However, for many of the countries, there continues to exist a separate official rate linked to, but different from, the market rate. In addition, inadequate information flows in the market tend to lead to wide variations in rates, especially among bureaus. This informational problem reduces efficiency and competitiveness in the market and allows for the possibility of collusive practices by the larger dealers in the market. This is despite the fact that all countries require dealers to openly display current rates, or at least indicative rates, in their place of business and to report transactions data to the Central Bank on a daily basis.

The extent to which the central bank imposes restrictions on the determination of the market rate differs from country to country. A similar situation exists in Sierra Leone, The Gambia, and Kenya, where the exchange rate is determined freely in the foreign exchange market, as a weighted average of rates posted.

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The Bank of Ghana uses moral suasion to hold the exchange rate down in the interbank market, which usually leads to a shortage of foreign exchange in the interbank market. Commercial banks must therefore ration the foreign exchange provided to importers or force them to queue for it. In The Gambia, commercial bank transactions with the Central Bank are included in the determination of the interbank rate. This is also true for Kenya, Ghana, and Sierra Leone, although in Mozambique, transactions with the Central Bank are excluded from the calculation of the market or secondary rate.

In Nigeria, rates in the interbank market are subject to a 1 percent spread between the buying and selling rates. Since the bulk of the transactions involve purchases from the Central Bank of Nigeria, the selling rate in the interbank market for most transactions is closely linked to either the central bank auction rate or, otherwise, the rate fixed by the Central Bank for its quantity allocation mechanism.

Besides transactions with the central bank, other transactions, for example, those involving the execution of letters of credit, may not be included in the calculation of the foreign exchange market rate. In The Gambia, only actual spot transactions go into calculating the market exchange rate.

In other countries, for example, Mozambique, attempts are being made to include purchases of foreign exchange associated with the opening of letters of credit in the calculation of the average exchange rate in the interbank market. In Nigeria and Sierra Leone, the applicable exchange rate for transactions executed on letters of credit terms, is the prevailing rate at which the importer purchases the foreign exchange.

In all the countries surveyed, the official rate is closely related to, or is the same as, the market-determined rate. In The Gambia, the rate for official transactions external debt servicing and other official government transactions determined weekly at the fixing session has generally been close to the prevailing market rates. In Nigeria, a close link exists between the Central Bank of Nigeria auction rate and the prevailing market rates, given that the bulk of the foreign exchange in the interbank market is derived from the auction. Mozambique sets its official rate within a 2 percent band of the market or secondary rate of the previous day.

The official rate in Sierra Leone is determined weekly, based on a weighted average of all the transaction rates of both the commercial banks and bureaus, with a 2 percent spread between the buying and selling rates. In Kenya, the official rate is based on a weighted average of the buying and selling rates between commercial banks and their clients, which would also be in line with the rates in the auction market. In Ghana, the official rate is based on the average of the market-determined rates in the last five days. The concept of forward markets to cover exchange risks is practically nonexistent in the countries surveyed, with the exception of Nigeria and, to some extent, Kenya.

In early , forward transactions in foreign exchange were introduced in Nigeria. However, data on the value and exchange rates associated with these transactions are not widely available. In Kenya, the Central Bank sells foreign exchange forward for the purchase of petroleum. Forward transactions in the rest of the market are fairly restrictive and are related to interest rate differentials.

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As a general rule, the ability of a central bank to regulate and participate in the domestic interbank foreign exchange market is linked closely to i its capacity to know what is happening in the market in real time, and ii its weight in the market as a buyer or seller of foreign exchange. Additional factors are the degree of development of its capacity to conduct foreign exchange operations domestically as well as the extensiveness of its operations in international foreign exchange markets.

Central banks that have a presence in international markets by actively managing their international reserve position tend to have their foreign exchange departments better organized, with separate sections for dealing, research, control and payments, in order to ensure effective checks and balances. For example, the foreign exchange dealing unit would be responsible for intervening in the domestic market and for filling orders on behalf of the government.

Similarly, the research section would typically establish the rules that dealers must follow in their trading, as well as conduct research to determine exposure limits of banks and other authorized dealers. The control section would ensure that rules and procedures are followed and that reconciliations are made of transactions completed. The payments unit would normally be responsible for the execution of payments, the formulation of authorization procedures, and the maintenance of the SWIFT system Society for Worldwide Interbank Financial Telecommunication. This organizational structure is also helpful to ensure that foreign exchange transactions in the domestic market are undertaken efficiently and safely.

Some countries -- for example, Sierra Leone, Mozambique, Ghana, and Nigeria -- have organized their foreign exchange operations broadly along these lines. A major constraint, however, continues to be the absence of an electronic exchange to carry out transactions and receive quotes instantaneously. In general, central banks in the countries concerned rely primarily on frequent calls to commercial banks on an informal basis for the quotation of rates.

Two issues regarding official involvement of a central bank in interbank foreign exchange markets are of interest to market participants: i whether the central bank, through its foreign exchange operations, intervenes in a manner that may have an influence on the market rate. The degree and nature of central bank intervention in influencing the interbank rate varies from country to country. In the case of Mozambique, discretionary open market operations as an intervention instrument are not used by the Bank of Mozambique, given its lack of reserves, but the Bank does make regular sales of foreign exchange to the market.

These sales do not influence the market directly, since it sells at the prevailing market rate of the previous day. However, the amount it sells indirectly influences market developments and expectations and affects the exchange rate in subsequent days. The central banks of The Gambia and Sierra Leone do not intervene in the interbank market with a view to influencing the movements in the exchange rate.

For the most part, these purchases have not had an undue effect on the exchange rate. The Central Bank of Ghana has tended to be a net seller of foreign exchange in the interbank market, basing its decision on targets for reserve accumulation and the perceived need for foreign exchange among the commercial banks. This has led to a more appreciated exchange rate than that which would clear the interbank market, as the degree of need of each bank is assessed by the size of its customer base and the length of its queue, rather than the price that such banks are willing to pay for foreign exchange.

In Nigeria, the Central Bank reserves the right to intervene to affect the exchange rate through the buying and selling of foreign exchange. The result is that the Central Bank is effectively able to fix the rate at which these funds are allocated. In Kenya, intervention in the market is achieved mainly through regular sales and purchases of foreign exchange in the market by open auctions.

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To ensure the orderly and efficient operation of interbank markets, central banks normally issue foreign exchange regulations. Some are of a prudential nature, while others are motivated by concerns regarding exchange control and the need to ensure adequate competition in the market. Typically, regulations address the allowable open positions of dealers in order to reduce individual exposure and exchange risk, and establish working balance limits to prevent a cornering of the market by any subset of dealers. Most countries in the survey have yet to develop a comprehensive set of prudential guidelines.

For example, the Bank of Mozambique has limits on the working balances and foreign exchange exposure of nonbank dealers, requiring them to sell excess foreign exchange holdings to banks, but is still in the process of developing prudential regulations for banks. There are no regulations governing open positions and working balance limits for dealers in Sierra Leone. The Central Bank will, however, allow commercial banks to build up an inventory in excess of the open position limit to meet the foreign exchange needs of clients with proof of letters of credit and other documentation of foreign exchange needs.

It should be pointed out, however, that the tight exposure limit does provide an incentive for interdealer trading, as overexposed banks have an option to sell to other dealers rather than to the Central Bank. In all of the cases under consideration, working balance limits tend not to be very binding, given the excess demand for foreign exchange in the interbank markets in these countries.

For many developing countries, external financing of the balance of payments has become an important source of foreign exchange receipts. At issue is the question of the treatment of external aid funds in relation to the interbank market. Several important questions arise.

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Specifically, what modalities are used to channel these funds into the interbank market? At what exchange rate are these funds transacted? Will transactions involving external aid funds affect the equilibrium interbank exchange rate? Does the practice of tying aid to imports from the donor add additional complications?

In Mozambique, all external aid funds are channeled into the interbank market at a single rate. Certain restrictions apply to the use of aid funds.

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No donor funds tied or untied can be used for imports included on the negative list. To gain access to the use of tied aid, firms have to submit applications to the Office for the Coordination of Import Programs of the Ministry of Commerce GCPI , which confirms that the applications meet the requirements of the funds in question. The Bank of Mozambique allocates the tied funds to the commercial banks.

Firms do not need to make any advance payments in local currency, except for the normal security margins applied by commercial banks when opening letters of credit. In Ghana, receipts from aid funds are sold in the interbank market by the Bank of Ghana at existing market rates.

Aid funds can be freely used as long as donors are provided with letters of credit and other documentation exceeding the value of the funds. Aid funds constitute at least 30 percent of the foreign exchange in the interbank market. In The Gambia, there are no restrictions as such on the use of aid funds in the interbank market. Donors may require customs documentation indicating importation of goods equivalent to the amount of the aid funds and other conditions such as place of origin and procurement procedures.

Transactions involving aid funds are typically carried out through the opening of letters of credit; those transactions associated with letters of credit are excluded from the calculation of the market rate.

All aid fund transactions are carried out at the prevailing market rates. In Nigeria, aid funds are not channeled directly into the interbank market. However, they constitute part of the source of foreign exchange of the Central Bank of Nigeria which participates in the interbank market. A successful interbank foreign exchange market is likely to reflect both the degree to which many of the critical issues and problems discussed above have been resolved as well as the successful implementation of sound monetary, fiscal, trade, and exchange policies.

For the countries surveyed, the introduction of a floating exchange arrangement was sparked by a high degree of market segmentation and different exchange rates in the exchange market and an increasing diversion of foreign exchange resources into the parallel market.