26/08/2024
Forex Market Structure
The foreign exchange market, commonly known as the forex or FX market, is a global decentralized marketplace for trading currencies.
As the largest financial market in the world, with a daily trading volume exceeding $7 trillion, it plays a pivotal role in the global economy by facilitating international trade and investment.
In the following lessons, we will explore the structure of the forex market, its key participants, and a short history on the birth of retail forex trading.
For the sake of comparison, let us first examine a market that most folks are probably very familiar with: the stock market.
This is how the structure of the stock market looks like:
Centralized Financial Market
By its very nature, the stock market tends to be very monopolistic. There is only one entity, one specialist that controls prices.
All trades must go through this specialist. Because of this, prices can easily be altered to benefit the specialist and not traders.
How does this happen?
In the stock market, the specialist is forced to fulfill the orders of its clients. Now, let’s say the number of sellers suddenly exceeds the number of buyers.
The specialist, which is forced to fulfill the order of its clients, the sellers, in this case, is left with a bunch of stock that he cannot sell off to the buyer side.
In order to prevent this from happening, the specialist will simply widen the spread or increase the transaction cost to prevent sellers from entering the market.
In other words, the specialists can manipulate the quotes it is offering to accommodate their needs.
Trading Spot FX is Decentralized
Unlike in trading stocks or futures, you don’t need to go through a centralized exchange like the New York Stock Exchange with just one price.
In the forex market, there is no single price for a given currency at any time, which means quotes from different currency dealers vary.
Forex Market Structure
“So many choices! Awesome!”
This might be overwhelming at first, but this is what makes the forex market so freakin’ awesome!
The market is so huge and the competition between dealers is so fierce that you get the best deal almost every single time.
And tell me, who does not want that?
Also, one cool thing about forex trading is that you can do it anywhere. It’s just like trading Jordans or rare handbags.
You want that mint condition Air Jordan 4 Retro Eminem Encore 2017, so it is up to you to find the best deal out there.
The FX Ladder
Even though the forex market is decentralized, it isn’t pure and utter chaos!
Despite its decentralized nature, the forex market does have a hierarchical structure that dictates how different market participants interact and trade.
Understanding this hierarchy helps in comprehending the flow of transactions and the role of various entities within the market.
The participants in the FX market can be organized into a ladder. To better understand what we mean, here is a neat illustration:
Forex Market Hierarchy
At the very top of the forex market ladder is the interbank market.
The trades in the interbank market are typically large, involving millions or even billions of dollars, contributing to the market’s overall liquidity.
Composed of the largest banks in the world, the participants of this market trade directly with each other (“bilaterally”) or through voice or electronic brokers (such as EBS Market and Reuters Matching).
The competition between the two companies, EBS and Reuters (now rebranded as Refinitiv), is similar to Coke and Pepsi.
The two electronic brokers, both organized as central limit order books (CLOBs), quickly became the main sources
of price discovery and reference prices for the entire FX spot market.
They are in a constant battle for clients and continually try to one-up each other for market share. While both companies offer most currency pairs, some currency pairs are more liquid on one than the other.
For the EBS platform, EUR/USD, USD/JPY, EUR/JPY, EUR/CHF, and USD/CHF are more liquid.
Meanwhile, for the Reuters platform, GBP/USD, EUR/GBP, USD/CAD, AUD/USD, and NZD/USD are more liquid.
All the banks that are part of the interbank market can see the rates that each other is offering, but this doesn’t necessarily mean that anyone can make deals at those prices.
Like in real life, the rates will be largely dependent on the established CREDIT relationship between the trading parties.
It’s like asking for a loan at your local bank. The better your credit standing and reputation with them, the better the interest rates and the more money you can borrow.
Next on the ladder are the hedge funds, corporations, retail market makers, and retail ECNs.
Since these institutions do not have tight credit relationships with the participants of the interbank market, they have to do their transactions via commercial banks.
This means that their rates are slightly higher and more expensive than those who are part of the interbank market.
At the very bottom of the ladder are non-professional traders known as retail traders.
The retail forex market consists of individual traders who participate in the market primarily through online trading platforms provided by retail forex “brokers.”
It used to be very hard for us little people to engage in the forex market but thanks to the advent of the internet, electronic trading, and retail brokers, the difficult barriers to entry in forex trading have all been taken down.
Retail traders often use high leverage ratios, allowing them to control larger positions with a relatively small amount of capital.
This gave us the chance to play with those high up the ladder and poke them with a very long and cheap stick.
Now that you know the forex market structure, let’s get to know them forex market playaz!
