Understanding interbank rates: A guide to optimizing cross-border payments

The global foreign exchange (FX) market handles daily trading volumes exceeding $7.5 trillion1, of which the top-tier interbank market accounts for 51% of all transactions2. These transactions impact currency valuations, the margins on international payments, and the timing of transferring money.

The efficacy of these transactions mainly depends on interbank rates, which form the basis of worldwide forex markets. A 20-paise movement in rates could mean lakhs lost or saved on large transactions. Yet, many companies struggle with rate unpredictability, hidden conversion costs, and opaque bank spreads.

Whether you're managing treasury operations, planning an international expansion, or optimising payment cycles, understanding interbank rates helps you cut costs, seize better conversion opportunities, and maintain competitive pricing in global markets.

The interbank exchange rate is the price at which banks buy and sell foreign currencies with each other. It reflects the form of market forces, where additional mark-ups or margins like those charged by a bank or brokers, do not apply. but in the case of retail exchange rates, they do apply. 

The pricing structure of interbank rates is based on the following core components that determine how rates are quoted and traded in the wholesale currency market:

• Base currency vs quote currency: The first listed currency in a currency pair is called the base, while the second currency is the quote. The interbank rate specifies how much of the quoted currency is needed to buy one unit of the base currency.

• Bid vs ask rates: The difference between the bid (the highest price a buyer will pay) and ask rates (the lowest price that a seller will accept) is known as the spread. This reflects market liquidity and volatility. Major currency pairs, like those involving the USD, typically display tighter spreads due to higher trading volumes and better liquidity. A tighter spread means there's minimal difference between buying and selling prices. For example,  USD/INR, which is a commonly traded currency pair, will have a spread of just 2-3 paise versus 10-15 paise for less traded currencies.

• Real-time nature: Interbank rates change continuously during trading hours, responding instantly to market forces and economic developments. It ensures transparency and efficiency in the forex market.

The interbank market operates within a decentralized forex market, where major banks serve as primary liquidity providers and market makers. In India, this system functions under the RBI's oversight, with Category-I Authorized Dealers forming the core trading network. These institutions connect through platforms like Reuters Dealing and Bloomberg FXGO, enabling real-time price discovery and seamless transactions.

Major banks like SBI, HDFC, ICICI, and other global institutions continuously quote bid and ask prices based on their positions, risk assessment, and market dynamics. Their active participation ensures efficient price discovery along with maintaining market liquidity. During market stress, these established banks maintain stability by continuing to provide quotes, while smaller players typically reduce their exposure.

Take, for instance, when an Indian bank needs to execute a $10 million USD/INR trade. The bank's traders receive real-time quotes from multiple counterparties through their trading platforms:

Bank A: 83.20/83.25

Bank B: 83.22/83.26

Bank C: 83.19/83.24

They analyze these quotes, considering factors like counterparty risk and settlement efficiency, before executing at the optimal rate.

It decides to execute with Bank C at 83.24, offering the most competitive rate (assuming it has high execution reliability), making the total conversion amount:

$10 million × ₹83.24 = ₹832,400,000

Through the Clearing Corporation of India Ltd (CCIL) guaranteed settlement system, the entire process, from quote to settlement, is typically completed within two business days.

Fluctuations in the interbank rate stem from a dynamic interplay of multiple variables. Understanding these factors can help predict rate movements and optimize payment timing. Let’s look at these different market forces and their impact:

• Market supply and demand: When banks see increased demand for a certain currency from their corporate clients, they adjust their interbank quotes to reflect this pressure. Investor sentiment amplifies these movements — when it is positive, banks often tighten their spreads due to increased trading confidence and liquidity. Conversely, any negative sentiment leads banks to quote wider spreads, protecting themselves against potential market volatility.

• Macroeconomic indicators: GDP growth figures, inflation rates, and interest rate differentials with major economies influence the interbank rate.  For instance, when a country reports strong economic growth, it typically leads to increased foreign investment inflows. This forces banks to adjust their interbank quotes as they handle larger currency volumes. Banks might tighten their spreads due to improved market liquidity and confidence, directly affecting the rates at which they trade with each other.

• Geopolitical events: Wars, trade agreements, and political instability can cause substantial volatility in interbank rates.  When the Russia-Ukraine conflict began, banks worldwide adjusted their interbank rates to reflect this heightened risk. Trading desks reduced their position limits and widened their spreads, particularly for currencies directly affected by the conflict, showing how global events reshape the rates banks offer each other.

• Central bank policies: Actions taken by a country’s central bank in the currency market have direct consequences for interbank rates. When the RBI intervenes by selling USD, it changes the supply-demand dynamics in the interbank market. Banks adjust their quotes based on this intervention, typically leading to tighter spreads and more stable rates as they know the RBI is actively managing volatility.

• Global trade dynamics: Trade balances fundamentally influence interbank rates through their impact on currency demand. When India runs a trade deficit, banks experience increased dollar demand from importers, leading them to adjust their interbank quotes higher. Conversely, during periods of strong exports, particularly in services, banks see more dollar supply, often resulting in more favorable interbank rates for rupee trades.

The mid-market rate represents the theoretical midpoint between buying and selling prices in the global forex market. While this rate serves as a benchmark for fair pricing, it differs significantly from the actual interbank rates used in transactions. Understanding this difference is crucial for businesses managing international payments.

The relationship between interbank and mid-market rates creates a layered pricing structure where each market participant adds their markup. Consider a scenario where the USD/INR mid-market rate is 83.00. The interbank rate might be 83.05/83.15, while retail customers could see rates of 82.95/83.35. This cascading markup structure means businesses typically pay a premium over the interbank rate, making it essential to understand these differences when planning international transactions. You can also read more about how to save costs on FX in our blog section.

From setting competitive prices to handling currency conversions, interbank rates influence multiple aspects of financial decision-making. Yet most businesses struggle with rate volatility, hidden margins, and timing their transactions effectively. Here's how interbank rates impact key business decisions:

• Benchmark rate for revenue realization: As a benchmark for international transactions, interbank rates serve as the foundation for determining fair exchange rates. For instance, when an Indian IT services company prices its contracts in USD, the interbank rate helps them establish competitive rates while maintaining profit margins.

• Cost optimization: While businesses don't access these rates directly, understanding the relationship between interbank rates and final conversion rates helps in cost optimization. If the USD/INR interbank rate is 83.20, and a bank quotes 83.50, the business can identify the 30-paise spread being charged. This transparency enables better negotiation of forex fees and more accurate cost projections.

• Transfer pricing efficiency: For Indian subsidiaries of global companies, interbank rates influence transfer pricing calculations. These rates determine the actual cost of cross-border fund transfers between the parent company and their Indian entities. By tracking interbank rates, businesses can optimize their transfer pricing markups and ensure better tax efficiency while maintaining compliance.

• Working capital management: Interbank rates directly affect how exporters manage their working capital cycles. When dealing with international payments spanning 30-90 days, rate movements can impact realized value. Understanding interbank trends helps exporters time their conversions - they might hold USD collections when INR shows weakening trends or accelerate conversions during favorable rates. Knowing how to manage this becomes especially critical when managing large payments.

The importance of interbank rates in global business operations cannot be overstated. Every international payment, whether it is an IT company receiving overseas revenues or a manufacturer importing raw materials, depends on these rates.  Businesses navigating these rates effectively stand to gain tangible advantages in their cross-border transactions.

In today's dynamic marketplace, understanding interbank rates is a strategic necessity.  These rates, shaped by everything from RBI policies to global economic shifts, demand constant attention and informed management.

For businesses handling significant foreign exchange volumes, mastering interbank dynamics unlocks multiple benefits. They secure more favorable rates by strategically managing the timing of their transactions and strengthening their position in banking partnerships. Perhaps most important, they develop robust strategies to protect against market volatility while capitalizing on favorable currency movements.

References:

1. https://www.bis.org/publ/qtrpdf/r_qt2212f.htm 
2. https://en.wikipedia.org/wiki/Foreign_exchange_market