How Forex Trading Works – With an average daily transaction volume of $5 trillion, the foreign exchange (forex) market is the largest market in the world. Market participants include forex brokers, hedge funds, retail investors, companies, institutional investors such as central banks, governments, and pension funds.
All interbank transaction activity affects the demand for the currency and its exchange rate. However, the main market makers, the large banks that execute significant volumes of currency trading, provide the base rate on which all other transactions are quoted.
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An exchange rate is a price or exchange rate that shows the cost of buying one currency in exchange for another. Forex traders buy and sell currencies in the hope that the exchange rate will work in their favor. For example, a trader could buy euro/dollar (EUR/USD) today at the current exchange rate (known as the spot rate) and close the position the next day with an offset trade. The difference between the two rates represents a profit or loss on the trade.
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For example, suppose a trader buys (goes long) EURUSD at a rate of $1.10 per EUR today. The next day, the trader closes the position with an offsetting sell trade at $1.12; the difference is the profit on the trade. However, not all currency trading involves speculation. For example, companies buy and sell goods abroad and, in doing so, often need to buy or convert local currency into foreign currency to facilitate transactions.
Unlike most other exchanges, such as the New York Stock Exchange (NYSE) or the Chicago Board of Trade (CBOT), the foreign exchange (or FX) market is not a centralized market. In a centralized marketplace, each transaction is recorded by price and quantity. There is usually a central location to which all transactions can be traced, and often there is a centralized network of market makers.
However, the foreign exchange or currency market is a fragmented market. No “exchange” records all transactions. Trading takes place on multiple exchanges around the world, without a unique exchange listings feature. Also, there is no clearing house for currency transactions. Instead, each market maker or financial institution records and maintains its own transactions.
Trading in a decentralized market has its advantages and disadvantages. In a centralized exchange, traders can monitor the trading volume of the entire market. However, at a time when transaction volumes are low, large multi-billion dollar deals can have a disproportionate impact on price. On the contrary, in the forex market, transactions are made in a specific time zone of that specific region. For example, for US traders, European trading starts early in the morning, while Asian trading starts after the US trading session closes due to the 24-hour forex market cycle. , which spans several trading sessions, it is difficult for a large trade to manipulate the price of a currency in all three trading sessions.
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The international nature of the interbank market makes it difficult to regulate. However, with such major players in the market, self-regulation can sometimes be even more effective than government regulation. For individual Forex investments, Forex brokers must be registered as futures commission dealers with the Commodity Futures Trading Commission (CFTC) and be members of the National Futures Association (NFA). The CFTC regulates brokers to ensure they meet strict financial standards.
Currencies are quoted in pairs using two different prices, called bid and ask. Bid and ask prices are similar to how stocks are traded. The bid price is the price you receive when you sell a currency, and the ask price is the price you receive when you buy a currency. The difference between the buying and selling prices of a currency is known as the bid-ask spread, and represents the cost of trading the currency less broker fees and commissions.
The main market makers that make bid-ask spreads in the foreign exchange markets are the largest banks in the world. These banks are constantly doing business with each other on behalf of themselves or their clients; they do so through a segment of the foreign exchange market known as the interbank market.
The interbank market combines elements of interbank transactions, institutional investments, and business transactions through their financial institutions. The buying and selling rates of all these participants and their transactions form the basis of the prevailing exchange rate, or
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From this, determine the price of all other participants. Competition between similar institutions ensures tight bid-ask spreads and fair prices.
Most people do not have access to the prices available in the interbank foreign exchange market because their trades are not large enough to be traded by interbank participants. In other words, the forex market is a volume discount business, which means that the higher the volume of transactions, the closer the exchange 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 liquid the market becomes and the greater the potential for price fluctuations, creating trading opportunities. The increased liquidity also allows retail investors to easily enter and exit their trades because the volume is so high.
Most of the foreign exchange volume is traded through about 10 banks. These banks are our well-known brands, including Deutsche Bank (NYSE:DB), UBS (NYSE:UBS), Citigroup (NYSE:C) and HSBC (NYSE:HSBC).
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Governments 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 is primarily responsible for pricing the bank’s interbank and institutional clients and offsetting that risk with other clients on the counterparty’s side.
Each bank is structured differently, but most banks have a separate team called the Forex Sales and Trading Department. Sales and trading desks are typically responsible for taking orders from clients, obtaining quotes from spot traders, and forwarding quotes to clients to see if they want to trade. Although online forex trading has become more common, many companies still deal directly with forex advisers on the trading desks of financial institutions. These advisors also provide risk management strategies for companies aimed at mitigating adverse movements in currency exchange rates.
Typically, on the larger trading desks, one or two market makers may be responsible for each currency pair. For example, one trader might trade EUR/USD while another trades an Asian currency like the Japanese Yen. AUD traders may also be responsible for New Zealand dollars, while there may be independent traders listing Canadian dollars.
Institutional traders generally do not allow custom crosses. Forex interbank desks generally trade only the most popular currency pairs (called majors). In addition, business units may have designated intermediaries for transactions in foreign or exotic currencies, such as Mexican pesos and South African rand. Like the entire foreign exchange market, the interbank foreign exchange market is open 24 hours a day.
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Bank agents will determine their prices based on a number of factors, including current market interest rates and the volume (or liquidity) available at current price levels. If liquidity is tight, traders may be reluctant to take a position in a currency that will be difficult to liquidate if there is a problem in the market or in the country. If a trader takes a position in a small market, the spread is usually wider to offset the risk of not being able to close the position quickly in the event of a negative event. This is why the forex market typically experiences wider bid-ask spreads at certain times of the day and week, such as Friday afternoons before the US market closes or before the holidays.
Interbank traders also take into account the bank’s forecast or view of where the currency pair is likely to go and their stock positions. For example, if a trader believes that the euro is rising, he may be willing to offer a more competitive price to a client who wants to sell him euros because the trader believes that he can hold a position in euros for a few hours and book later. the day for a more competitive price Good price for counter trades – earn some profit points. Market price flexibility is unique to market makers who do not offer fixed spreads.
Similar to how we see prices on electronic forex broker platforms, interbank traders use two main platforms: one provided by ReutersDealing and the other provided by Electronic Brokerage Services (EBS).
The interbank foreign exchange market is a recognized credit system in which banks trade solely on the basis of the credit relationships they have established. All banks can see the best market rates currently available. However, each bank must have an authorized relationship to transact at the rates offered. The bigger the bank, the more credit relationships they can have and the better prices they can get. this
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