FOREIGN EXCHANGE-THE FASTEST-GROWING MARKET OF OUR TIME

FOREIGN EXCHANGE-

THE FASTEST-GROWING MARKET OF OUR TIME

WHO ARE THE PLAYERS IN THE FX MARKET?

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Since the foreign exchange market is an over-the-counter (OTC) market without a centralized exchange, competition between market makers prohibits monopolistic pricing strategies. If one market maker attempts to drastically skew the price, then traders simply have the option to find another market maker. Moreover, spreads are closely watched to ensure market makers are not whimsically altering the cost of the trade. Many equity markets, in contrast, operate in a completely different fashion; the New York Stock Exchange (NYSE), for instance, is the sole place where companies listed on the NYSE can have their stocks traded. Centralized markets are operated by what are referred to as specialists, while market makers is the term used in reference to decentralized marketplaces. Since the NYSE is a centralized market, a stock traded on the NYSE can have only 1 bid/ask quote at all times. Decentralized markets, such as foreign exchange, can have multiple market makers—all of whom have the right to quote different prices. Let’s look at how both centralized and decentralized markets operate. 

Centralized Markets

By their very nature, centralized markets tend to be monopolistic: with a single specialist controlling the market, prices can easily be skewed to accommodate the interests of the

FIGURE Centralized Market Structure

FIGURE Decentralized Market Structure 

specialist, not those of the traders. If, for example, the market is filled with sellers from whom the specialists must buy but no prospective buyers on the other side, the specialists will be forced to buy from the sellers and be unable to sell a commodity that is being sold off and hence falling in value. In such a situation, the specialist may simply widen the spread, thereby increasing the cost of the trade and preventing additional participants from entering the market. Or specialists can simply drastically alter the quotes they are offering, thus manipulating the price to accommodate their own needs.

Hierarchy of Participants in Decentralized Market 

While the foreign exchange market is decentralized and hence employs multiple market makers rather than a single specialist, participants in the FX market are organized into a hierarchy; those with superior credit access, volume transacted, and sophistication receive priority in the market.

At the top of the food chain is the interbank market, which trades the highest volume per day in relatively few (mostly G-7) currencies. In the interbank market, the largest banks can deal with each other directly, via interbank brokers or through electronic brokering systems like Electronic Brokering Services (EBS) or Reuters. The interbank market is a credit-approved system where banks trade based solely on the credit relationships they have established with one another. All the banks can see the rates everyone is dealing at; however, each bank must have a specific credit relationship with another bank in order to trade at the rates being offered. Other institutions such as online FX market makers, hedge funds, and corporations must trade FX through commercial banks.

Many banks (small community banks, banks in emerging markets), corporations, and institutional investors do not have access to these rates because they have no established credit lines with big banks. This forces small participants to deal through just one bank for their foreign exchange needs, and often this means much less competitive rates for the participants further down the participant hierarchy. Those receiving the least competitive rates are customers of banks and exchange agencies.

Recently technology has broken down the barriers that used to stand between the end users of foreign exchange services and the interbank market. The online trading revolution opened its doors to retail clientele by connecting market makers and market participants in an efficient, lowcost manner. In essence, the online trading platform serves as a gateway to the liquid FX market. Average traders can now trade alongside the biggest banks in the world, with similar pricing and execution. What used to be a game dominated and controlled by the big boys is slowly becoming a level playing field where individuals can profit and take advantage of the same opportunities as big banks. FX is no longer an old boys club, which means opportunity abounds for aspiring online currency traders.

Dealing Stations—Interbank Market The majority of FX volume is transacted primarily through the interbank market. The leading banks of the world trade with each other electronically over two platforms—the EBS and Reuters Dealing 3000-Spot Matching. Both platforms offer trading in the major currency pairs; however, certain currency pairs are more liquid and generally more frequently traded over either EBS or Reuters D3000. These two companies are continually trying to capture each other’s market shares, but as a guide, here is the breakdown of which currencies are most liquid over the individual platforms:

          EBS               Reuters

          EUR/USD       GBP/USD

          USD/JPY        EUR/GBP

          EUR/JPY        USD/CAD

          EUR/CHF       AUD/USD

          USD/CHF       NZD/USD 

      Cross-currency pairs are generally not traded over either platform, but instead are calculated based on the rates of the major currency pairs and then offset using the “legs.” For example, if an interbank trader had a client who wanted to go long AUD/JPY, the trader would most likely buy AUD/USD over the Reuters D3000 system and buy USD/JPY over EBS. The trader would then multiply these rates and provide the client with the respective AUD/JPY rate. These currency pairs are also known as synthetic currencies, and this helps to explain why spreads for cross currencies are generally wider than spreads for the major currency pairs.