Offshore Currency

OFFSHORE CURRENCY

GROUP MEMBERS

NITIN SHEWAKRAMANI HITESH BATHIJA RITURAJ CHHOTARAY SANJU MISTRY PURNANAND SANKET

Introduction to Foreign Exchange Market “A foreign exchange market is market in which currencies are bought and sold. It is to be distinguished from a financial market where currencies are borrowed and lent.”

Foreign exchange market is the largest financial market in the world. It has its own special features with respect to the way it is organized, the participants in the market and the method by which the transaction is settled.

Some salient features of forex market ✔

✔ ✔ ✔ ✔ ✔

Location. Size of the market. 24-hour market. Efficiency. Currencies traded. Flexibility in trading.

The foreign exchange market is the largest market in the world. Daily trading volumes often exceed US $100 billion which is more than 50 times the volume on the New York Stock Exchange. Main Participants There are four main participants in foreign exchange market. They are retail customer, commercial banks, foreign exchange brokers and central banks.

Retail Customer

Commercial banks

Brokers

Commercial banks

Central banks

A. Retail customer: There are three types of retail customers. First, more than 80% of retail customers are actual demanders such as importers, exporters, travelers, etc. Second, some retail customers are arbitragers who seek arbitrage from any foreign currency trading. The last retail customers are speculators. They are looking for extra profits through foreign exchange trading. B. Banks: Commercial banks buy and sell foreign exchanges for their clients. In order to do these transactions, commercial banks should hold foreign exchange deposits with banks in foreign countries. C.

Foreign Exchange Brokers: In the U.S., (some in New Zealand) banks utilizing the foreign exchange market usually do not transact directly with each other but rather transact by the use of foreign exchange brokers. The role of brokers is to arrange a transaction between two parties only. Brokers cannot own the foreign exchange involved. Hence, brokers are free from foreign exchange risks.

D.

Central Banks: If brokers are available, then central banks usually use brokers to intervene foreign exchange markets. If not, central banks directly contact commercial banks. When commercial banks run out of foreign currencies, central banks are supposed to supply demanded foreign currencies. If central banks do not have enough foreign currencies, then a currency crisis happens.

Introduction to offshore currency market “Offshore is anything that is not “onshore” within the boundaries of where you presently live. In other words, any place outside your homeland is considered “offshore.” Every country is offshore to every other place. And each jurisdiction has its own ever-changing laws and political aspirations.”

Offshore currency markets are those where a resident of a domestic country trades in a currency of foreign origin say for e.g. an Indian having a trading a/c in London and trades in GBP or USD or in any other currency other than Indian Rupee. With liberalization in the domestic regulations and globalization of financial markets abroad, an increasing number of Indian companies are raising funds in international financial markets. Typically the operations are in Eurocurrency markets, which provide larger access at competitive rates. Eurocurrency market or offshore market as they are called is an international capital market which specializes in borrowing and lending of currencies outside the country of issue. Thus deposits in dollars with a bank in London are Eurodollars. Similarly, Japanese yen held by banks in London is euro yen; pound-sterling held by banks in the Germany is euro sterling, and so on. The main centers of Eurocurrency are London and a few other places in Europe. The growth of the market has extended beyond these limits and includes a few centers of Asia too, such as Singapore and Hong Kong.

The offshore currency market is very big in size and the participants in this market are many so it makes this market more lucrative and attractive to the investors all around the world. Even though the market is growing but there are some problems attached to it as investors have some restrictions in maintaining the amount to be invested in other currencies and markets.

Evolution of offshore currency markets The foundation of modern euro currency was laid in 1949. The new Chinese Communist government apprehended that their $ earnings would be blocked by the U.S.A, to overcome the threat, it began to disguise its $ earnings by placing them with a Russian owned bank in Paris. Following the outbreak of the Korean war in 1950, the USA blocked Peking’s identifiable $ balances in the USA. Fearing similar action against their holdings, the Russian banks in Paris and London began disguising their balances by placing them with banks in Western Europe instead of directly depositing them in New York. Thus the Western Banks had claims on $ balances in the USA and the communist depositors had similar claims on the Western Banks. Another contributing factor was the decision taken by the British government in late 1957 to impose a ban on new overseas loans, denominated in sterling to finance trade between countries outside the sterling area. During the same period, exchange control restrictions were relaxed throughout Western Europe, affording commercial banks the freedom to conduct foreign exchange business and to accept deposits in foreign currencies. The situation was utilized by the London banks to offer their restricted non-sterling area clients the alternative of financing in $. The real impetus for the growth of Euro$ came from certain developments in the USA itself. Regulation Q of the Federal Reserve act provided mandatory ceilings on interest rates that could be paid in bank deposits. Under the regulations, no interest was payable on bank deposits of less than 30 days’ duration, while interest rates for longer terms were governed by strict ceilings. Thus the interest rates payable on $ deposits in the USA was restricted, while no such restriction was there for deposits outside the USA. By offering higher interest rates than those prevailing in the USA, banks operating outside the USA were able to attract substantial $ deposits from non US residents. The higher interest also resulted in transfer of some of $ balances kept by foreign investors in New York to outside the USA. Initially, these deposits were placed with banks in London, as they had a

ready use of these funds in foreign exchange business and lending to non-sterling areas. Thus London gained prominence as a financial centre for Euro currency. Another regulation that encouraged flow of funds from the USA to European centers was regulation M of the Federal Reserve act. This regulation required the banks to maintain certain % as reserves against deposits. Except for a brief period, this regulation was not applied to deposits of European branches of US banks. This resulted in the cost of operations lower in Europe as compared to that in the USA. A part of the economy in operations could be passed on the customers in the form of higher rates of interest on deposits at the European centers. The absence of regulations encouraged some US banks to move some of their depositors a/c’s, including those of Americans, to the European markets. All the factors thus far mentioned encouraged the flow of funds into the Eurocurrency markets. Certain other factors ensured its sustenance by creating adequate demand for the funds thus generated. One such factor was the controls and restrictions on borrowing funds in the US fro reinvestment abroad, begun as a voluntary restraint programme in 1965 and made mandatory in 1968. As a result of the restrictions, the borrowers were driven to seek loans outside the US market and naturally resorted to the Eurocurrency markets. This was how the offshore or the Eurocurrency market came into existence.

Characteristics of offshore currency markets 1.

Transaction in each currency takes place outside the country of its issue. For example, dollars earned by a Japanese firm from exports may be deposited with a bank in London. The London bank is free to use the funds for lending to any other bank. The bank may use it for lending to a French bank. Thus the utility of the currency is entirely outside the control of the central bank of the country issuing the currency. For this reason Eurocurrencies are also referred to as offshore currencies.

2.

Even though the currency is utilized outside the country of origin, it has to be held only in the country of its issue. To continue the same ex, the Japanese firm deposits its dollar earnings with a bank in London. The London bank will keep the funds in a New York bank in its own name. When the London bank lends the amt to the French bank, it will give suitable instructions to the New York bank, on receipt of the instructions the New York bank will debit the a/c of the London bank and credit it to the a/c of the French bank. Thus ultimately the settlement of dollar transactions takes place in New York, similarly settlement of all eurosterling transactions are made in London.

3.

Though Eurocurrencies are outside the direct control of the monetary authorities of their respective countries of issue, they are subject to some form of indirect control. This is because the settlement of all transactions has to take place only in the country of issue. If the country of issue imposes any restrictions, the conversion of balances in the currency held outside the country into another currency would also be affected. As already stated conversion into another currency would involve clearing in the country of issue at some point of transaction, this automatically subjects them to the restriction.

4.

Eurocurrency is not a foreign exchange market. It as a market for deposits with and between banks (inter-bank deposits) and for loan by banks to the non-bank public. It is a market in which foreign currencies are lent and borrowed as distinct from the foreign exchange market, where they are bought

and sold. It consists of a pool of predominantly short-term deposits which provide the biggest single source of funds that commercial banks transform into medium and occasionally long term international loans or eurocredits. 5.

The transactions in the market involve huge amount running into millions of dollars, the large scale financing has led to the development of syndications of loans, where a large number of banks participate in the lending operations.

6.

Eurocurrency market is a highly competitive market with free access for new institutions in the market. Consequently, the margin between the interest rates on deposits and advances has narrowed down considerably.

7.

In this market investors get to trade basket of currencies which help them to manage their currency risks by using various measures.

8.

These markets provide good economic and political stability as it helps the offshore investors to park their funds and enjoy the interest on it.

Types of offshore currency markets The offshore currency market is a big market and the people investing in it are in huge numbers but the market consist of 2 main types:

1) Spot Market 2) Future Market

Spot Market

Spot currency trading represents the most widely used foreign currency instrument. The spot foreign exchange market basic characteristics contributing to its popularity are: • High volatility Volatility represents the degree of price fluctuation of a particular currency for a specific time period. This means that a particular currency pair may change its price with as many as 150 - 250 pips for as little as several seconds. This might represent a great opportunity for quick profits and yet, quick losses as well. • High liquidity • short-term contract execution In a spot deal, the bilateral contract between two parties exchanging currencies is based on a predetermined exchange rate within two business days of the contract date. The only exception to the 2-day rule is the Canadian dollar since the spot delivery is done in the next business day. Those three characteristics lead to minimization of the credit risk on the spot market.

Forward Market

It is the market where by an agreed amount of foreign currencies are bought and sold for a specified future delivery at a predetermined rate of exchange. The basic characteristics of the forex forward market are: • Decentralization This allows traders form all over the world to enter into different deals either by using the services of a broker or on one-on-one basis. • No standard regarding the settlement dates The settlement dates that are established on the forward market can range from 3 days to 3 years. Currency swaps are rarely longer than a year but in principle no technical restrictions exist to execute such a deal. The only requirement is that the date is a valid business day for the currencies that are part of the deal.

Segments of Eurocurrency markets Euro credits: Most of the lending in Euro currency markets take the form of Eurocredit. Eurocredits are medium and long term loans provided by international group of banks in currencies which need not be those of the lenders or borrowers. Eurocredit belongs to wholesale sector of the international capital market and normally involves large amounts.

Security: Eurocredit are provided mostly without any collateral security from the borrower. Greater emphasis is laid on the credit rating of the borrower rather than on any tangible security. By avoiding collateral security complicated procedures can be avoided. Type of Facility: The conditions stipulated for drawing and repayment of the facility depends upon the kind of credit provided. Eurocredits are normally provided in either of the following two forms: (i) Revolving credit (ii) Term credit. Revolving credit is similar to cash credit facility. It is a standby facility to meet temporary but recurring financial requirements of the borrower. Term credit is similar to medium-term loans provided by banks. This facility is utilized in full for some time and then, in accordance with the agreement already entered into. Period: The period of Eurocredits extends up to 15 years. But most of the credits are for periods of 5 to 8 years. On an average about 5% of the total credits are for periods ranging from 1 to 5 years and about 10% from 10 to 15 years. Interest: Generally interest for dollar loans is fixed at a percentage over Libor, say 1% over Libor. The interest is revised six months, considering the changes in Libor. Thus, technically, the credit is ‘rolled over’ or renewed every six months. The difference between the interest charged on the loan and the Libor is the lending margin. Currency: Most of the loans raised are in dollars. Some loan agreements also provide for currency option. That is, initially the loan is raised in dollars. The borrower is given the option to roll over the loan in a different currency according to his requirement. Syndication of Loans: Each Eurocredit runs into a huge amount of a few hundred million dollars. It is not safe or possible for a single bank to undertake the entire amount. Thus few

banks form a syndicate to provide finance to the borrower. The practice is also partly due to the US laws which provide limitations on loans of any single bank to any single borrower. These are not permanent groupings and formed in each case by banks willing to participate in the credit. Protection to Lending banks: One major step taken by lending banks to protect their interests is to analyze the position of the borrower and his country’s economy and political environment thoroughly before committing themselves on the loan. In case of weaker borrowers, the lending banks try to compensate the higher risk involved by prescribing higher lending margins. Euro Bonds: A major source of borrowings at Euro markets is through the issue of international bonds known as Eurobonds. Eurobonds are those sold for international borrowers in several markets simultaneously by international group of banks. They are issued on behalf of multinational corporations, international agencies and governments. In the past borrowers were largely from industrialized countries. Of late, developing countries have entered the market on a large scale. Most of their borrowings had been balance of payments-oriented, either directly or indirectly. These are unsecured securities. Therefore only borrowers of high financial standing are able to issue such bonds. Selling of these bonds is done through syndicate. Features: Most Eurobonds are bearer securities. Most of them are denominated in US dollars, issued in denominations of USD 10,000. The average maturity of Euro bonds is about 5 to 6 years although it is normal to find issues with maturity up to 15 years. Types of bonds: There are 4 main types of Eurobonds: a) Straight or Fixed-rate bonds b) Convertible bonds c) Currency option bonds d) Floating Rate notes Eurocurrency Deposits:-

While Eurobonds represents the funds amassed by the banks on behalf of international borrowers, Eurocurrency deposits represent the funds accepted by the banks themselves. Eurocurrency time deposits are by far the most important instruments in the Euromarkets surpassing by several times the outstanding under Eurobond and foreign bond issues. Certificate of Deposit:A Certificate of deposit resembles a time deposit with the difference that the former is negotiable while a time deposit is not. Certificates of deposits (CDs) evidence receipt of money by the bank and also carry the bank’s guarantee for repayment of principal and interest. Types of CDs:1. Straight CDs 2. Floating rate CDs 3. Tranche CDs 4. Discount CDs Euro Notes:Euronotes constitute the instruments of borrowing issued by corporate in the Eurocurrency market, with or without the underwriting support of banks. This is evolved as a process of disintermediation in the market whereby the borrowers are directly approaching the lenders without the intermediation of banks and financial institutions. Following are instruments in Euronotes:✔ Commercial papers ✔ Note Issuance facilities ✔ Medium term notes All these come under the offshore or the Eurocurrency markets.

Advantages of offshore currency markets Access to stable financial markets:It provides access to politically and economically stable jurisdiction. The people investing in these markets are investing where there money is safe and away from the restrictions of the domestic currency markets. Government regulation is less:Those investing in the offshore market are free from stiff govt regulations and restrictions as they are not bound by the domestic govt rules they tend to invest more and create liquidity in the markets which results in more and more investors attracting towards the markets. Helps borrowing and lending of currencies:The major advantage of these markets is that it helps in the exchange of currencies at a global level and facilitating export, imports and all such transactions requiring foreign currencies it also act as a major borrower and lender of foreign currencies. Provides investors with more investment avenues:Offshore finance is one of the few industries, along with tourism, that geographically remote island nations can competitively engage in. It can help developing countries source investment and create growth in their economies, and can help redistribute world finance from the developed to the developing world. It also provides investors with investments avenues they never thought they may invest in like junk bonds, ADR’s etc. Makes the domestic currency more open in the market:These markets provide the global platform to the local currency and encourage trades in the currency of the domestic country.

Enables companies to go global money wise :Offshore markets helps the domestic co’s to trek the international market for their need for finance and all other need of business funding let it be for working capital, expansion or for acquiring any firm etc, it gives the co’s an extra avenue to chalk out their finances

Disadvantages of offshore currency markets 

Domestic currency is fully convertible:Once the domestic currency is trading in the offshore market it has to be fully convertible then only it can be traded so this opens a gap where the currency risk comes fully convertible currency can be traded and can bring insecurity in the minds of the domestic investors as it can turn up or down any time.



Speculation in the domestic currency increases:The offshore currency market trades many currencies so at a time the investor can trade in n no of currencies as more and more trades are done the volatility in the currencies increases and the speculations in the market increase leading to some degree of market making for a particular currency.