Introduction to the Foreign Exchange Market

The rationale behind this post is to break down the inner workings of the foreign exchange market and perhaps provide some enlightenment on the current situation, the forex market in general, the reason why we have and need forex brokers, and how forex brokers make their profit.  More importantly, it aims to provide some understanding as to why we, as forex speculators, can and should, despite a very volatile market, continue to trade.

Rationale

Let’s start with a basic explanation of why the forex market came to be, and how it is used by its principal participants.  We’ll continue the explanation into the structure of the market, and how it operates.  In conclusion, we’ll look at the implications and how this affects speculators. 

The forex market isn’t usually used as a medium for investments, unlike other markets, such as those that trade equity and bonds.  While speculation plays a smaller, but nonetheless important role, the vast majority of forex trades are primarily made as a means to facilitate international business transactions.

An example might help to shed a little light on this.  Let’s say you’ve got a guy in Detroit who decides he wants to buy a nice shiny new import.  He’s got his eye on a Mitsubishi Eclipse and goes to the local Mitsubishi dealership, where he’ll naturally pay for his car with U.S. Dollars.  That’s all well and good, but the Japanese workers in the Mitsubishi factory in Japan naturally want to get paid in their own currency, namely Japanese Yen.  Somewhere along the line, the U.S. Dollar money from the car purchase has to be converted to Japanese Yen to pay those workers.

If you think about it, huge multi-nationals like Nestle, Exxon-Mobil, Microsoft, Honda, Sony, G-E and tens of thousands of other smaller global entities move nearly every single U.S. Dollar, Japanese Yen, Euro, Pound Sterling, Saudi Arabian Riyal, Brazilian Real and Russian Ruble plus dozens of other foreign currencies you’ve never even heard about, through the foreign exchange markets.  In a single day, more than $2.3 trillion in foreign exchange is traded, and that figure is expected to rise to $3 trillion within two years time.  It isn’t difficult to comprehend, then, how truly insignificant is the presence of the individual speculators.

The fact is, businesses don’t really care (much) about the variances and intricacies of the foreign exchange rates.  They’re in the business to make a product, sell it and reap the profits.

A bank, as the central depository of a company’s cash, is naturally the facilitator of a company’s foreign exchange transactions.  Decades ago, it was a matter of a simple telephone call from a banker in one country to another banker in a different country.  Banks that had an international presence could merely do a branch to branch transfer. 

Remember, banks are in the business to make money, just like any other business.  So when a bank bought foreign currency at one price, they naturally added their margin to it before selling it to another customer.  That margin is called the spread.  For all intents and purposes, that was, and remains, a fairly reasonable cost.

From our earlier example, Mitsubishi gets Japanese Yen in payment for the Eclipse, and is now able to pay its workers who built the car.  The car owner is happy, Mitsubishi is happy and the Mitsubishi factor workers are happy.  The banks which facilitated the foreign exchange transaction are also happy, because they earned a tidy little profit (the spread) for handling the transaction, and for accepting the associated risks inherent with foreign exchange.

One of the consequences of transacting all this foreign exchange business is that bank traders soon developed an ability to speculate as to the direction of future currency rates. With a better grasp of how the market works, a bank could give a customer a quote adding a spread to the current rate but actually hold off or hedge until a better rate comes along.  In so doing, the banks were able to dramatically increase their net income.  One unfortunate end result, though, was that the method of redistributing the liquidity made it impossible to complete certain forex transactions.

For that reason alone, the foreign exchange market needed to be made available to non-bank participants.  Naturally, the banks wanted to be able to execute more orders in the forex market which would allow them to profit from less experienced participants (who provided a better distribution of the liquidity) and which permitted them to execute their hedge orders from their international customers. 

Forex Market Structure

We now know why the foreign exchange market exists, so let’s look at how a forex transaction is actually facilitated.

At the very top of the forex market are transactions which are collectively called Interbank transactions.  The “Interbank” is not, as some people may believe, an exchange.  Rather, it is a collection or compilation of agreements between and among the major money center banks in the world.

An example (yes, another one) may make it easier to understand this thing we’re calling the “Interbank” market.  In most larger offices or business, perhaps even in your own home, there may be several computers which are inter-connected by means of a simple network cable.  Now, each computer operates independently until the moment it needs a resource, program or file from one of the other computers.  When that happens, computer A will contact computer B (or C or D, etc.) and request permission to access the needed resource.  If the owner or operator of Computer B authorizes it, and if Computer B is functioning the way it should be, then the needed file or program can be accessed.  Within minutes, Computer A’s request is fulfilled.  It works the same way in the forex market; just substitute Computer A and Computer B for Bank A and Bank B and let resources substitute for currency.  You now have the machinations for the relationships that exist within the Interbank system.

By the same context, if you’ve ever tried to locate resources from a computer that isn’t united by a computer network, you probably know full well what a time consuming, inefficient, sometimes futile effort it can be.  You have to search each and every independent computer until you’ve found your resource, copy it and then download it to your own computer.  Regarding prices and forex currency inventory, the same issue exists within the Interbank market system.  If a bank in Taiwan occasionally transacts business with a firm in Sao Paula they need to exchange their currency.  In this case, it can be quite difficult to determine what the proper exchange rate between the New Taiwan Dollar and the Brazilian Real should be.  Because of situations such as this, the Electronic Broking Service (EBS) and Reuters established their services.  For simplicity, we’ll refer to this service as ESB.

In a way, the EBS service acts as a blanket over the Interbank communication links.  Through the EBS service, Interbank members are able to see how much currency is available, and the price(s) the other Interbank participants are willing to pay.  It’s important to understand that the EBS is not in itself a market nor is it a market maker.  The EBS system is merely an application allowing bank members to see offers and bids from the other members.

The forex market’s second tier essentially exists within each individual bank.  If you were to call your local Citibank branch, they can arrange for you to exchange your U.S. Dollar for the foreign currency of your choosing.  In all probability, they will likely just move the desired currency from one bank branch to another one.  This is known as a single party micro-exchange, so you are pretty much at their mercy as it applies to the foreign exchange rate you’re quoted.  You can either accept their “kind” offer or shop around for a better rate.  Anyone who trades in the forex market should consider paying their bank a visit, at least once, to have an idea of their quotes.  Certainly, it will be very “enlightening,” if not downright shocking, to see just how profitable these transactions are… for your bank.

The third tier is the retail market.  Established foreign exchange brokers such as Forex.com, Oanda and FXCM, etc. or any broker who wishes to set up a retail operation, needs first to find a liquidity provider.  The large majority of these forex brokers sign an agreement with a single bank.  This bank agrees to provide liquidity only under certain conditions:  That is only if they can simultaneously hedge it on EBS, including their desired spread.

These spreads will be highly competitive, and that is because that volume will be much greater than any single bank patron would ever transact.  Bear in mind, banks are in the business to make money, and third tier providers will almost never precisely match what actually exists on the Interbank system.  Banks collect the spreads and no agreement between them and a forex retailer is going to alter their priority.

Think of retail forex as a kind of casino.  Most of the participants have little or no knowledge of trading effectively or successfully and, as expected, they’re consistent losers.  The forex broker has the house advantage because of the inherent spread system and the normal probability distribution of returns.  What results, is a system that plays one loser against one winner and collects the spread.  If there is a dis-equilibrium within their internal order book, a broker may hedge the exposure with their second tier liquidity provider.

Though it may not sound good, there are significant advantages to the speculators that work with them.  Since it is “internal,” many features, such as high leverage on an account with only a small balance, a non-standard contract size, and commission-free transactions can be provided which may not be available through any other means.

An ECN or Electronic Communications Network operates similarly to a second tier bank, but it exists, rather, on the third tier.  The ECN generally will establish a liquidity agreement with more than one second tier bank.  Instead of internally matching the book orders, it just passes the quotes through from the banks, as they are, to be traded.  You might look at it as an EBS, of sorts, intended for the little guys.  While there may be several advantages to the model, it still isn’t the Interbank. 

Understand this, the banks are either going to make their desired spread, or they won’t even bother trying.  Depending on the bank and market conditions, this may take the structure of price shading or wider spreads.  For its efforts, the ECN collects a commission for each transaction.

Beside the commission factor, other disadvantages need to be considered by a speculator before using an ECN.  For example, most offer significantly less leverage and only permit full lot transactions.  Under specific market conditions, a bank may pull out their liquidity, which will leave traders without the opportunity to get into our out of positions at a chosen price.

Trade Mechanics

Given that there is in excess of $2 trillion a day being traded on the forex market, it’s easy to believe that there will always be enough liquidity in the market to do what needs doing.  Sadly, belief doesn’t negate the truth that for each and every buyer in the market, there MUST also be a seller, otherwise no transaction can occur.  If an order is too big to handle at the current price, then the price has to move to a point where there is enough open interest to cover the transaction.  Each time you see a price move even a single pip, it’s an indication that an order was transacted or executed which “consumed” the open interest at its existing price.  Prices can move in no other way.

As we discussed previously, each bank lists on the Electronic Broking Service how much and at which price the bank is willing to transact in a given currency.  It’s important to note that Interbank participants are under no obligation to enter into a transaction if they feel it is not in their best interest.  Remember, the Interbank has no “market makers;” only speculators and hedgers.

You may notice that there is generally open interest of different sizes at different prices. Each of those units represents an existing limit order; in this example, then, each unit is representative of $1 million in currency.

Knowing this information, say a market sell order is placed for 38.4 million, then the spread would widen instantaneously from 2.5 to 4.5 pips simply because there would not be any orders that were between the 1.56300 price and the 1.56345 price.  The spread wasn’t increased by any broker, bank or market maker; it was a natural byproduct of the sell order that was placed.  Provided there were no additional orders, the spread would continue to remain that large.  Fortunately, at some point in time, someone somewhere will look at a price point somewhere between those two figures as an ideal opportunity and place an order.  Such an order will either consume (remove) interest or increase it; the action it takes will largely depend on whether or not it’s a market order or a limit order, respectively.

You may wonder what might have happened if a sell order for 2 million is placed, just a split second after the 38.4 million order hits?  That order would be filled at 1.5630.  You may ask why was that order “slipped?”  Because no one was willing to take the flip side of the deal (at 1.56320).  It’s not that anyone was trying to cheat the trader; again, it was merely a by-product of the order flow.

The more interesting question would be what if all of the listed orders were canceled suddenly?  In that case, the spread would increase to the point at which there would exist bids and offers.  Now, that might be 5, 8,10 or even, say, 100 pips.  It will widen to whatever is the difference between the bid price and the offer price.  Nobody came in to “set” the spread; they merely refused to enter into a transaction at any price between it.

You can’t force an order into existence that simply doesn’t exist.  Regardless which market is under examination, or what broker is attempting to facilitate a transaction, it is nearly impossible to avoid both spreads and slippage.  In the trading world, they are simply a fact of life.

Speculator Implications

Trading has often been justifiably described as a zero sum kind of game.  If Trader Alpha sells a commodity or security to Trader Beta and the price of it goes up, then Trader Alpha just lost money on the transaction.  However, if the price of the security goes down, then Trader Alpha made money from Trader Beta’s mistake.

Even in an enormous market such as the Forex market, each transaction must have both a buyer and seller, and, without fail, one of the participants will lose money.  Generally, this is essentially irrelevant to the participants within the general realm of forex trading.  But there may arise certain situations where it does become significantly important, and one such situation is a media event.

Of late, there has been a great deal of talk about how, during some spectacular news event, it is (or should be) illegal, immoral or in some cases, just plain evil for a broker or a bank or some other liquidity provider to cancel or withdraw their order (which increases the spread) or for a slip order to be executed (as though that was really what they wanted in the first place) more then normal. 

Cancellations and slip orders occur for specific reasons that have absolutely nothing to do with anyone trying to screw everyone else.  Let’s look at an example which will help explain why these things happen.

Leading up to the release of an economic report, certain traders will generally enter into a position (one way or another) in anticipation of the news.  As it becomes imminent, banks on the Interbank market will pull or remove their speculative orders in fear of significant losses.  Technical traders will also pull their orders, as it is a common practice that they avoid the news altogether.  Macro traders and hedge funds are already positioned or else they’re waiting until after the release of the news to make a decision which is dependent upon the result.

Where, then, is the liquidity, which is necessary to preserve a tight spread going to come from?

Moving down to the second tier, a bank is only willing to provide liquidity to a retail broker or an ECN if they can immediately hedge the positions on Interbank with, of course, the requisite spread.  If the Interbank spreads widen as a result of lowered liquidity levels, the bank will have to broaden the spreads applicable to their “downstream” players, also.

At the third tier, the ECN’s are merely passing along the banks’ offers, so spreads will continue to widen to their customers.  The retailer that guarantees spreads of between 2 and 5 pips just created a huge hole in his risk profile as he can no longer hedge his net exposure.  In turn, the variable spread retailers widen their spreads to match the banks’ or else they will run into the same kinds of problems that the fixed spreads brokers are having to deal with.

Now, let’s think about all of this for just a moment. What will happen if a number doesn’t hit what its expected to hit?  How many traders are going into this with positions wrongly chosen, who will need to get out of that position ASAP?  How many macro traders or hedge funds will instantaneously drop their macro orders?  And how many retail traders’ issued “straddle” orders?  What numbers of them will be waiting to hear about a miss and execute their market orders?

And with the technical traders sitting out on the sidelines, who in their right mind is going to be so foolish as to take the other position on all of these orders?

The simple answer is no one will be that foolish.  Within 5 seconds of the news hitting, it is a just a single direction market, one way or the other.  And that long pin bar which you see graphed is the grand total of two prices -- the one just before the announcement and the one right afterward.  However many pips are between them is the gap.

It should come as no surprise that slippage occurs at this point in time.

Conclusions

Each and every tier of the foreign exchange market has distinct advantages and disadvantages. Depending upon your priorities, you need to choose between the restrictions and limitations you can accept and those you cannot.  It should go without saying, but you cannot always get everything that you want.

If you focus only on slippage and spreads, the natural byproducts of order flow, you are pursuing a futile ideal and passing up on enormous opportunities to capitalize on the market’s true inefficiencies.  News and media events are but one of the times when a large number of participants are inappropriately positioned and it’s fairly easy to make a profit from their stupidity. 

If a forex trader really wants to take profitability to the next level, they should spend their time focusing on how best to identify these positions, and trade with an objective to capturing the price movement which they will, inevitably, cause.

No one is going to argue that a foreign exchange broker is the foreign exchange trader’s best buddy, but they still can and do provide an invaluable service, and their efforts need to be appropriately compensated.  By accepting a forex broker for what he is, and what he can offer, learning how to work with him, given the limitations of their relationship, traders will have access to a wealth of opportunity that they could never otherwise envision.


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