Structure of the Forex Market

The forex is unique among financial markets in a number of ways. One of these is that it was not traditionally used as an investment vehicle. It had, and still maintains to some extent, a somewhat more utilitarian purpose. In today’s globalized economy, most businesses have some international exposure, creating the need to exchange one currency for another in order to complete transactions. For example, Honda builds its cars in Japan and exports them to the United States, where an eager American buyer exchanges his dollars for a brand new Honda. Some of this money has to make its way back to Japan to pay the factory workers that built the car, but first those dollars have to be exchanged for Japanese yen, since that is the currency the Japanese factory workers are paid in. Transactions such as this are facilitated by international banks and are done through a mechanism known as the foreign exchange market, or forex. Since banks are used to facilitate these cross-border transactions, they naturally want to be paid for their services. This payment comes in the form of a bid/ask spread – offering to buy the desired currency at a slightly lower price than they are willing to sell it at, and pocketing the difference. Considering the fact that more than $3bn moves through the forex market daily, these seemingly small fees can add up to a significant sum.

Since the 1970’s most of the world’s major currencies have been on a (mostly) free-floating exchange mechanism, allowing for exchange rates to be determined by market forces, that is, supply and demand. I say “mostly” because there have been times when major central banks have intervened in the market to manipulate exchange rates by either buying or selling large amounts of their currency, but normally this only takes place in extreme situations. There are also other central banks that choose to manage their currencies much more strictly, but these are a minority in the developed world. So in most cases, this free-floating exchange rate mechanism allowed currencies to fluctuate against one another much more, and this in turn opened the door to speculation on the future movement of exchange rates. The banks’ intimate knowledge of the forex market, and their high level of capitalization allowed them to be the first to speculate in the forex market, and to significantly increase their profits by doing so. An unfortunate consequence of this speculation however was that liquidity at certain times became scarce, and some necessary transactions could not be completed. In order to solve this problem, banks turned to expanding the number of participants in the market to include non-banks, thereby generating sufficient order flow (liquidity distribution) to complete clients’ transactions, and also to profit from these newer and less knowledgeable market participants. These less experienced forex market participants first included large funds (such as the legendary Quantum Fund), but nowadays also include your local retail forex dealer.

Another unique feature of the forex market is that it is an over-the-counter (OTC) market, meaning that there is no central exchange (like a stock exchange) where transactions take place. Instead, top-tier transactions are made in the “interbank market”, which is a collection of the world’s largest money center banks, all free to trade currencies amongst each other at whatever rate they can agree on. Of course, it may be difficult to find your way around such a maze, so the brilliant minds at the leading banks developed the Electronic Broking System (EBS) to enable participants to easily see at what rates all the other participants are willing to deal at. A competing system was also developed by Reuters (D2). Today, one is preferred over the other mostly on the basis of which currency pair you want to trade, with EBS used mostly for EUR/USD, USD/JPY, EUR/JPY, USD/CHF and EUR/CHF, and Reuters D2 used for all other currency pairs. In 2006, EBS was acquired by ICAP. It should be noted that while these services provide a centralized structure for pricing information, they DO NOT constitute a centralized exchange. The forex is still very much an OTC market.

The 2nd tier of the market is made up of smaller bits of larger multinational institutions. This is when, for example, a bank branch in the US deals with another branch of the same bank in, say, Japan. So when you walk into your local branch and want to exchange currency, they will give you a quote which is not exactly representative of the interbank exchange rate. You are free to shop around for a better quote, and you would often be wise to do so, as rates can vary significantly from one bank to another.

Most retail forex brokers are a part of the 3rd tier, as they often deal with only a single 2nd tier liquidity provider. This is not always the case, as some retail brokers offer direct access to multiple liquidity providers, and are therefore themselves a part of the 2nd tier. This is particularly true of Electronic Communication Networks (ECNs), who normally route retail traders’ orders directly to the interbank market.