Forex Market Structure
For the sake of comparison, let us first examine a market that most
folks are probably very familiar with: the stock market.
This is how the structure of the stock market looks like:
By its very nature, the stock market tends to be very monopolistic.
There is only one entity, one specialist that controls prices.
All trades must go through this specialist. Because of this, prices
can easily be altered to benefit the specialist and not traders.
How does this happen?
In the stock market, the specialist is forced to fulfill the order of its
clients. Now, let’s say the number of sellers suddenly exceed the
number of buyers.
The specialist, which is forced to fulfill the order of its clients, the
sellers in this case, is left with a bunch of stock that he cannot
sell-off to the buyer side.
In order to prevent this from happening, the specialist will simply
widen the spread or increase the transaction cost to prevent sellers
from entering the market.
In other words, the specialists can manipulate the quotes it is
offering to accommodate its needs.
Trading Spot FX is Decentralized
Unlike in trading stocks or futures, you don’t need to go through a
centralized exchange like the New York Stock Exchange with just
one price. In the forex market, there is no single price that for a
given currency at any time, which means quotes from different
currency dealers vary.
The market is so huge and the competition between dealers is so
fierce that you get the best deal almost every single time. And tell
me, who does not want that?
Also, one cool thing about forex trading is that you can do it
anywhere.
The FX Ladder
Even though the forex market is decentralized, it isn’t pure and utter
chaos!
The participants in the FX market can be organized into a ladder.
To better understand what we mean, here is a neat illustration:
At the very top of the forex market ladder is the interbank market.
Composed of the largest banks in the world and some smaller
banks, the participants of this market trade directly with each other
or electronically through the Electronic Brokering Services(EBS)
or the Reuters Dealing.
The competition between the two companies – the EBS and the
Reuters Dealing – is similar to Coke and Pepsi.
They are in constant battle for clients and continually try to one-up
each other for market share. While both companies offer most
currency pairs, some currency pairs are more liquid on one than the
other.
For the EBS platform, EUR/USD, USD/JPY, EUR/JPY, EUR/CHF,
and USD/CHF are more liquid. Meanwhile, for the Reuters platform,
GBP/USD, EUR/GBP, USD/CAD, AUD/USD, and NZD/USD are
more liquid.
All the banks that are part of the interbank market can see the rates
that each other is offering, but this doesn’t necessarily mean that
anyone can make deals at those prices.
Like in real life, the rates will be largely dependent on the
established CREDITrelationship between the trading parties. Just to
name a few, there’s the “B.F.F. rate,” the “customer rate,” and the
“ex-wife-you-took-everything rate.”
It’s like asking for a loan at your local bank. The better your credit
standing and reputation with them, the better the interest rates and
the larger loan you can avail.
Next on the ladder are the hedge funds, corporations, retail market
makers, and retail ECNs. Since these institutions do not have tight
credit relationships with the participants of the interbank market,
they have to do their transactions via commercial banks. This
means that their rates are slightly higher and more expensive than
those who are part of the interbank market.
At the very bottom of the ladder are the retail traders. It used to be
very hard for us little people to engage in the forex market but,
thanks to the advent of the internet, electronic trading, and retail
brokers, the difficult barriers to entry in forex trading have all been
taken down. This gave us the chance to play with those high up the
ladder and poke them with a very long and cheap stick.
Forex Market Players
Now that you know the overall structure of the forex market, let’s
delve in a little deeper to find out who exactly these people in the
ladder are.
It is essential for you that you understand the nature of the spot
forex market and who are the main forex market players.
Until the late 1990s, only the “big guys” could play this game. The
initial requirement was that you could trade only if you had about
ten to fifty million bucks to start with. Chump change right?
Forex was originally intended to be used by bankers and large
institutions, and not by us “little guys.”
However, because of the rise of the internet, online forex brokers
are now able to offer trading accounts to “retail” traders like us.
Without further ado, here are the major forex market players:
1. The Super Banks
Since the forex spot market is decentralized, it is the largest banks
in the world that determine the exchange rates.
Based on the supply and demand for currencies, they are generally
the ones that make the bid/ask spread that we all love (or hate, for
that matter).
These large banks, collectively known as the interbank market, take
on a ridonkulous amount of forex transactions each day for both
their customers and themselves.
A couple of these super banks include Citi, JPMorgan, UBS,
Barclays, Deutsche Bank and HSBC. You could say that the
interbank market is THE foreign exchange market.
2. Large Commercial Companies
Companies take part in the foreign exchange market for the
purpose of doing business.
For instance, Apple must first exchange its U.S. dollars for the
Japanese yen when purchasing electronic parts from Japan for
their products. Since the volume they trade is much smaller than
those in the interbank market, this type of market player typically
deals with commercial banks for their transactions. Mergers and
acquisitions (M&A) between large companies can also create
currency exchange rate fluctuations.
In international cross-border M&As, a lot of currency conversations
happens that could move prices around.
3. Governments and Central Banks
Governments and central banks, such as the European Central
Bank, the Bank of England, and the Federal Reserve, are
regularly involved in the forex market too.
Just like companies, national governments participate in the forex
market for their operations, international trade payments, and
handling their foreign exchange reserves.
Meanwhile, central banks affect the forex market when they adjust
interest rates to control inflation. By doing this, they can affect
currency valuation.
There are also instances when central banks intervene, either
directly or verbally, in the forex market when they want to realign
exchange rates.
Sometimes, central banks think that their currency is priced too high
or too low, so they start massive sell/buy operations to alter
exchange rates.
4. The Speculators
“In it to win it!”
This is probably the mantra of the speculators. Comprising close to
90% of all trading volume, speculators as forex market players
come in all shapes and sizes.
Some have fat pockets, some roll thin, but all of them engage in the
forex simply to make bucket loads of cash.
Know Your Forex History!
At the end of the World War II, the whole world was experiencing so
much chaos that the major Western governments felt the need to
create a system to stabilize the global economy.
Known as the “Bretton Woods System,” the agreement set the
exchange rate of the US dollar against gold. Which allowed all other
currencies to be pegged against the US dollar.
This stabilized exchange rates for a while, but as the major
economies of the world started to change and grow at different
speeds, the rules of the system soon became obsolete and limiting.
Soon enough, come 1971, the Bretton Woods Agreement was
abolished and replaced by a different currency valuation system.
With the United States in the pilot’s seat, the currency market
evolved to a free-floating one, where exchange rates were
determined by supply and demand.
At first, it was difficult to determine fair exchange rates, but
advances in technology and communication eventually made things
easier.
Once the 1990s came along, thanks to computer nerds and the
booming growth of the internet (cheers to you Mr. Al Gore), banks
began creating their own trading platforms.
These platforms were designed to stream live quotes to their clients
so that they could instantly execute trades themselves.
Meanwhile, some smart business-minded marketing machines
introduced internet-based trading platforms for individual traders.
Known as “retail forex brokers”, these entities made it easy for
individuals to trade by allowing smaller trade sizes.
Unlike in the interbank market where the standard trade size is one
million units, retail brokers allowed individuals to trade as little as
1000 units!
Retail Forex Brokers
In the past, only the big speculators and highly capitalized
investment funds could trade currencies, but thanks to retail forex
brokers and the Internet, this isn’t the case anymore.
With hardly any barriers to entry, anybody could just contact a
broker, open up an account, deposit some money, and trade forex
from the comfort of their own home.
Brokers basically come in two forms:
1. Market makers, as their name suggests, “make” or set their
own bid and ask prices themselves and
2. Electronic Communications Networks (ECN), who use the
best bid and ask prices available to them from different
institutions on the interbank market.
Market Makers
Let’s say you wanted to go to France to eat some snails. In order
for you to transact in the country, you need to get your hands on
some euros first by going to a bank or the local foreign currency
exchange office. For them to take the opposite side of your
transaction, you have to agree to exchange your home currency for
euros at the price they set.
Like in all business transactions, there is a catch. In this case, it
comes in the form of the bid/ask spread. For instance, if the bank’s
buying price (bid) for EUR/USD is 1.2000, and their selling price
(ask) is 1.2002, then the bid/ask spread is 0.0002.
Although seemingly small, when you’re talking about millions of
these forex transactions every day, it does add up to create a hefty
profit for the market makers!
You could say that market makers are the fundamental building
blocks of the foreign exchange market.
Retail market makers basically provide liquidity by “repackaging”
large contract sizes from wholesalers into bite size pieces. Without
them, it will be very hard for the average Joe to trade forex.
Electronic Communications Network
Electronic Communication Network is the name given for trading
platforms that automatically match customer’s buy and sell orders
at stated prices. These stated prices are gathered from different
market makers, banks, and even other traders who use the ECN.
Whenever a certain sell or buy order is made, it is matched up to
the best bid/ask price out there.
Due to the ability of traders to set their own prices, ECN brokers
typically charge a VERY small commission for the trades you take.
The combination of tight spreads and small commission usually
make transaction costs cheaper on ECN brokers.
