The World of Currencies
Why this chapter
To understand that money does not cross borders, and why whether your company can receive a payment from another country depends on that.
An analogy
Picture two postmasters in neighboring towns. A resident of the first town wants to send a hundred som to the second. Nobody carries a sack of coins over the mountain pass: the first postmaster records that he owes the second, the second pays the money out to the recipient, and once a month they settle their mutual records. It all rests on one thing: they hold accounts with each other and they trust each other. Close those accounts — and no post, no letters and no technology will help: money will stop moving between the towns at all. The thirteenth chapter is about that network of accounts, about who is in charge of it, and about what happens when somebody in it stops being trusted.
How it works
Money does not cross borders. It is rewritten in the books of correspondent banks: your “dollar account” at the local bank is a claim on that bank, which holds a claim on Citi, which holds reserves at the Fed. SWIFT carries messages, not money: the real weapon is closing correspondent accounts, not switching off the messenger.
The Fed is the central bank of the dollar planet. Only it can create dollars, while dollar debts are held by the whole world (eurodollars, ch. 9). So in every crisis: swap lines to friendly central banks (the 2008 peak: ~$583 billion; in March 2020 — 5 standing lines + 9 temporary ones), FIMA repo for everyone else. The hierarchy of access: a master account at the Fed is for banks only; fintechs and non-banks live one floor below, on someone else's obligations.
The investor's view: the “impossible trinity” — free capital flows, a fixed exchange rate, your own policy rate: any two of them kill the third. A widening of the Fed's swap lines is a thermometer of global stress and a signal that the panic is turning.
The words of this chapter
Nostro and vostro
Banks' accounts with each other: a nostro is our account with them, a vostro is their account with us. All international movement of money is entries across accounts like these.
They were invented because a bank in one country has no access to another country's payment system. It needs a local partner who will make the payment in its name.
A correspondent account
That very account a bank holds at another bank or at a central bank, through which its settlements run.
It is needed because a payment has to end up somewhere: any chain of claims ends in an account with whoever issues that currency.
SWIFT
A network for exchanging messages between banks. It carries instructions, not money.
It was invented so that payment instructions travel in a single format rather than as telegrams in free text.
The FX position
The difference between a bank's FX claims and its FX obligations. It is the position, not any individual trade, that brings profit or loss when the exchange rate moves.
The concept is needed because exchanging currency, for a bank, is rewriting obligations with a spread: the difference between the buying and the selling price.
A swap line
An arrangement between central banks to exchange currency for a time, so that local banks can get dollars from their own central bank instead of hunting for them in a frozen market.
It was invented because the world's debts are denominated in dollars, and only the American central bank can create settlement dollars.
The impossible trinity
A rule of choice: free movement of capital, a fixed exchange rate, and an interest rate of your own. Any two are possible at once; the third dies.
This is not an invention but an observation: every attempt to keep all three ended in a currency crisis.
A letter of credit
A bank's obligation to pay the seller against the documents presented: ship the goods, confirm it with papers, and you are paid, regardless of your relationship with the buyer.
It was invented as a replacement for trust between strangers from different countries. The bank puts up its balance sheet in place of the parties' reputations.
What happens to the balance sheet
Follow the pyramid of claims. At the bottom is you: you have an account at a local bank, and it owes you dollars. The local bank holds an account at a large foreign bank, and that bank owes the dollars to it. The large foreign bank holds an account at the central bank of the issuing country, and only there does the real settlement money sit. Every floor is an obligation of the floor above. Two conclusions follow. The first: the risk of your FX account equals the risk of the whole chain, not just of your bank. The second: climbing one floor higher is bought with a license and capital, not with technology.
Where the money comes from here
The correspondent bank earns fees for putting payments through and the balances other banks keep with it at no interest. Your local bank earns the spread on exchanging currency and a fee for the transfer. A guarantee of payment against documents brings in a fee for the risk taken on and needs almost no money — the goods themselves serve as security, which is why this kind of financing is considered the dullest and the most durable banking business there is. The one who loses is whoever's chain broke: a customer with an FX account in a country whose banks lost their correspondents. Here is why this matters to you: when working with another country, check not the tariffs but the route of the payment and who stands on the upper floors.
What people usually get wrong
The common belief. My dollars are in my bank, and they are my money.
What is actually true. Your bank owes you dollars because its correspondent owes them to it, and the central bank of the issuing country owes them to that correspondent. The real settlement money sits only on the top floor.
The common belief. Being cut off from the messaging system stops all of a country's payments.
What is actually true. Messages can be carried another way: through intermediaries, by old telex, through third currencies. Slower and more expensive, but possible. What stops payments is closing accounts, not cutting off the mail.
The common belief. Fast international transfers work because money has learned to fly quickly.
What is actually true. Companies promising a transfer in minutes usually do not move money across the border at all: they have two pools of money in two countries, and the mutual claims are settled from time to time.
After this chapter you will be able to
- read an FX account as a chain of claims and find the link in it that lies outside your jurisdiction
- tell the message channel apart from the settlement channel, and name which of them being cut off stops payments
- judge not the deal but the position an institution is left with after the deal
- work out which floor of the money pyramid a customer balance sits on, and whose bankruptcy would wipe it out
- replace trust in an unfamiliar counterparty with a condition that can be checked, and see what risk the fee was taken for
Check yourself
A country's bank was cut off from the international messaging system. Can it still make payments?
Yes, more slowly and more expensively.
That system carries instructions, not money. While the bank's accounts at foreign correspondents are alive, payments go through intermediaries and other channels of communication. What stops everything is exactly the closing of accounts.
The bank bought dollars from a customer and the same day sold them to another customer at a slightly higher price. What FX risk does it have?
Practically none.
The risk lives not in the trade but in the position left after it. Bought and immediately sold — there is no position, only the difference that was earned. What is dangerous is whatever is left unmatched by the end of the day.
A country wants free movement of capital, a fixed exchange rate and control of its own rate, all at once. What will happen?
One of the three will break.
That combination does not hold: any two can be kept. Every currency crisis in an emerging country is an attempt to keep all three at once, and the only question is what will be sacrificed in the end.
In short
Money does not travel between countries: banks simply keep accounts with each other and rewrite who owes whom. Your account in dollars is a promise from your bank that rests on a promise from its foreign partner. So the reliability of such an account equals the reliability of the whole chain, not just of your bank. Cutting a country off from the messaging system is unpleasant but survivable; closing the accounts means stopping payments altogether. And to trade with a stranger in another country, a simple thing was invented: the bank pays the seller against correctly drawn-up papers.
Reading is half the job. In the academy this chapter is worked through by posting entries: you run the operations yourself and see whether the balance sheet still balances.