For most retail traders, understanding the structure of the Forex market is something that is often overlooked. This is a critical element that needs to be considered when designing and implementing any trading plan. The forex market differs from other global markets due to the way it is structured. The main factors affecting the structure of the Forex market are the ways Forex products are traded, the participants and their motivation, regulation and the sheer size of the market. Since transactions in the Forex market are done over-the-counter (OTC) and not through a central exchange like futures or shares, prices changes differently. Understanding these differences is essential to your development as a forex trader and will only serve to help you in the future.
Over The Counter
The first thing to understand about the structure of the forex market is the way in which products are traded. Forex is for the most part, an over the counter (OTC) market. This means that there is no central exchange through which instruments are traded. When we refer to instruments, we are referring to the different forex products participants use to conduct transactions, whether they are corporate, speculative or hedging. These products include: Spot forex, outright forwards, forex swaps, forex options. When a product is traded OTC, it is done so through a market maker. A market maker in forex is usually a bank or broker that facilitates currency trades by providing buy and sell quotes and then taking orders. Orders can be hedged or passed on so there is no exposure/risk, matched within the internal order book or held by the market maker, meaning they take the other side of the order and take a position against the client.
Other commonly traded instruments such as shares and futures are exchange traded products, this means that any transaction involving these instruments is done through an exchange such as the New York Stock Exchange (NYSE) and London Stock Exchange (LSE). The points below highlight some features of OTC and exchange traded markets.
- Market Made
- Trading firm is the counterparty
- Heavy price competition
- Price and execution quality varies
- Exchange is counterparty to all trades
- Less price competition
- Standardised price and execution
- Regulatory oversight from exchange
Let’s have a deeper insight on the definition of OTC, in the context of the Forex market. Since there is no central exchange through which is to process orders and transactions, a unique network has been established in order to allow participants to communicate and transact. This network has different levels, each with its own institutions serving different functions within the forex market.
The interbank market is essentially a network between larger banks. This network is made possible through EBS (electronic broking services) and Reuters spot matching systems. These two applications effectively aggregate the order books of the banks, showing the various bids, offers and amounts that each is willing to transact at. This allows proper market function to occur by providing sufficient liquidity and efficient processing. The interbank market is only accessible by larger banks with the highest credit standings. This is to eliminate any counterparty risk and reduce competition. By restricting access to the interbank market, the big banks continues maintaining their share of forex turnover and thus gaining profits.
At the top of the food chain we have the foreign exchange dealers. These are the dealer banks which conduct foreign exchange business for their clients or themselves. The major banks include; Deutsche Bank, UBS, Citigroup, Barclays Capital, RBS, Goldman Sachs, HSBC, Bank of America, JP Morgan, Credit Suisse and Morgan Stanley. These banks handle approximately 2/3 of the daily forex volume and along with others form what is known as the interbank market. These banks deal with each other on behalf of clients or for themselves, providing much needed liquidity to the market so large transactions whether corporate or speculative can be facilitated and proper market function can occur. The dealer banks that form the interbank market are effectively the market makers of the forex market, they set the prices and manage the volume for the rest of the market to feed off.
On the next level of the forex market we have the market that exists for financial and non-financial participants. This may include smaller banks, businesses, hedge/mutual/pension funds, CTAs and large investors. Traditionally the majority of foreign exchange turnover has been the result of international trade flows. This trend has changed in recent years with the majority of turnover from capital flows, speculative and hedging activities. This shift reflects the increasing recognition of foreign exchange as a means of generating returns by all market participants, and the need to manage foreign exchange risks through hedging activities.
On the next level, we have forex brokers and retail ECNs (electronic communications network). Traditionally forex brokers were the intermediary party between buyers and sellers where they facilitated the transaction between the end user and their liquidity provider (market maker bank). It is still the case today but some brokers will also run a book and trade against their clients. Brokers and ECNs will usually have an agreement with one or more liquidity providers, through which they can hedge positions on their book and manage any exposure they might have. A liquidity provider could be any one of the above mentioned prominent banks, or even another retail broker, depending on their needs.
Behind the scene of all these, we also have the central bank.The central banks follow their respective currency, making sure it’s price movements aren not erratic and promoting stability. They are participants in the market to diversify their currency reserves, influencing the value of their exchange rate (less common nowadays) and make international payments on behalf of the government. To do all this, the central bank has its own dealers who use a number of larger banks to help facilitate these flows of funds. Central bank involvement used to be far more common and had a greater effect than it has nowadays. Rather than actively participating in the market buying and selling their currency, central banks use verbal intervention instead to affect the value of their currency.