs such as telephone and telex expenses, a careful examination of the entire operation seems advisable.
On the other hand, there may be a good reason for changes in outstanding balances and, therefore, in limits. For example, the volume of unliquidated exchange contracts rose substantially when floating rates became a reality after August 1971. Importers and exporters who had previously handled their exchange needs on a spot basis whenever they needed a certain currency then began to protect their interests through forward purchases and sales. A spot contract is settled within a few business days, but a forward contract, by definition, is not settled until several months in the future. Therefore, the aggregate limit for unliquidated exchange contracts had to be substantially increased, and there was a very good reason to do so.