For the sake of comparison,
let us first examine a market that you are probably very familiar with: the
stock 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 order of its clients. Now,
let's say the number of sellers suddenly exceed 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 its 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 that for a given currency at any time, which means
quotes from different currency dealers vary.
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 baseball cards. You want that mint condition Mickey Mantle rookie card,
so it is up to you to find the best deal out there. Your colleague might give
up his Mickey Mantle card for just a Babe Ruth card, but your best friend will
only part with his Mickey Mantle rookie card for your soul.
The FX Ladder
Even
though the forex market is decentralized, it isn't pure and utter chaos! The
participants in the FX market can be organized into a ladder.
At the very top of the forex market ladder is the interbank market. Composed of
the largest banks of the world and some smaller banks, the participants of this
market trade directly with each other or electronically through the Electronic Brokering
Services (EBS) or
the Reuters
Dealing 3000-Spot Matching.
The competition
between the two companies - the EBS and the Reuters Dealing 3000-Spot Matching
- is similar to Coke and Pepsi. They are in 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 plaform, 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. Just to name a few, there's the "B.F.F.
rate," the "customer rate," and the
"ex-wife-you-took-everything rate." 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 larger loan you can avail.
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 the retail traders. 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. 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!
