The ultimate inside traders.

Central banks are often called in to bolster a faltering currency, but they can be governmental profit centers as well.

Central banks, ponderous creatures bulging in foreign currencies, play a dual role on the $880 billion-a-day foreign exchange markets. They plow billions of dollars into

Currency traders are somewhat in awe of central banks, which can make or break markets. It pays to know what these mammoths do on forex markets and why.

Information is power

The key: Central banks are well-informed. They keep in touch with a worldwide network of banks and brokerage houses, gathering information about market sentiment and compiling economic statistics.

They also can capitalize on interventions. A recent Canadian study shows the Bank of Canada booked $349 million in trading profits on $160 billion worth of interventions from 1975 through 1988.

"When currencies float, there's an awful lot of evidence that suggests central banks earn profits from trading foreign exchange," says Robert Aliber, professor of international economics and finance at the University of Chicago. "But within the (Exchange Rate Mechanism), when they try to prevent a change that would otherwise be inevitable, they lose money."

Central banks usually want the market to know when they are intervening. "They may, in the first wave of intervention, call up 10 to 20 banks and do $10 million a piece to get widespread dissemination of information that (they) are in the market," says Mark M. Cohen, managing director of C Wave Capital Management Corp., a Fort Lee, N.J., trading advisor.

When market sentiment is against them, central banks play a more subtle game. "They take one or two counterparties and intervene relatively heavily through them to make the flows in the market appear more natural," Cohen says. In those cases they insist on anonymity.

"If it's sizable, (the Banque de France) comes through the back door, meaning they use Credit Lyonnais or Societe Generale," says Mark G. Nichols, manager at Groupe Banque Worms in Paris.

But the market is quick to detect a discreet intervention, if only because the amounts are large and the central banks use the same intermediaries.

Banks and brokerage houses are happy to accommodate central banks because they are valued customers. "It's one thing to see (an intervention) on Reuters or hear it through the grapevine, than actually be at the other side and know with real certainly that it's not just some trader talking his position," says Steve Geovanis, managing director, foreign currency desk at Merrill Lynch in New York.

Central banks seeking an immediate effect intervene on their domestic cash markets.

"When we intervene, it's mostly on spot markets," says Peter Fischer-Erlach, head of the Bundesbank's foreign exchange and investment desk. "Ninety or 95% of our interventions are grounded in Germany."

Sometimes the Bundesbank intervenes through outright forward deals.

"This signals to the market: It's a long-term intervention. They mean business," says Peter Gloyne, foreign exchange manager at First Chicago.

Adds Ezra Zask, president of Ezra Zask Associates, a Falls Village, N.J., trading advisor: "By providing high rates in the forward market, they give speculators incentives to either take profits on their short positions, or to buy the currency and establish long positions. It removes some daily speculators from the market."

Position of advantage

By putting feelers in the market every day, central banks are in a unique position to predict the effect of interventions or interest rate cuts, conceivably, using such knowledge to their advantage.

"It's absolutely unthinkable that the Bundesbank would do something like that," Fischer-Erlach says. "I've been here since the '60s and all that time the Bundesbank has not taken a single position in any currency (before an intervention or interest rate policy announcement)."

Central banks may balk at speculation and insider trading, but they like to see their foreign reserves yield a healthy profit. "What we're trying to do is maximize returns, within the rather risk-averse disciplines that are placed upon us," says a Bank of England spokesman.

Central banks hold set amounts of currencies and invest in government bonds and first class commercial assets. They are foremost concerned with liquidity, needed for interventions. The Bank of Canada, for example, has specific maturity limits for securities it holds. When the reserves rise, the bank moves its duration targets upwards.

"All the central banks play the yield curve and the interest game to try to improve returns," Zask says, adding they are still hesitant to use derivatives. "They just don't do anything until it's been really tested and also they need political approval," he says. "Imagine how embarrassing it is when an instrument backfires."

Currency traders say central banks are slowly discovering the derivatives game. The Bank of Spain is rumored to have used over-the-counter options as a way of propping up the peseta, and the smaller European banks are said to use derivatives to hedge their reserves.

The Bundesbank, however, is of the old school. "Investments abroad ... are practically not changed; we take a very long-term view," Fischer-Erlach says. The bank still keeps its reserves in U.S. dollars and "has not used derivatives in a single transaction," Fischer-Erlach says.

Aggressive traders?

Because of their portfolios' sheer size, central banks are continuously in the markets. Are they aggressive traders? Says Ron Levin, currency strategist at J.P. Morgan in New York: "Although some of the (Organization for Economic Cooperation and Development) central banks have a little more trading mentality than others, none of them can be characterized as aggressively managing their portfolio."

Other factors come into play, too.

Carl B. Weinberg, chief economist at High Frequency Economics, says: "Central banks have no mandate to make money that way and if they do, it's just by chance."

Central banks also suffer certain diplomatic restrictions. "It would not be good neighborly behavior for one central bank to speculate on the currency of another central bank," the Bank of England spokesman says.

Besides being small, central bank trading desks generally do not recruit experienced dealers but breed their own, picking from a stock of economists and mathematicians.

"In part (that is) because of the salary issue," says UC's Aliber. "Any skilled trader is going to earn 10 times as much outside the central bank."

Central bank dealers generally spend three years at the desk, then move up within the bank or jump over to the trading world. For example, one or two (out of 15) a year leave the Bank of England.

Bank rollers

In a sort of perverted twist on central bank authority, some smaller players developed a taste for action that ended badly. In the late 1980s, Bank Negara, the Malaysian central bank, enjoyed a larger-than-life reputation as an aggressive speculator and inspired awe among currency traders.

"They almost became the Soros of the day," says Mark Cohen of C Wave. "When Soros is buying, you buy."

But some currency traders dismiss allegations that Negara was a profit-driven hedge fund as a popular forex myth.

"They just have a lot of currencies to hedge and they're doing it aggressively," says David DeRosa, a Swiss Bank Corp. currency trader.

Negara's fortunes changed in 1992. The bank's contingency reserve fund plummeted by $3.72 billion, a 90% plunge. Fighting inflation and revaluating holdings caused "book losses," according to a bank statement.

But currency traders suspect wrong bets on forex markets caused at least part of the loss. It seems Negara has become more careful recently.

"Negara's profile has dropped dramatically since their reserve losses," says Steve Geovanis of Merrill Lynch.

In another bad call, Mongolia's central bank squandered about $80 million on foreign currency speculating in 1990-1991, virtually wiping out this formerly Communist country's reserves. Mongolia, clasped between Russia and China, has an estimated gross domestic product of less than $100 per head.

The dealers, some still in their teens at the time, held $1 billion positions and kept abreast of the market by using a single telex machine and making operator-assisted phone calls, according to a Reuters report. The former central bank governor, one of the chief dealers at the time, is on trial now.

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