The role of banks in international trade is crucial. The banks provide financing products such as letters of credit, forex and helps to reduce risks and allow transactions to go smoothly for importers and exporters worldwide. Because of the worldwide trade, commerce, and finance, forex markets tend to be the world’s largest and most liquid asset markets. Nostro and Vostro accounts helps ease foreign exchange in international trade.   

NOSTRO

A nostro account refers to an account that a bank holds in a foreign currency in another bank. Nostros, a term derived from the Latin word for “ours,” are frequently used to facilitate foreign exchange. The opposite term “vostro account” derived from the Latin word for “yours,” is how a bank refers to the accounts that other banks have on its books in its home currency.

A Nostro account is an account maintained by a domestic bank with a foreign bank in foreign currency. For example, State Bank of India has opened an account with Bank of America in New York for dealing in US Dollars, this account is called as the Nostro account for the State Bank of India. In the Nostro account, the domestic bank acts as the facilitator – in this case SBI is the facilitator.  A Nostro account with debit balances is considered an asset because domestic banks are often used as custodians to manage the bank’s operations regarding foreign exchange transactions. A bank recognizes the Nostro balance in the account as a debit balance with other banks and hence recorded as the bank’s assets on the balance sheet.

Nostro accounts are usually held by banks and large corporations that are involved in international trade. By holding funds in another bank in a foreign currency, the bank can conduct international trade transactions and foreign exchange without having to convert its local currency into foreign currency. Nostro accounts work by allowing one party to hold money in a bank in a foreign country in that country’s currency. When transactions are conducted through a nostro account, the bank that holds the account aids in completing transactions involving different currencies.

VOSTRO

A Vostro account is an account maintained by a foreign bank with the home currency of that bank. In the Vostro account, the foreign bank acts as the facilitator. Hence SBI’s opening   Vostro account with Bank of America, makes Bank of America facilitator. Vostro means yours. A Vostro account with a credit balance is considered a liability, and a vostro with a debit balance (a loan) is an asset. Another example of such an account is SBI holding a vostro account in HSBC. Several banks, including HDFC Bank and UCO Bank, have opened as many as 30 special vostro accounts to facilitate overseas trade in the rupee. Sberbank and VTB Bank — the largest and second-largest banks of Russia, respectively are the first foreign lenders to receive the approval from RBI. The move to open the special vostro account clears the deck for settlement of payments in rupee for trade between India and Russia, enabling cross-border trade in the Indian currency, which the RBI is keen to promote. RBI announced the guidelines on overseas trade in the rupee in July 2022.

The Government of India has allowed 20 Russian banks, including Rosbank, Tinkoff Bank, Centro Credit Bank and Credit Bank of Moscow have opened Special Rupee Vostro Accounts (SRVA) with partner banks in India. All major domestic banks have listed their nodal officers to sort out issues faced by exporters under the arrangement.

Additionally, it is anticipated to facilitate trade with Russia and other nations subject to sanctions. The RBI’s finalized mechanism allows authorized dealer banks in India to open special rupee vostro accounts on behalf of partner banks. The authorized dealer bank will then need to present the specifics of the arrangement to the central bank for approval.

Domestic banks use Vostro account to provide international banking services to their clients who have global banking needs. Vostro is an integral offshoot of correspondent banking that entails a bank or an intermediary to facilitate wire transfer, conduct business transactions, accept deposits and gather documents on behalf of the other bank. It helps domestic banks gain wider access to foreign financial markets and serve international clients without having to be physically present abroad.

The SRVA is an additional arrangement to the existing system that uses freely convertible currencies and works as a complimentary system. For perspective, freely convertible currencies refer to currencies permitted by rules and regulations of the concerned country to be converted to major reserve currencies like U.S. dollar or pound sterling and for which a fairly active market exists for dealings against major currencies. The existing systems thus require maintaining balances and position in such currencies.

Functioning of SRVA

The framework involves three important components: invoicing, exchange rate and settlement.

The framework entails three important components – invoicing, exchange rate and settlement.

1. Invoicing entails that all exports and imports must be denominated and invoiced in INR.
2. The exchange rate between the currencies of the trading partner countries would be market-determined.
3. The final settlement also takes place in Indian National Rupee (INR).

How much money do you think is in nostro vostro accounts worldwide?

There are $27 trillion dollars resting in nostro and vostro accounts to fulfill payments. Let that sink in for a moment, there is $27 trillion of “dead capital” laying idle for days on end in these accounts.

Foreign exchange is the trading of different national currencies or units of account. It is important because the exchange rate, the price of one currency in terms of another, helps to determine a nation’s economic health and hence the well-being of all the people residing in it.

Currency fluctuations create uncertainty and can quickly turn a solid profit into losses. That is why we need a currency strategy.

There are more than 100 different kinds of official currencies in the world. However, most international forex trades and payments are made using the U.S. dollar, British pound, Japanese yen, and the euro. Other popular currency trading instruments include the Australian dollar, Swiss franc, Canadian dollar, and New Zealand dollar.

The Bretton Woods Agreement

The purpose of the Bretton Woods meeting was to set up a new system of rules, regulations, and procedures for the major economies of the world to ensure their economic stability. To do this, Bretton Woods established the International Monetary Fund (IMF) and the World Bank.

The Bretton Woods agreement was created in a 1944 conference of all of the World War II allied nations. It took place in Bretton Woods, New Hampshire. Under the agreement, countries promised that their central banks would maintain fixed exchange rates between their currencies and the dollar.

The Bretton Woods Agreement and System created a collective international currency exchange regime that lasted from the mid-1940s to the early 1970s. The Bretton Woods System required a currency peg to the U.S. dollar which was in turn pegged to the price of gold.

As a result of the Bretton Woods Agreement, the U.S dollar was officially crowned the world’s reserve currency, backed by the world’s largest gold reserves. … Needing a place to store their dollars, countries began buying U.S. Treasury securities, which they considered to be a safe store of money.

Why did the Bretton Woods system collapse?

The US decision to suspend gold convertibility ended a key aspect of the Bretton Woods system. The remaining part of the System, the adjustable peg disappeared by March 1973. A key reason for Bretton Woods’ collapse was the inflationary monetary policy that was inappropriate for the key currency country of the system

The present values of the foreign currencies (last week): 

• U.S Dollars: 73.79 Indian Rupees
• British Pounds: 93.77 Indian Rupees
• Japanese Yen: 0.70 Indian Rupees
• Euro: 86.02 Indian Rupees
• Australian Dollar: 51.98 Indian Rupees
• Swiss Franc: 80.00 Indian Rupees
• Canadian Dollar: 55.11
• New Zealand Dollar: 48.24 Rupees
• Chinese Yuan: 10.84 Rupees
• United Arab Emirates Dirham: 20.13 Rupees
• Pound Sterling: 93.90 Rupees

Investment Managers and Hedge Funds

Portfolio managers, pooled funds and hedge funds make up the second-biggest collection of players in the forex market next to banks and central banks. Investment managers trade currencies for large accounts such as pension funds, foundations, and endowments. An investment manager with an international portfolio will have to purchase and sell currencies to trade foreign securities. Investment managers may also make speculative forex trades, while some hedge funds execute speculative currency trades as part of their investment strategies.

Multinational Corporations

Firms engaged in importing and exporting conduct forex transactions to pay for goods and services. Consider the example: Thermax Ltd is India’s leading solar energy companies; Thermax buys German solar panel from a German company which imports American components. Thermax sells the solar energy plant to a Chinese company. Thermax receives Chinese yuan which they must covert in Euro to pay the German manufacturer and the German manufacturer must then exchange euros for dollars to pay the American components company. The fact is that firms trade forex to hedge the risk associated with foreign currency translations. The same German firm might purchase American dollars in the spot market, or enter into a currency swap agreement to obtain dollars in advance of purchasing components from the American company in order to reduce foreign currency exposure risk.

Big Indian organizations such as Tata Motors, Dr Reddy’s, Infosys, ICICI Bank, HDFC Bank, MakeMyTrip etc are listed on New York Stock Exchange (NYSE). Indian companies can raise foreign currency funds through the issue of American Depository Receipts (ADRs) and Global Depository Receipts (GDRs).

These ADRs and GDRs help companies to tap foreign funds and increase their shareholding base which leads to better share valuation and also creates value for shareholders.

However, most companies go for the GDR route since the accounting norms and other disclosures in case of GDR are less stringent than the requirements in the U.S.

Let’s understand them one by one.

American Depository Receipts

American Depository Receipts (ADRs) are a way of trading non-U.S. stocks on the U.S. exchange. Through ADRs, Indian companies who are willing to raise funds from the U.S. can do so by issuing shares on American Stock exchange.

However, the issuance of ADR is governed by the rules and regulations as laid down by the regulator SEC (Securities and Exchange Commission). The Indian Companies will have to maintain accounts as per the American Standards.

The Indian companies cannot directly list their equity shares on the international stock exchange. So in order to overcome this problem; the companies give shares to an American bank. These American banks in return for those shares provide receipts to the Indian companies.  The companies raise funds by providing those ADR receipts in American share market.

How are ADRs created?

Indian companies cannot directly list their equity shares on the international stock exchange. In order to overcome this problem the corporation gives shares to an American Bank. These banks will take hold of the stock, and issue receipts to Indian companies in return. The companies raise funds by providing those ADR receipts in American share market. These ADRs are listed on the major stock exchanges of the US, like NASDAQ. They can also be sold Over-The-Counter (OTC).

Trading Mechanism of ADRs

One ADR comprises of a certain number of shares in an Indian company and these ADRs are quoted in US dollars. The investors of a foreign country can buy and sell shares directly and the investor is free to convert the ADR to receive the equivalent number of shares. For example, an American citizen willing to invest in Infosys limited in U.S. can do so by purchasing ADR from the listed entity. As an investor, they will receive all the dividends and capital gains in US dollars, no matter where the original company is from.

Trading Mechanism of GDRs

GDRs act as negotiable certificates. Therefore, they are usually traded just like shares of a company in any international market. A single GDR can represent different amounts of shares, as per the company’s needs and objectives. GDRs can also be used to raise capital from countries in the form of US Dollars or Euros. When GDRs are traded in Euros, they are known as European Depository Receipts or EDRs.

What are the Types of GDRs available to Investors?

There are two broad categories of GDRs –

1. Rule 144A GDRs:

These GDRs are those which operate through the rule 144A of the Securities Exchange Commission (SEC) of the US. This rule allows non-American companies to trade and raise capital in the American Markets. It also makes these GDRs a cheaper alternative to raise capital from American markets than Level III ADRs.

2. Regulation S GDRs:

These GDRs are those which help non-American companies raise funds and establish a trading presence in the European markets only. These GDRs usually trade on the London or Luxembourg Stock Exchange only, and are popularly known as REG S GDRs. Only non-American investors can trade in Reg S GDRs. A company can issue both REG S and Rule 144A GDRs, but they will be subject to different laws.

Differences between ADR and GDR:

• American Depository Receipt (ADR) is a depository receipt which is issued by a US depository bank against a certain number of shares of non-US company stock. Whereas Global Depository Receipt (GDR) is a depository receipt which is issued by the international depository bank, representing foreign company’s stock. ADR is issued in America while GDR can be issued in both America and Europe.
• ADR is listed in American Stock Exchange i.e. New York Stock Exchange (NYSE) whereas GDR is listed in non-US stock exchanges like London Stock Exchange or Luxembourg Stock Exchange.
• ADR can be traded in America only while GDR can be traded in all around the world. ADR Market is more liquid (cash) as compared to GDR market. Liquidity plays a crucial role in financial markets. The improvement and stability of market liquidity is important for market participants and serves as a way to enhance financial market credibility. In the absence of liquidity, financial markets cannot provide accurate price signals to investors and corporations, which are crucial for efficient risk sharing and accurate investment decisions. Without the availability of counter-offers, financial markets cease to exist, and they are replaced by individualized bilateral contracts. Thus, some liquidity is necessary for the very existence of a financial market.
• Investor’s participation is more in ADR as compared to GDR.
• ADR market is a retail investor market whereas GDR’s market is institutional one.
• ADR’s disclosure agreements are more tedious as compared to GDR.

Pros and Cons of ADRs and GDRs:

Depository receipts are a unique way of raising funds for companies and a unique investment for diversified portfolios. However, before we invest in them, we should consider the pros and cons of using ADRs and GDRs for both investors and the issuing companies.

Pros:

• They provide access to investments in the foreign markets, thus becoming a great way to diversify our portfolio.
• They are denominated in US Dollars and Euros, both of which are very powerful currencies to hold investments in.
• Since they are treated like shares, they can easily be traded in markets. They also offer all shareholder benefits to different investors.
• For companies, depository receipts are a great way to attract positive international attention and expand their base of shareholders as well.

Cons:

• Depository receipts are one of the most expensive ways to raise capital for companies.
• Since all transactions are happening in foreign currencies, the investments and capital are subject to the volatility of the foreign exchange or forex market.
• Depository receipts are only suitable for High Net Individuals as high amounts of capital are needed to trade in them.
• There are a limited number of companies which offer their shares in the form of depository receipts, thus leaving lesser choices for interested investors.
• So if you are planning to invest in a foreign company, you can do so through depository receipts.

Gold: It is considered the most important of all stocks even today; its store value keeps increasing. It is the most important components of the global economy since 1945. Most often gold’s value remains fairly constant and increases over time. It is therefore used as an ideal hedge against (boundary) inflation. Many investors have never seriously considered gold to be a long-term investment, but the topic of investing in gold did come to the forefront of during the 2008–2009 recessions. People invest in gold because despite high inflation, its value does not depreciate. Gold is also a safe asset. Remember this point always, that increasing gold prices are a traditional indicator of a recession or a downturn in an economy. People are very scared when it comes to the pricing of gold; they get worried that if price of gold falls, they might lose because the value of other investments may also go down in the future. Indians traditionally hold the yellow metal in very high esteem; they hoard lot of gold for the same reason. And, why not, gold saving has helped people to get their children married, their education, clearing healthcare bills etc.

US Dollar: The strongest currency in the world is this currency. The virtual strength of the U.S. economy supports the value of its currency. It is the reason the dollar is the most powerful currency. Around $580 billion in U.S. bills (bank notes) are used outside the country. That’s 65 percent of all dollars. That includes 75 percent of $100 bills, 55 percent of $50 bills, and 60 percent of $20 bills. Most of these bills are in the former Soviet Union countries and in Latin America. They are often used as hard currency in day-to-day transactions. More than one-third of the world’s GROSS DOMESTIC PRODUCT (GDP) comes from countries that peg (bringing up to scale) their currencies to the dollar. That includes countries that have adopted the U.S. dollar as their own; they are Ecuador, East Timor, El Salvador, Marshall Islands, Micronesia, Palau, Turks and Caicos, British Virgin Islands, Zimbabwe. Another 89 keep their currency in a tight trading range relative to the dollar. In the foreign exchange market the dollar rules. Ninety percent of forex trading involves the U.S. dollar. The dollar is just one of the world’s 185 currencies according to the International Standards Organization List. But most of these currencies are only used inside their own countries. Theoretically, any one of them could replace the dollar as the world’s currency. But they won’t because they aren’t as widely traded. The chart below shows the 10 most traded currencies in 2018.

1. US dollar (USD)
2. Euro (EUR)
3. Japanese yen (JPY)
4. Pound sterling (GBP)
5. Australian dollar (AUD)
6. Canadian dollar (CAD)
7. Swiss franc (CHF)
8. Chinese renminbi (CNH)
9. Swedish krona (SEK)
10. New Zealand dollar (NZD)

Most of the trade in oil is invoiced in US Dollar. Whenever India buys oil from Iran, natural gas from Russia and electronics from China, we do not pay them in Rial, Rouble or Yuan, we pay them in Dollars. Similarly, when India sells leather to Australia, they pay us in Dollars. Dollar Rupee exchange rate is thus very important for both imports and export health of a country. If it goes high, consumers suffer, it goes low exporters suffer.

Oil Prices:  Oil prices are higher because of high demand and low supply; it depends upon OPEC (Organization of the Petroleum Exporting Countries) quotas, or a drop in the dollar’s value. India is a heavy importer of oil and it is the most important energy resource. An increase in the global oil prices hurts the Rupee and the Indian economy. Demand for oil and gas follow a predictable seasonal swing. Demand rises in the spring and summer due to increased driving for summer vacations. Demand drops in the autumn and winter. Low supply occurs when war or natural disaster curtail exports from oil-producing countries. Traders often bid up prices when they hear of impending disasters or the threat of war. Oil prices decline once production resumes. When commodities future traders anticipate increased demand, they usually start bidding oil prices higher in January or February. Around 70 percent of gas prices are based on oil prices. U.S plays a major role in fixing oil prices.

Stocks (Share market): Though it is called stock market or equity market and is primarily known for trading shares/equities, other financial securities – like exchange traded funds (ETF), corporate bonds and derivatives based on stocks, commodities, currencies and bonds which are also traded on the stock markets. When the economy is doing well or is expected to do well, the share prices of stocks in that country rise, and when the economy is doing badly, their value drops. India’s individual stock ownership rate is quite low; this adds an extra layer of risk to the Indian stock markets that are affected by global shocks. An important aspect to note is that stock markets are determined by the other three factors noted above: gold, dollar and oil prices. India is an odd economy. It’s highly included with the global economy but does not have enough leverage to affect it in any way. It is hence vulnerable to external shocks a lot, things that the government cannot control.

Connection between Gold, Oil Prices, Dollar and Stock Market: Now coming to the original question, what is the relationship between these four assets? They react to each other in a variety of ways. If the future expectations of the global economy are bad, people run to the safety of the US Dollar and Gold and sell stocks. The price of gold rises, the value of dollar rises against the Rupee. FII’s (foreign institutional investors) and FDI’s pull money out of the Indian stock market causing it to decline. When the price of dollar rises, oil prices increase for India. This puts strain on the economy as inflation increases. Because of high inflation people invest more in gold and less in stocks causing the stock markets to fall. When the price of oil decreases, energy costs reduce. This will reduce the costs of energy, we will spend less Dollars buying oil and the Rupee strengthens. When the price of dollar goes down, price of oil goes down reducing energy company shares costs.

There are many other permutations and combinations to note. Gold and oil are positively related. A rise in oil prices is an indication of bad times and gold prices rise correspondingly. Gold and stocks are negatively correlated. If stocks go up, gold goes down and vice versa. These effects are collective. If we break down the stock market into individual stocks, they react differently to change in oil and gold prices. An increase in oil prices causes the energy stocks to rise because of higher expected profits, an increase in gold prices will cause Gold ETF’s and banking stocks to rise but other stocks might fall or remain stable. An increase in the value of the dollar causes IT stocks to rise because their revenue comes in Dollars but cause energy stocks to fall.

It is of no use to study the price of these assets in isolation as they heavily depend on the prevailing macroeconomic conditions. For example, when the business cycle is positive i.e. the GDP is rising, stocks rise, but, gold falls. If inflation is rising along with GDP, then both gold and stocks rise, stocks rise on FDI infusion and gold rises because of inflation. Add an external change in oil and this relationship becomes even complex. Add U.S Dollar and we have got ourselves in a commotion. In conclusion, no one can say for certainty how one or the other price might react to a change in the other. Modern financial markets function on volatile conditions. Because of this very uncertainty, they trade based on expectations of how prices might react.