Chapter 1: Explain FX business to my farmer friend
The Covid situation has kept us from going back to our hometown for far too long. We are all missing our hometown, family, and relatives. Not sure because of that, I dream about my journey to travel back and meet my old farmer friend who is doing farming and having a small shop in front of his house for buying and selling rice and fertilizer. I still could remember the dialogue we had after waking up. It would be a beautiful dream:*
Me: Hi Tom, how are you, bro?
Tom: Hi hi, Good to see you back. I’m doing good. How about you.
Me: I’m doing good.
Tom: The Covid times have been very difficult. I am just glad our family is doing okay.
Me: Cool*, I’m happy to hear that. How about your shop business recently day?*
Tom: Not too bad. But the price nowadays is not stable. Managing the store gives me a headache sometimes!
Me: Of course, everything is changing now. The not only price of your rice and fertilizers though
Tom: Yep yep. What are you doing in Singapore?
Me: I was helping SBD bank build systems for their eFX business.
Tom: Nice bro, haven’t heard you for a long time. What is eFX business, man?
Me: Yeah, eFX is a sub-portion of FX business
Tom: Then what is FX business — He is stressing
Me: Hmm…. FX business is a Foreign Exchange business. In which you are not selling/buying normal products like rice, fish…etc. But in fact, you are selling and buying money.
Tom: Buying and selling money — He doesn’t trust me
Careful man, if I were you I won’t do that business, you should keep it for yourself. But what kind of business is buying and selling money?
Me: Yeah, I felt the same too at first. But now, I think money is actually a kind of product though. You know right? It is just a piece of paper or a pile of paper.
Hmm… we now are buying and selling all kinds of money in the world from EUR, USD, SGN…to PHP, VND.
Tom: It looks like an easy way to make money. Am I right? — He is curious
Me: Yeah, it is very easy. We have a lot of smart people sitting behind the computer screens, just doing buy low and sell high. They do it 24 hours a day and throughout the whole week. And then at the weekend, they are just waiting for the next trading day back to the grind.
Tom: Ooh..crap. I also want to do that. Waittttt !!! Nobody wants to buy or sell with me. — He is disappointed.
Me: No lallll…, you can buy and sell with our banks. Just remember one thing is “buy low, sell high”. This game is very easy my friend. Just one rule rules all: buy low, sell high.
Tom: Yeah, easy though. But I have a doubt, why do people want to buy and sell their money? I always keep my money in a safe place. I’m scared man, I can not sell and buy my money like my rice and fertilizer — He is pointing to his shelves.
Everyone in our town will know that I am rich. Then they will try to steal and rip me off. 😇
Me: Yeah, you’re right, keep it for yourself. But let see the big picture, there are people who need currency to buy your rice. For instance, a Singaporean person wants to buy your rice because they don’t do farming, Tom. They have to have VND to purchase your rice. — Tom’s face looks happy and triumphant.
I continue: Where do they get these VND amounts? Of course, they go to the Vietnamese local banks to buy it by their SGD dollar. That is a simple example of why there is a money market. Ooh shit, the professionals normally call them “Capital market”, not “Money market”. ;)
Tom: Yeah, I got it. Absolutely we should call it a “Capital market”, I’m pretty sure that it was started in capitalist countries, not from our communist country. People here like to keep their money tightly. So we can call it a “Communist market”.
Me: Hmmm… you may be right…lol. That’s an interesting way of explanation. Let me show you the pie chart of the main traded currencies:
Tom: Hold on. If it is easy so you have earned a lot of money from the SBD bank right? — He is thinking
Me: Hell yeah. They pay very well though. It is freaking easy. My team built automatic trade management systems. It does the money-making while we chill and drink coffee.
Tom: You are so lucky. So just people want to move money around the world so they are going to buy and sell money.
Me: Yes, you’re again but that is not simple like that. There are a lot of players in the capital market. Banks are just one kind of them. Allowing me to explain to you in more detail:
There are financial institutions such as hedge funds, investment funds, government, brokers..etc.
But you can group them into three categories[1]:
- Reporting dealers
- Non-financial customers
- Other financial institutions
And then, in the end, there is a market, like a wet market, a lot of people participate to buy and sell all kinds of money around the world.
Tom: Nice, I wish it is a wet market so that I can visit and see all kinds of money from all countries. Then I will collect one of each currency for my granddaughter. hehe :))))
Me: Yeah me too. I only see the numbers though. Pretty sad, my rich bosses never gift us the real money. Only in number in my bank account. Lol 😂 😂
Tom: You’re badass, that is all you need right? Using that money to buy the real paper money lal.
Me: I’m just joking. Yeah, you are so right.
Tom: So there is only one market in Singapore? Why don’t we open a market in Vietnam? Our country has a lot of “gold” forests and silver sea.
Me: Hehe, it is not that simple. Our economy is pretty small and then not enough people want to transact with us. Technically, we can open a market like our wet markets for everyone to trade. But they won’t come to trade — the rich. I’m afraid that they do not completely trust us.
Anyway, from what I know the five biggest markets in the world right now are London, New York, Singapore, Hong Kong, and Tokyo.
These five centrals are having 90% of the trading daily trading volume. The biggest one is in London.
Most big banks have an office for FX trading there. SBD Bank also has one too. Sometimes we got calls from London traders complaining that our pricing is not working too 😂
Tom: But why is it London? It doesn’t make sense how New York isn’t bigger than London especially since America is the world’s largest economy.
Me: Hold on Tom. The data speaks for itself. It is our implicit bias that we rank New York ahead of London. That is because of London’s historical prestige in FX trading and its geographical position. England is till motherland of America though.
Tom: Thanks I get it. Now it makes sense to me.
Ok, I have already understood a bit about the FX business. Let me you more stupid questions. In Vietnam, we have ABC bank which is for trading businesses, especially exporting and importing ones. And you know that we have a lot of businesses in Singapore too. We also have a lot of Singapore companies here and there. So for sure, there is a market for buying and selling VND and SGD. Now can you help me understand how SBD (Singapore Bank of Dollar) bank and ABC (Asia Bank of Commerce) bank will make a deal of selling VND and buying SGD?
Me: Ok, it is a very good question. This is a question I asked myself after I joined SBD bank. Let me show you a diagram of how money flows between countries.
The above diagram shows an example of an SBD bank trader selling VND to ABC bank. Then the flow of money can be (1), (2), (3), (4), (5), (6).
In short, the SBD branch in Vietnam sends the VND to ABC bank in Vietnam, then after that ABC branch in Singapore will send SGD back to SBD bank in Singapore. In reality, the process is much more complex but we can understand it in a nutshell like this.
Tom: Wow, nice man. Sound easy to understand with your magic chart. But hold on…for a moment.
Again a stupid question. Let say SBD bank pay for ABC bank on Friday but next Monday, the ABC bank declares bankruptcy and has no money to pay SBD bank. What will happen to SBD bank? Let say there is a 500 million dollars deal. It’s a huge risk for your bosses.
Me: Man! You’re thinking like a banker now. You’re not my farmer friend anymore..lol
I’m glad that you ask it. It has happened in the past. On June 26, 1974, Herstatt Bank, a German bank, was declared bankrupt at the end of the trading day in Europe but during the trading day in US markets. This caused its counter-parties — and indeed the entire FX market — a lot of distress as it eroded confidence between traders. [2]
After this event, all the big banks were sit down to discuss and they came out with a solution in the end.
They found an intermediate organization, they call it CLS (Continuous Linked Settlement) — [3]. Everyone will put their money to invest into this company for their profit but as collateral for their international trading. I’m not sure our local banks join this company or not but I’m pretty sure all international banks are.
You may ask what purposes of this company if it is not pure for profit. Yes, it is playing as an intermediate or neutral player in the market. To avoid the above tragedy, all international trade will go through this company. They will hold money from both sides and only deposit money for all parties whenever all funds from both sides are received.
So you see the money flow will be like the below diagram:
Tom: But what if CLS goes bankrupt??
Me: Haha, yes it is possible though. But in comparison, the risk is very low if there is no CLS. Remember that the company is funded by all big banks in the world, its business has no huge risk. Just receiving money from both sides and sending them back. And then you charge a small fee for that service. Very easy to make money right? So forget about the idea it will go bankrupt.
Tom: Haha, you’re right, I’m worried too much then.
Me: Yes, they are building a system that is hard to fail unless there are exceptional events. Because this is their way of producing profit, all big players will protect it at all costs.
Tom: Yeah, ok now I’m pretty sure I can work for a bank now. I’m kind of ready to become a trader for ABC bank though. It looks easy for selling and buying in the wet market. Now can you tell me about your team? how is your team organized to go fishing? sorry I mean to do FX business?
Me: You don’t need to sorry about that, actually the global market is like the open sea, you can have a small or big ship with a good crew to go fishing. Sometimes you have to face a huge storm or hurricane*, such as the finance recession 2008. In this context, the market is very volatile then you need to have a good crew to help your ship overcome the huge market waves. Sometimes big ships also sink — like Leman Brothers. So in big banks, FX business normally combines three structure teams below to go fishing.*
I call it a horizontal structure:
- Front office
- Middle office
- Back office
Most fun things happen in the front-office. So I show you a bit more detail of the front-office structure.
You know what! When I joined SBD bank, I didn’t know the kinds of traders there are. I used to think traders are of only one type. However, I soon learned there are spot traders, swap traders, electronic traders, sale traders, and options traders.
You can think of the capital market like a wet market with a lot of small shops which the bosses call “products” such as Spot, Forward Outrights, Swap, NDF, Option…etc. To be honest I don’t understand them all. I don’t know all the shops in this market Tom.
There are also Sale desk people who help the bank structure or combine all possible kinds of currency pairs or products, or option strategies to meet the bank customers’ needs. You can think of them as fish sellers, tomato sellers but they are more fancy and prestigious.
Tom: Nah, It seems very complex team for a simple “buy low and sell high” business.
Me: Haha, yes, they have to. But you don’t need to. You don’t need to separate your people into front-office, middle office, and back office.
To be honest, trading is all about risk management — no more, no less.
There are non-human risks such as market risk, system risk, and human risk. Human makes mistakes right. You can’t avoid or deny these risks. But I am not talking about errors here. I am talking about cover-ups that employees do. By dividing them into three separate teams help us prevent mistakes and cover risk. That is the cost we have to pay by adding more people and introducing some lack of efficiency.
Tom: So where you are now? You’re in front-office or back-office?
Me: Yeah, I’m in the technology department which we have our teams serving different offices. Our main focus is building all kinds of systems to support business in effective and automatic ways. To be more specific, my team was building a risk center management for eFX team in front-office. They were using it to manage all known risks such as auto skewing price, auto hedging risk position out.
Sorry “Skewing price” means we have a system to automatically modify buying/selling price of our currencies. And “auto hedging risk position” I mean we have a software system automatically buying/selling our capital currencies based on certain market conditions and business rules.
Tom: Now, I feel it is not simple at all. But why did you only build the system, why would you go to the front-office to do the real business. I think will make you more money than building the system so.
Me: yeah, you’re right again my friend, working in front-office is like being the first citizen in the FX business. They will get a high salary and more bonuses than us, but actually, everything comes with a cost. They are the hardest working people in the room, they work earlier than us but are more stressed than us.
They are people very good at buying and selling money. We are not good at it. I am only good at programming and building software systems. But anyway, I’m also happy to build a system that can make money and fun.
It is kind of fun to see it earning money automatically. Like I said before, I just come to the office and drink coffee while I can see the money printing from our system. It is like a moron feeling….lol
Tom: Ok, it is making sense to me. I’m glad that you go far in life. Not like me staying around our hometown and our river. I wish you could help me build the same system for my shop to buy and sell Rice and fertilizer in an automatic way. Then I don’t need to work anymore. Haha
Me: Sure man, I can do that, but first let me call my boss to resign firstly — I resigned from SBD bank since 21/09/2021
And we shall start.
Tom: Cool. Let do that, my friend. Before that could you help me explain what are spot/swap/outrights….?
Me: Shit, forget about it — I lost my patience
They are just shit terms for different kinds of trades. We don’t need to know them now. Just remember one thing: “buy low, sell high”. That’s all.
Tom: Ok ok. let go and grab some beers then.
Me: Absolutely. Go!
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Reference:
[1] Foreign exchange turnover in April 2019 https://www.bis.org/statistics/rpfx19_fx.pdf#page=16
[2] Herstatt Bank https://en.wikipedia.org/wiki/Herstatt_Bank
[3] CLS group — https://en.wikipedia.org/wiki/CLS_Group#:~:text=CLS (originally Continuous Linked Settlement, foreign exchange market (FX).
Thanks to my dear friends: Aniket, Edmund for reviewing. To continue chapter 2.
