How the Forex Market works

The Forex Market is Decentralized
In the present day, the world’s forex market is the greatest market of all time, with daily trading exceeding 5 trillion dollars, the competition between brokers, trades and the other market participants is aggressive. The currency market has no central exchange, contrasting to traditional markets where the trading is controlled at a central point.

Prices of all currency exchanges are not cleared by a central exchange. Therefore, the price can vary from broker to broker when trading the spot FX market. The market is competitive so if you have the information and know what you look for you can get the best pricing. Forex trading can be done from literally anywhere in the world, provided you have a liquidity provider (i.e. a broker) you can find buyers and sellers for all currency pairs.

The FX Market Broken-Up
Even though the market for trading forex is decentralized, the market participants and their trading volume is widely known, as listed below:

Major world banks and some smaller banks make up the largest portion of the currency market and are called the interbank market. The banks trade with each other or through an electronic trading platform, like the Electronic Brokering Services or the Reuters Dealing 3000-Spot Matching. The rate at which each bank will loan or will trade a currency pair is listed, each bank makes loans to each other based on their credit relationship with each other. The better the relationship the better the larger the loan and the better the interest rates.

Next are the hedge funds, corporations and brokers; retail market makers, and ECNs brokers. Since these institutions do not have as strong credit relationships with the participants of the interbank market, they must 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.

Lastly are profession non-institution trades or retail traders, like you and me. It used to be difficult for retail traders in the forex market. However, with the birth of the internet, electronic trading became available to all. Retail brokers emerged to cater for this growing market and no there are no barriers and nothing stopping an individual to trade the forex market like world’s largest banks.

Forex Market Participants

1: The Speculators
Speculators as forex market participants are professional and amateur retail forex traders. Some have more capital than others. Before the year 2000, only the rich could benefit playing this game, minimum requirement was at least ten million dollars. The average person was not supposed to be able to profit from the forex market. It was built to be used by big banks and reserve banks. The internet changed everything, allowing retail brokers to open accounts for retail traders anywhere in the world. To fully understand the forex market, we must analyze the other participants.

2: The World’s biggest Banks
The super banks determine the exchange rate for currency, by doing so forming an interbank market. Spread prices are quoted for bid/ask, based on the supply and demand, all this is possible as the forex market is decentralized. This interbank market generates the major of forex trading volumes with transactions for their clients and themselves. These are some of the biggest banks in the world: UBS, JP Morgan Chase, Citigroup, Deutsche Bank and Barclays Capital. These banks comprise most of the forex markets’ daily transactions.

3: Central Banks and National Reserve Banks
Almost each National Government has a reserve bank; in addition, some entire regions have reserve banks too called central banks like, The Reserve Bank of South Africa or The ECB (European Central Bank). These institutions govern and control pricing within of the forex market. Central banks affect the forex market adjusting interest rates to control inflation, by doing so affecting currency valuation. Furthermore, a central bank can start greatly selling or buying a currency to realign exchange rates. The worlds governments participate in the forex market for their operations, international trade payments, and managing their foreign exchange reserves.

4: Big Corporations
Large public and private companies participate in the foreign exchange market. International mergers and acquisitions between large companies can alter exchange rates. In addition, import and export of goods and services by big corporations can cause currency variation. Big companies are not the major forex markets participants and therefore deal with big banks for their forex transaction.

Retail Forex Brokers
In the past, only the big speculators and highly capitalized investment funds could trade currencies, but thanks to retail forex brokers and the Internet, this isn’t the case anymore. Anybody can find a broker, open an account, deposit money, and trade forex from home. Traditional brokers can be either Market Makers (B-Book) or ECN (A-Book). Market Makers set their own bid and ask price, ECN brokers use the most competitive bid and ask price available from different sources on the interbank market.

Market Makers
Retail Market Makers allow traders to take very small contracts. They do this by purchasing liquidity at wholesale prices, adding a markup and breaking it down into small units called micro lots. The market maker will traditionally offer spread trading, for example if the buying price (bid) for GBP/USD is 1.25000 and the selling price (ask) is 1.25003, then the bid/ask spread is 0.0003. This is a small amount; around one thirtieth of a cent. However, with the forex market as big as it is market makers can experience relevantly high trading volumes from all over the world.

ECN (Electronic Communications Network)
An ECN broker uses the ECN to automatically match customer’s buy and sell orders. These orders are executed through the Electronic Communications Network from different market makers, banks, and other traders who use the ECN. When a sell or buy, order is made, it is matched up to the best bid/ask price. ECN brokers typically charge a small commission for the trades you take. The combination of tight spreads and small commission usually make transaction costs cheaper on ECN brokers.

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