FX Market Structure: The FX market is an over-the-counter market with no centralized exchange. Traders have a choice between firms that offer trade-clearing services. Unlike many major equities and futures markets, the structure of the FX market is highly decentralized. This means that there is no central location where trades occur. The New York Stock Exchange, for example, is a totally centralized exchange. All orders pertaining to the purchase or sale of a stock listed on the NYSE are routed to the same dealer and pass through the hands of a single clearing firm. This structure requires buyers and sellers to meet at the NYSE in order to trade a stock that is listed on this exchange. It is for this reason that there is one universally quoted price for a stock at any given time. In the FX market there are multiple dealers whose business is to unite buyers and sellers. Each dealer has the ability and the authority to execute trades independently of each other. This structure is inherently competitive as traders are faced with a choice between a variety of firms with an equal ability to execute their trades. The firm that offers the best services and execution will capitalize on this market efficiency by attracting the most traders. In the equities markets, the execution of trades is monopolized and there is no incentive for a clearing firm to offer competitive prices, to innovate, or to improve the quality of their service. The FX market has clear advantages over the equities markets in terms of efficiencies created by decentralization and competition.
Forex Market Participants
While the foreign exchange market was traditionally exclusive to all but a select group of large banks, advances in technology and reductions to capital flow barriers have brought in a variety of new participants. Because all of these participants affect the supply of and demand for currencies, it is important to understand the role each plays in the market.
Commercial and Investment Banks
Commercial and Investment banks make up the “Interbank” market and trade on electronic brokerage systems (EBS). These banks trade among themselves via strong credit relationships, and account for the largest portion of FX trading. These banks trade on a proprietary basis (they trade for themselves) and through customer flow (they fill orders for clients outside of the Interbank market). The Interbank market consists of the world’s largest Commercial and Investment banks and caters to the majority of commercial turnover as well as enormous amounts of speculative day-trading volume. These banks will trade among themselves via credit relationships they have established with one another as part of a system of balancing accounts. Large Corporations, Hedge Funds, Central Banks are all customers on the Interbank market. Aside from trading exclusively amongst themselves, these banks also trade with large corporations, hedge funds, central banks, or specialized dealers that cater to smaller retail traders. For example, when a large international corporation based in Japan needs to pay its employees in the United States, they must buy USD with JPY. To buy USD, this corporation will go to a bank to make the transaction. This trading amounts to billions of dollars daily, or about ¾ of daily FX volume. Due to their size and the large volume that they trade, these banks have unique access to: Important information on direction and size of capital flows. This means they may be able to make reasonable short-term predictions on FX movements based on the large positions they hold and trade. Significant capital power they might use to defend their proprietary positions at significant technical levels. This is often what creates support and resistance. Large research departments that offer fundamental and technical analysis to prop traders. All of these factors make it requisite for a good trader to take advantage of all the resources these banks provide. Possible trading opportunities as well as information on the particular interests of banks is disclosed in much of the research these banks create.
Central banks have access to huge capital reserves. Central banks have specific economic goals. Central banks regulate money supply and interest rates. Central banks are large players with access to significant capital reserves. They enter the FX market primarily in a supervisory capacity in order to stabilize money supply and interest rates. Central banks closely monitor economic activity, and have many options available to them to regulate their economies. Many of these options relate to specific policies that greatly impact the FX market. Central banks set the overnight lending rates to change the rate of interest paid on their domestic currency. They buy and sell government securities to increase or reduce the supply of money. They buy and sell their domestic currency in the open market to influence exchange rates. Knowing the policy of a central bank and its opinion of the domestic economy will allow a trader to anticipate what actions the central bank is most likely to take in future policy meetings.
Corporations primarily use FX to hedge against currency depreciation. Corporations also buy and sell currencies in order to meet payroll for international offices. Foreign exchange plays an increasingly important role in the daily business of corporations as globalization forces them to make and receive payments in foreign currencies. When international transactions of goods are made, a transaction of currency is also necessary. Whether it is to pay employees abroad or to pay for products coming from a foreign nation, corporations must exchange their local currency for the domestic currency of the nation they are trading with. When a corporation agrees to buy or sell goods to a client in foreign nation at a future date, it runs the risk of its local currency depreciating in the meantime. If a corporation believes that its local currency is expected to depreciate, and as a result the outstanding position is at risk, it would most likely enter the FX market and buy the domestic currency of the country with which it is trading.
GLOBAL MANAGED FUNDS
Many profit-seeking managed funds invest in foreign financial instruments. When they purchase and sell these instruments, an FX conversion is always necessary. Global fund managers (large mutual, pension, and arbitrage funds) invest in foreign securities and other foreign financial instruments. These investments can have substantial impacts on spot price movements because these firms constantly re-balance and adjust their international equity and fixed income portfolios. These portfolio decisions can be influential because they often involve sizable capital transactions. Major changes in equity or bond markets of respective countries dictate the roles of Global Managed Funds in the FX market. When equity markets are performing well they will attract substantial global capital, which will drive a domestic currency higher. To purchase stocks or bonds in a foreign nation, managed funds must exchange their local currency for the domestic currency of the country in which they are purchasing financial instruments. Many of these funds implement currency-hedging strategies. When they wish to hedge existing investments so they don’t incur the risks of depreciating currencies, they can also generate significant selling flows. Under the umbrella of Global Managed Funds are pure FX funds (Global Macro Funds).