Market Structure

 


The stock market has a centralized market and only one specialist that controls prices.  Prices can be altered to benefit the specialist because all trades must go through him.  For example, he can widen spreads or increase transaction costs to manipulate the market.

 

Trading Spot FX is Decentralized

Quotes from different currency brokers vary because there is not a centralized exchange like in the stock market.
There is a lot of competition between brokers so you are almost sure to get the best deal every time.  The forex market can be organized into a ladder illustrated below:

Major Banks
Electronic Brokering Services or ECN (BlackBull Markets)
Medium-sized and small Banks
Normal Retail Brokers
Retail Traders

The interbank market sits at the very top of the ladder mostly made up of the largest banks in the world.  People trade directly with each other or through the Reuters Dealing 3000-Spot Matching or Electronic Brokering Services (EBS).
    
EBS and the Reuters Dealing - 3000 Spot Matching are like comparing Walgreens and CVS.  They are always competing for customers or clients.  Even though they both offer the major currency pairs, some currency pairs are more liquid on one than the other.
USD/CHF, EUR/USD, EUR/JPY, and USD/JPY are all more liquid on the EBS platform.  NZD/USD, EUR/GBP, GBP/USD, and USD/CAD are all more liquid on the Reuters platform.  Not everyone can make deals at the rates that the different banks are offering.
Interest rates and loans are largely dependent on the established credit rapport between the trading parties.  It’s very similar to asking for a loan at your local bank.
The next step on the ladder consists of retail market makers, hedge funds, retail ECN’s, and corporations. Transactions are done through commercial banks so the rates are a little higher than those participants of the interbank market.
    
The retail traders make up the bottom part of the ladder.  Electronic trading and the internet make it easy for the average Joe to participate in the forex market.  Retail brokers have also helped pave the way.

 

Players in the Forex Market

It wasn’t until the end of the 1990’s when the internet came into play that allowed the average person to participate in forex.  Before that, it required 30-50 million dollars to partake.  The major forex players are described below:
 

Large Commercial Companies
Exchanging currency is a regular part of business for many commercial companies.  Dell must exchange the U.S. dollar to the Japanese yen before they buy their electronic parts from Japan.  Commercial banks are usually used for this type of trade because volume is much smaller than the interbank market.

Governments and Central Banks
Governments participate in forex just like major companies for handling their foreign exchange reserves, payments for international trade, and numerous other operations.  Central banks also control inflation by adjusting interest rates.

The Super Banks
Exchange rates are determined by the largest banks in the world because the forex market is a decentralized market.  This means that they make the bid/ask spread based on supply and demand.  Super banks include Citigroup, Barclays Capital, and UBS.

The Speculators 
The speculators make up 90% of the trading volume and come in all shapes and sizes.  They are all “In it to win it” no matter how big or small their wallets are.

Forex History
The “Bretton Woods System” was put in place at the end of World War II as a way to stabilize the global economy.  The exchange rates were placed against gold.  This worked for awhile, but soon became obsolete when major economies around the world started growing at different rates.
Exchange rates were soon determined by supply and demand as the “Bretton Woods System” was abolished.  The market evolved with the United States at the head of a free-floating market in 1971.  Fair exchange rates were difficult to determine at first, but that quickly changed as technological advances in communication simplified things.
Trading platforms were finally created by banks in the 1990’s allowing clients to execute trades instantaneously from live quotes streamed by online platforms.  Retail forex brokers allowed individuals to trade with as little as 1000 units when in the past, the interbank markets required a million units.

Retail Forex Brokers
Retail forex brokers allow anyone to be able to trade forex by signing up, depositing money, and trading through the comfort of their own home.  These brokers come in two forms:
1)    Electronic Communications Networks (ECN’s) - The bid and ask prices are made available to them by different institutions on the interbank market.
2)    Market Makers - Bid and ask prices are set by themselves, the broker. 

Market Makers
Retail market makes in a sense “repackage” large contract sizes from wholesalers into smaller pieces.  Market makers are a fundamental part of the foreign exchange market.  Let’s say that you wanted to go to Germany to partake in the beer festival there.  When you get there, you go to exchange your currency for euros.  The EUR/USD buying price (bid) is 1.2000 and the selling price (ask) is 1.2002.  This would mean that the spread is .0002.  
It seems small, but when dealing with millions of these transactions there is a massive profit to be made by the market makers.

Electronic Communications Network
ECN brokers charge a very small commission and have tight spreads.  Prices are gathered from different banks, market makers, or even other traders who use ECN.  Customer’s buy and sell orders are automatically matched up with the best bid/ask price available.

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