How do banks settle foreign-currency transactions—what mechanisms and steps are used?

In very few countries is this FX (settlement) a central bank function. Predominantly it is a treasury (FI) function. The mechanism used to settle is no different from any other settlement that the bank does on a deferred basis, except a currency pair is involved.

The most common aspect of this is an FX dealer in between. This FX dealer is primarily the market maker. There are many scenarios as to how a transaction can happen.

Consider the following diagram:


Scenario: American Bank wants to send 500,000 Thai Baht to a Bank in Thailand (both banks are denoted by the blue square).

The American Banks' options are:

1. The American Bank's FX Desk can buy the Thai Baht directly from the Thai Bank in Thailand.
2. The American Bank can use another US Bank to buy Baht (other American Bank denoted by red square)
3. The American Bank can work with another Thai Bank (correspondent bank) to buy Thai Baht
4. The Bank can also use a 3rd Party FX dealer in the US
5. The Bank can also use a 3rd Party FX dealer in Thailand.

In all these scenarios, there is someone who is willing to sell 500,000 Thai Baht to the American Bank in exchange for US Dollars.

I'll run through a singe example here. Just to make the numbers easy, lets assume that 1US$ = 32 Thai Baht.

This is the prevailing rate in the market.

In this example the US Bank will buy 500,000 worth of Thai Baht from another US Bank which will deliver the same to the Bank in Thailand:

Here are the steps (caution it is a very crude settlement example):

• Blue American Bank FX Desk sees an FX Rate of 31.50 Baht for 1 US$ being quoted by the Red American Bank.
• The FX dealer for the Blue American Bank confirms the deal.
• Blue American Bank wires US$ 15,873 to the Red American Bank. This is US Dollar Transaction.
• The Red American Bank confirms the transaction.
• The Red American Bank has a rate of 32Thai Baht to 1US$ from the Blue Thai Bank. (This is FX cost to the Red American Bank as offered by the Blue Thai Bank).
• The Red American Bank confirms 500,000 Thai Baht Buy against US Dollars and the transaction amount is: US$ 15,625.
• Blue Thai Bank instructs the Red American Bank to deposit the amount in its US Nostro Account in the US the amount US$ 15,625 which the Red American Bank does. (Again a domestic US transfer).
• Blue Thai Bank now releases 500,000 Thai Baht into the beneficiary's account as required by Blue American Bank.
• The difference of US$ 248 is the income by the FX Desk at Red American Bank.
• The Blue American Bank probably quoted 31.0 Thai Baht to 1US$ to its customer who was wanting to buy 500,000 Thai Baht in the first place. The difference in price between quoted and the price bought, is the Red American Bank's profit.
• The US Dollars sitting in the nostro account in the US for the Blue Thai Bank would then either be reused (consider the reverse example), or eventually they would be wired via SWIFT bank in Thailand at a later settlement date/day.

Roughly this is how the transaction is done.

• List of Central Banks: List of Reserve & Central Banks of the World