Dear Wayne, thank you so much for this another very interesting and straightforward video. Tbh this is the best explanation of Forex-Accounting on UA-cam. I'm currently working on that topic at university and still struggle to find sources that clearly explain the Forex-Accounting system like you did. Do you have any recommendations for articles that describe and support this system?
Wayne I was wondering if you could do a video to explain how floating exchange rates are set either through trade like this example or through trading of currencies. Text books always say it is supply and demand but never give examples showing the nuts and bolts as you do. I know interest rates also affect the exchange rate. Hope you have the time to explain this in your normal brilliant way. Thanks.
This is so interesting, man. Thank you for the clear explanation! It's baffling to me that this super fundamental stuff about the world is not taught in school. Thanks! 3:50 So accounts receivable, does the bank take on the risk that this amount will balance in the future with the accounts payable on the foreign account? For example, if the transaction takes place at an exchange rate of 3:1 but the R$ is strengthening and later it is 2:1 - does that mean that the bank loses out because the 100 US$ accounts payable is only worth 200 R$ instead of the 300 R$ that is recorded in accounts receivable? Also, does that mean that domestic banks have the ability to "create" local currency in the accounts receivable, as long as it is backed by the equivalent value foreign currency in accounts payable offshore? Because that accounts receivable amount seems to have appeared from out of nowhere (from the point of view of the Brazilian domestic banking system)
Hey, thanks for your video, it is quite interesting. I would like to make you a question. Following your explanation, the difference between the first and second case is that, in the former, Itau changes its receivables account for reserves in the FX transaction, while in the second case it diminishes Citi deposits when it is executing the FX transaction. Let's suppose now that Itaú wants to borrow funds in the U.S., change these dollars for Brazilian reals and invest them on Brazilian money markets. More specifically, if we take the second case, this would be just not possible, since Itaú would be diminishing the receivable account at the same time as it would be diminishing deposits held by whoever would be purchasing the dollars, not freeing up reals that are required to purchase some asset at the Brazilian money market. How would you account for this type of operation? How can Itau chose in the FX market where the money comes from (from reserves or from deposits)? Thanks!
Wayne I was wondering if you could give some more explanation on what influences exchange rates through actual trade in goods like this example and transactions between banks buying and selling currency. Text books always quote supply and demand but never give any examples of actual transactions showing the nuts and bolts of how that really works in practice. Most of the transactions us trading in currencies right, not to facilitate actual trade in goods? Hope you have the time to shed more light on this like you have with the payments videos. Thanks
Thanks so much for this I am very grateful. One thing can you explain the capital account for the banks. If reserves are being credited isn't the opposite entry a debit to amounts owed to the central bank. Not sure what the capital account is, it can only be their retained earnings which you wouldn't debit surely? Thanks again
Hi Martin, 'Capital' is just a fancy term for 'equity,' or net wealth of the bank (Assets - Liabilities = Equity/Capital). Capital specifically is net private wealth than is dedicated towards investment activities. From the banks perspective, capital is the amount of money the bank owes its shareholders and owners, and represents the amount of money shareholders are risking. Capital can be increased by retaining net profit, or by issuing more equity shares. Capital plays a key role in the solvency of the bank. Following the Global Financial Crisis, banking reforms focused on "Capital Requirements." The Basel accords significantly increased "Capital Adequacy Ratios" requiring banks to hold a higher ratio of capital to assets. For the bank, Capital is the _buffer_ that offsets loan defaults...if a borrower defaults on $1000, the asset side of the balance sheet shrinks by $1000, but their liabilities stay the same, and therefore the banks capital declines by $1000 (i.e. owners lose $1000). Hope this answers your question. Thanks for watching! =)
Thanks again. I was wondering why the double entry when the American bank dumps its Brazilian reserves is a debit to the capital account. Why isn't it like the domestic bank earlier in the payment process and a debit to an inter company accounts receivable with its holding company bank back in the USA ?
If Citibank wanted to _loan_ (rather than transfer) its capital from Brazil they could do it with a payable/receivable as you suggest. The difference would be Citibank (USA) would be making a promise to return capital to Brazil, _eventually_, to settle its payable to Citibank (Brazil). Both would accomplish something similar, but you can consider the "transfer" a hard commitment, and the "loan" a soft commitment. Good Question! =)
at 7.35 you canceled accounts receivable.But isnt it that when you debit deposits of citibank which are accounts payable actually that you need to credit reserves of itau.why you credited accounts receivable.When a loan is made reserves move together with new deposits.So this is some kind of different contract? i have read the last comment about that but.. so this is not a classic loan?
this is possible but as you said banco itau in brazil would have reserve balance deficiency of 300 reserves that it has to acquire some day in the future
Stavros Karageorgis Hi Stravos, Why would anyone swap currency? It could be any number of reasons. Perhaps Citi is over leveraged in dollars and needs to shore up dollar denominated capital. Perhaps the real’s exchange rate is collapsing and Citi wants to protect the nominal value of their assets. Perhaps Citi’s settlement obligations require more US reserves. It could even be because of an exogenous factor like political turmoil or war. The video is obviously a hypothetical, so I didn’t put much time into the behavioral mechanics. I was mostly interested in the accounting. Thanks for watching! :)
My question is related to the whole Keen vs "Mosler" and MMT in general, regarding the effects on the "Money Supply" of the country with a. a current account surplus and b. a floating Fx sovereign currency. Keen recommended, provisionally, your video as 'covering' the matter. I am provisionally challenging that claim. In my vaguely remembered math lingo, it appears your example entails "loss of generality", and therefore does not address the issue in contention.
Stavros Karageorgis That’s fair enough. One example would be if the forex transaction was between two consumption transactions, in which case no new deposits are created. That example would be representative of a trade balance. The example shown is an example of a trade surplus. It is my belief that net foreign trades adds net financials assets to the surplus country. I’m very open to an example that proves me wrong. But I’d have to ask for the accounting to prove it :)
Can you state, as clearly as you possibly can, what sort of evidence or demonstration (simulation, perhaps?) you would accept as definitively "prov[ing] you wrong"? "Net [surplus] foreign trades [always] add net financial assets [denominated in which currency?] to the surplus country" appears to be your claim. Could you restate, as carefully as you can, what your claim is so I know what I have to disprove?
The long and the short of it, Wayne, is this: If an entity or entities is/are "sucking up" (on the net) money out of the domestic economy, it matters not one bit whether that/those entity/ies is/are domestic or foreign. One or more of the remaining entities would have to borrow (to wit, 'deficit-spend' in Moslerian parlance) to make up for that "leakage' and thus to keep economic activity at previous levels.
Hi Brant, If you have spotted a mistake in the accounting, I welcome the input. :) When discussing these balance sheets, i often encounter confusion between gov money, and bank deposits. Gov money is currency, whereas a bank deposit is a private agreement. The word "deposit" is very deceptive, because is it really an 'Accounts Payable' account. Because deposits are a contract, not money, banks are free to expand their liabilities at will (inside of regulatory requirements). So the new 'deposits' created in Brazil, don't involve a transfer of R$ currency, or a currency swap...they were created endogenously, by the bank. I argue, that Itau is comfortable expanding its domestic liabilities because it holds a net foreign asset (US dollars). If Itau needs R$ to immediately fund the new 'deposits' it will _then_ swap dollars, or borrow R$ from another Brazilian bank. This is a controversial position, because I'm arguing that a trade surplus results in a net expansion of deposits in the surplus country. I am actively working to address recent criticisms of the structure I have chosen...I have a CPA (my brother) to confirm the GAAP, and an economist friend who will model the stock and flows. It is my belief that the results will remain the same, but I have to confirm it. Either way, I will post a demo to reassert my position, or I will happily eat crow. :) Hope this helps! -Wayne
Thanks a lot my friend, I´ve waited for this for a long time, this is pure gold ;)
Good to hear from you again! =D
Thanks! As always your videos are crisp and clear.
Dear Wayne, thank you so much for this another very interesting and straightforward video. Tbh this is the best explanation of Forex-Accounting on UA-cam. I'm currently working on that topic at university and still struggle to find sources that clearly explain the Forex-Accounting system like you did. Do you have any recommendations for articles that describe and support this system?
I am also looking from the same.. if you find any interesting article on this subject please let me know...
Wayne I was wondering if you could do a video to explain how floating exchange rates are set either through trade like this example or through trading of currencies. Text books always say it is supply and demand but never give examples showing the nuts and bolts as you do. I know interest rates also affect the exchange rate. Hope you have the time to explain this in your normal brilliant way. Thanks.
This is so interesting, man. Thank you for the clear explanation! It's baffling to me that this super fundamental stuff about the world is not taught in school. Thanks!
3:50 So accounts receivable, does the bank take on the risk that this amount will balance in the future with the accounts payable on the foreign account? For example, if the transaction takes place at an exchange rate of 3:1 but the R$ is strengthening and later it is 2:1 - does that mean that the bank loses out because the 100 US$ accounts payable is only worth 200 R$ instead of the 300 R$ that is recorded in accounts receivable?
Also, does that mean that domestic banks have the ability to "create" local currency in the accounts receivable, as long as it is backed by the equivalent value foreign currency in accounts payable offshore? Because that accounts receivable amount seems to have appeared from out of nowhere (from the point of view of the Brazilian domestic banking system)
Hey, thanks for your video, it is quite interesting.
I would like to make you a question. Following your explanation, the difference between the first and second case is that, in the former, Itau changes its receivables account for reserves in the FX transaction, while in the second case it diminishes Citi deposits when it is executing the FX transaction.
Let's suppose now that Itaú wants to borrow funds in the U.S., change these dollars for Brazilian reals and invest them on Brazilian money markets. More specifically, if we take the second case, this would be just not possible, since Itaú would be diminishing the receivable account at the same time as it would be diminishing deposits held by whoever would be purchasing the dollars, not freeing up reals that are required to purchase some asset at the Brazilian money market. How would you account for this type of operation? How can Itau chose in the FX market where the money comes from (from reserves or from deposits)?
Thanks!
If you get a notification don't get excited I'm not Wayne
Wayne I was wondering if you could give some more explanation on what influences exchange rates through actual trade in goods like this example and transactions between banks buying and selling currency. Text books always quote supply and demand but never give any examples of actual transactions showing the nuts and bolts of how that really works in practice. Most of the transactions us trading in currencies right, not to facilitate actual trade in goods? Hope you have the time to shed more light on this like you have with the payments videos. Thanks
Thanks so much for this I am very grateful. One thing can you explain the capital account for the banks. If reserves are being credited isn't the opposite entry a debit to amounts owed to the central bank. Not sure what the capital account is, it can only be their retained earnings which you wouldn't debit surely?
Thanks again
Hi Martin,
'Capital' is just a fancy term for 'equity,' or net wealth of the bank (Assets - Liabilities = Equity/Capital). Capital specifically is net private wealth than is dedicated towards investment activities. From the banks perspective, capital is the amount of money the bank owes its shareholders and owners, and represents the amount of money shareholders are risking. Capital can be increased by retaining net profit, or by issuing more equity shares.
Capital plays a key role in the solvency of the bank. Following the Global Financial Crisis, banking reforms focused on "Capital Requirements." The Basel accords significantly increased "Capital Adequacy Ratios" requiring banks to hold a higher ratio of capital to assets. For the bank, Capital is the _buffer_ that offsets loan defaults...if a borrower defaults on $1000, the asset side of the balance sheet shrinks by $1000, but their liabilities stay the same, and therefore the banks capital declines by $1000 (i.e. owners lose $1000).
Hope this answers your question. Thanks for watching! =)
Thanks again. I was wondering why the double entry when the American bank dumps its Brazilian reserves is a debit to the capital account. Why isn't it like the domestic bank earlier in the payment process and a debit to an inter company accounts receivable with its holding company bank back in the USA ?
If Citibank wanted to _loan_ (rather than transfer) its capital from Brazil they could do it with a payable/receivable as you suggest. The difference would be Citibank (USA) would be making a promise to return capital to Brazil, _eventually_, to settle its payable to Citibank (Brazil). Both would accomplish something similar, but you can consider the "transfer" a hard commitment, and the "loan" a soft commitment.
Good Question! =)
Imagine tomorrow a new country is born with new currency , how will they determine exchange rate for this new currency
at 7.35 you canceled accounts receivable.But isnt it that when you debit deposits of citibank which are accounts payable actually that you need to credit reserves of itau.why you credited accounts receivable.When a loan is made reserves move together with new deposits.So this is some kind of different contract? i have read the last comment about that but.. so this is not a classic loan?
this is possible but as you said banco itau in brazil would have reserve balance deficiency of 300 reserves that it has to acquire some day in the future
Why would "Citibank" in Brazil wish to get rid of its Real reserves and get USD Reserves instead?
Stavros Karageorgis
Hi Stravos,
Why would anyone swap currency? It could be any number of reasons. Perhaps Citi is over leveraged in dollars and needs to shore up dollar denominated capital. Perhaps the real’s exchange rate is collapsing and Citi wants to protect the nominal value of their assets. Perhaps Citi’s settlement obligations require more US reserves. It could even be because of an exogenous factor like political turmoil or war.
The video is obviously a hypothetical, so I didn’t put much time into the behavioral mechanics. I was mostly interested in the accounting.
Thanks for watching! :)
My question is related to the whole Keen vs "Mosler" and MMT in general, regarding the effects on the "Money Supply" of the country with a. a current account surplus and b. a floating Fx sovereign currency.
Keen recommended, provisionally, your video as 'covering' the matter. I am provisionally challenging that claim. In my vaguely remembered math lingo, it appears your example entails "loss of generality", and therefore does not address the issue in contention.
Stavros Karageorgis
That’s fair enough. One example would be if the forex transaction was between two consumption transactions, in which case no new deposits are created. That example would be representative of a trade balance.
The example shown is an example of a trade surplus. It is my belief that net foreign trades adds net financials assets to the surplus country.
I’m very open to an example that proves me wrong. But I’d have to ask for the accounting to prove it :)
Can you state, as clearly as you possibly can, what sort of evidence or demonstration (simulation, perhaps?) you would accept as definitively "prov[ing] you wrong"?
"Net [surplus] foreign trades [always] add net financial assets [denominated in which currency?] to the surplus country" appears to be your claim. Could you restate, as carefully as you can, what your claim is so I know what I have to disprove?
The long and the short of it, Wayne, is this:
If an entity or entities is/are "sucking up" (on the net) money out of the domestic economy, it matters not one bit whether that/those entity/ies is/are domestic or foreign. One or more of the remaining entities would have to borrow (to wit, 'deficit-spend' in Moslerian parlance) to make up for that "leakage' and thus to keep economic activity at previous levels.
I don't understand the transfer of $100 becomes R300R. Somebody had to sell R300 for $100.
Hi Brant,
If you have spotted a mistake in the accounting, I welcome the input. :)
When discussing these balance sheets, i often encounter confusion between gov money, and bank deposits. Gov money is currency, whereas a bank deposit is a private agreement. The word "deposit" is very deceptive, because is it really an 'Accounts Payable' account.
Because deposits are a contract, not money, banks are free to expand their liabilities at will (inside of regulatory requirements). So the new 'deposits' created in Brazil, don't involve a transfer of R$ currency, or a currency swap...they were created endogenously, by the bank. I argue, that Itau is comfortable expanding its domestic liabilities because it holds a net foreign asset (US dollars). If Itau needs R$ to immediately fund the new 'deposits' it will _then_ swap dollars, or borrow R$ from another Brazilian bank.
This is a controversial position, because I'm arguing that a trade surplus results in a net expansion of deposits in the surplus country. I am actively working to address recent criticisms of the structure I have chosen...I have a CPA (my brother) to confirm the GAAP, and an economist friend who will model the stock and flows.
It is my belief that the results will remain the same, but I have to confirm it. Either way, I will post a demo to reassert my position, or I will happily eat crow. :)
Hope this helps!
-Wayne