How Does Forex Market Work – The foreign exchange market (forex) has an average daily trading volume of $5 trillion, making it the largest market in the world. Market participants include forex brokers, hedge funds, retail investors, corporations, central banks, governments and institutional investors such as pension funds.
All interbank trading activity affects the demand for currencies and their exchange rates. However, the primary market makers, which are the big banks that handle a significant portion of the Forex trading volume, provide the base exchange rates on which all other trading prices are based.
How Does Forex Market Work
An exchange rate is a price or rate showing how much it costs to buy one currency in exchange for another currency. Forex traders buy and sell currencies in the hope that the exchange rate will change in their favor. For example, a trader can buy the euro against the US dollar (EUR/USD) today at the current exchange rate (called the spot rate) and reverse the trade with an offsetting trade the next day. The difference between the two exchange rates represents the profit or loss on the transaction.
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For example, let’s say that today a trader buys (goes long) the euro against the US dollar at a rate of $1.10 for each euro. The next day, the trader closed the position, offsetting the sell trade at $1.12; the difference is the profit from the trade. However, not all currency transactions involve speculation. Companies, for example, buy and sell goods abroad and thus are often forced to buy or exchange their local currency for foreign currency to facilitate the transaction.
Unlike most other exchanges such as the New York Stock Exchange (NYSE) or the Chicago Board of Trade (CBOT), the forex (or FX) market is not a centralized market. In a centralized market, each transaction is recorded by price and volume. There is usually one central location from which all trades can be tracked, and there is often a centralized network of market makers.
However, Forex or the foreign exchange market is a decentralized market. There is no single “exchange” where every transaction is registered. Trading takes place worldwide on several exchanges without any of the characteristics of a stock exchange listing. Also, there is no clearing house for foreign exchange transactions. Instead, each market maker or financial institution registers and maintains its own trades.
Trading on a decentralized market has its advantages and disadvantages. In a centralized market, traders can control the volume of the market as a whole. However, in times when trading volume is low, large multi-billion dollar transactions can disproportionately affect prices. Conversely, in the foreign exchange market, transactions take place in specific time zones of that particular region. For example, trading in Europe starts early in the morning for US traders, while trading in Asia starts after the US trading session closes. As a result of the 24-hour forex market cycle spanning multiple trading sessions, it is difficult for one large trade to manipulate the price of a currency across all three trading sessions.
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The international nature of the interbank market can make it difficult to regulate. With such important market players, however, self-regulation is sometimes even more effective than state regulation. For individual forex investments, a forex broker must be registered with the Commodity Futures Trading Commission (CFTC) as a commission futures seller and a member of the National Futures Association (NFA). The CFTC regulates brokers to meet strict financial standards.
Currencies are quoted in pairs using two different prices, called bid and ask prices. The buy and sell prices are similar to how stocks are traded. The ask price is the price you would get if you were selling the currency, and the ask price is the price you would get if you were buying the currency. The difference between the buying and selling prices of a currency is known as the bid-ask spread, which is the cost of trading currencies minus brokerage fees and commissions.
The main market makers who set the bid and ask spreads in the foreign exchange market are the world’s largest banks. These banks constantly interact with each other, either on their behalf or on behalf of their customers, and do so through a sub-segment of the foreign exchange market known as the interbank market.
The interbank market combines elements of interbank transactions, institutional investments and corporate transactions through their financial institutions. The buying and selling rates of all these players and their transactions form the basis for the prevailing exchange rates – or
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From which the price for all other participants is determined. Competition between interbank institutions ensures tight bid/ask spreads and fair pricing.
Most individuals do not have access to the prices available in the interbank foreign exchange market because their transaction size is not large enough to be traded by interbank players. In other words, the foreign exchange market is a volume discount business, meaning that the larger the trade, the closer the rate will be to the interbank or market rate.
However, interbank participants are important to retail investors because the more participants there are, the more liquidity there is in the market and the greater the chance of price fluctuations, which can lead to trading opportunities. The additional liquidity also allows retail investors to get in and out of their trades with ease as very high volume is traded.
Most of the total volume of Forex transactions is done through about 10 banks. We all know these brands well, including Deutsche Bank ( NYSE:DB ) , UBS ( NYSE:UBS ) , Citigroup ( NYSE:C ) , and HSBC ( NYSE:HSBC ) .
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Government and central banks have some of their own centralized currency trading systems, but they also use the world’s largest institutional banks. An elite group of institutional investment banks has primary responsibility for setting prices for the bank’s interbank and institutional clients and offsetting that risk with other clients on the opposite side of the deal.
Each bank is structured differently, but most banks have a separate group known as the Foreign Exchange Sales and Trading Department. The sales and trading department is usually responsible for taking orders from the client, getting a quote from the spot trader, and passing the quote on to the client to see if he wants to trade it. Although online currency trading is becoming more common, many corporations still work directly with a currency advisor in the trading department of a financial institution. Advisors also provide companies with risk management strategies designed to mitigate adverse currency fluctuations.
Typically, in large trading centers, one or two market makers may be in charge of each currency pair. For example, one trader may trade the EUR/USD pair and another trader Asian currencies such as the Japanese yen. An Australian dollar dealer may also be responsible for the New Zealand dollar, while there may be a separate dealer that quotes the Canadian dollar.
Institutional traders generally do not allow individual crossovers. Interbank Forex desks usually work only with the most popular currency pairs (called major currencies). In addition, trading entities may have a designated dealer responsible for trading in exotic currencies or exotic currencies such as the Mexican peso and the South African rand. Like the foreign exchange market in general, the interbank foreign exchange market is available 24 hours a day.
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Bank dealers will set their prices based on a variety of factors, including the current market rate and the volume (or liquidity) available at the current price level. If liquidity is low, a trader may not want to open a position in a currency that will be difficult to rotate if something goes wrong in the market or in that country. If a trader enters a position in a thin market, the spread will usually be wider to compensate for the risk of not being able to exit the position quickly if a negative event occurs. This is why the forex market typically sees wider bid-ask spreads at certain times of the day and week, such as Friday afternoons before the US markets close or before holidays.
The interbank trader also takes into account the bank’s forecast or view of where the currency pair might go and their positions on the exchange. For example, if the dealer thinks that the euro is rising, he can offer a more competitive price to customers who want to sell them euros, because the dealer thinks that they can hold a euro position for a few hours and book. a back-to-back trade later in the day at a better price — a profit of a few pips. The flexible nature of market prices is unique to market makers who do not offer a fixed spread.
Similar to how we see prices on an electronic platform for forex brokers, interbank traders use two main platforms, one offered by ReutersDealing and the other offered by Electronic Brokerage Service (EBS).
The interbank foreign exchange market is an approved credit system in which banks trade solely on the basis of their established credit relationships. All banks can see the best available market rates at the moment. However, each bank must have an authorized relationship to trade at the rates offered. The bigger the banks, the more credit relationships they have and the better rates they can get.
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