From money exchangers, to banks, to hedge fund managers, to local Joes like your Uncle Pete – everybody participates in the forex market!
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.
“So many choices! Awesome!”This might be overwhelming at first, but this is what makes the forex market so freakin’ awesome!
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. It’s just like trading baseball cards. You want that mint condition Mickey Mantle rookie card, so it is up to you to find the best deal out there.
Your colleague might give up his Mickey Mantle card for just a Babe Ruth card, but your best friend will only part with his Mickey Mantle rookie card for your soul.
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 plaform, 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 CREDIT relationship 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 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:
- Market makers, as their name suggests, “make” or set their own bid and ask prices themselves and
- Electronic Communications Networks (ECN), who use the best bid and ask prices available to them from different institutions on the interbank market.
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.
Of course, it’s not enough to know the big guys in the biz. As Big Pippin once said, “Trading requires timing.” Do you know WHEN you should trade?