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.
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