Forex Market Structure and Players
Once you have an idea about the basics of Forex and its advantages, it’s time to know who are involved in this type of trading or in simple terms how is the forex market structured.
The term Forex market refers to the decentralized (meaning? there is no centralized place) market for trading currencies. Centralization as per word meaning means the degree to which decision making is concentrated at a single point. To understand it better have a look at the following diagrams:
If you consider the stock market, you already know that there is a centralized decision maker who decides the price and then buyers and sellers have to go through that centralized market or the exchange. All trades happen through this centralized marketplace which is normally the exchange in case of stocks or futures. Prices are control by this central market place which is the decision maker.
FX trading happens in a decentralized manner provided it’s a spot FX trade. Futures and Options on FX still have to go through an exchange as they are standardized. But as you know by now FX trades are mostly spot transactions and you don’t have to deal with a centralized exchange. With the advent in technology traders and dealers can create market place anywhere and connect with each other without the need for a centralized location. There are many currency dealers who quote different prices and hence you have lots of options too. Forex traders can look at the internet and see price quotes from various dealers from around the world. Wow so many flavours to choose from. Isn’t that great?
Let’s understand the basic functions of a Forex market (you know by now that market doesn’t refer to a physical location):
- Obviously you would have guessed by now, its basic function is to facilitate the conversion of one currency into another.
- Provide credit for national and international transactions.
- Minimize the exposure to the risk due to changes in the exchange rate, i.e. hedging function.
Ok, coming to the market structure now. Don’t be surprised if you come across some new terms in this section. We will talk about those terms as well as anything you have doubt about in detail. The following diagram shows how the FOREX market is structured and the market players involved:
In the topmost layer we see Major Banks. These are banks which do business for their clients or for themselves. They deal with each other and form what is known as the interbank market. These dealer banks which form the interbank market are effectively the market makers as they set the prices and provide liquidity. So, in simple terms interbank market is a network between large banks. This is made possible through the Electronic Broking Services (EBS, will be referred as EBS hereafter in the article) and the Reuters Spot Matching system which we have in our second stair in the structure above. Let’s try to understand how this works.
EBS is an electronic trading platform used to trade FX with large banks. Reuters Spot Matching system is the closest competitor to EBS and which one to choose is decided upon based on the currency pair. EBS is primarily chosen for currency pairs such as EUR/USD, USD/JPY, EUR/JPY, USD/CHF and EUR/CHF. Reuters Spot Matching is the main venue for AUD/USD, NZD/USD and USD/CAD. These two applications show the prices at which each bank is willing to transact at and thus ensuring proper market functioning.
Let’s get down to the next step in our staircase. In this step we have small or medium sized banks. As mentioned earlier, there are many banks whether large or small which participate in the Forex network. Banks participate in the currency market and are responsible for order execution and market making.
On the next level we have Retail market makers, Retail ECNs (Electronic Communications Network), Hedge Funds and Commercial businesses. Certain level of capitalization and business agreements are required for brokers and retail market makers to participate and quote prices in the interbank market which does not exist. These institutions do their transactions via commercial banks as they don’t have direct access to the interbank market.
In the bottom most level we have retail traders. Trader has the least level of capitalization and yet they are the risk takers. With the advent in technology and electronic trading, brokers have made it possible for the traders to participate in the Forex market.
Well, market structure looks a bit clear now. Let’s quickly have a look at the major players in the Forex market. These are players who form the different steps in our market structure staircase.
As mentioned earlier large banks deal with each other to form the interbank market for Forex trading. They are market makers as they quote prices to all inquiring market participants. These banks gain advantage on the difference between their buying price and selling price also called the spread. Each bank has a dealing desk which is responsible for order execution, market making and risk management.
- Businesses and Corporations
All market participants are not market makers. Very Important point in RED. All market players don’t have the capability to set prices as market makers. Some just buy and sell i.e. trade according to the current exchange rate. This is the case with commercial companies and businesses whether it be large or small. Their nature of business is such that they have to receive or pay for the services or goods that require them to either purchase or sell foreign currency. These players are also called commercial traders.
- Governments and Central Banks
Majority of the developed economies have central banks which serves as the central monetary authority. These Central banks are involved in the Forex market too but not to trade. Their main purpose is to facilitate government’s monetary policies and to ensure they even out or smoothen the fluctuation in the value of their currency through adjusting interest rate for example. By doing so they tend to affect the currency valuation which in turn affects the Forex Market.
Speculators are non-commercial traders including large investors, hedge funds and other entities that are trading in the financial markets for capital gains.
Well done! You now have a bit of a clarity on the Forex market structure and the market players. Let’s get into history now. It is interesting to know some of the historical events relating to the currency market and the way it has evolved into its current state.
Going back to a time in history when currencies were not prevalent, what do you think would have been the means of international payment? Guess It. It was nothing but gold and silver. Countries used gold and silver as a method of payment. The value of gold and silver were dependent on the supply and demand. For example, if a country’s coin had more gold (based on the size) than another, it had more value than the other. So in Ancient times currencies had value fixed to a specific quantity of gold or silver. There was the gold standard established in 1876, an important event in the history of forex market. Gold Standard means currencies were backed by a specific amount of gold which means governments established this system to ensure currencies could be converted to gold and vice versa.
With the onset of World War I, countries abandoned the gold standard system. The war interrupted the trading system and thus the movement of gold. However, gold always remained a form of monetary value.
By the end of World War II, the Bretton Woods Agreement was established to fill the gap created by abandoned Gold Standard system. This system led to US Dollar replacing the gold as a means of conversion for various currencies around the world and thus there were fixed exchange rates. After the end of World War II, there was rapid expansion in international trade and lots of capital movement because of which the fixed exchange rate system set by Bretton Woods Agreement was no longer stable. This system was then closed by the US President Richard Nixon eventually bringing in a free floating currency system.
With the arrival of computers in 1980’s, trading currencies became very prevalent across borders and there was lot of inflow and outflow of money resulting in big banks dealing with dollars, euros, pounds etc. getting exchanged.
By 1996, with the advent in web based technology, forex trading became more practical. Market makers realized that Forex market has enough liquidity and came up with web based trading platforms to provide fast ways for individuals to trade spot FX. Market makers were profitable with Forex Trading and which in turn reflected to the customers and then they lived happily ever after.