The foreign exchange market (forex) averages trillions of dollars per day in trading, making it the largest market in the world. Unlike most other exchanges such as the New York Stock Exchange or the Chicago Board of Trade, the forex market is not a centralized market. In a centralized market, each transaction is recorded by price dealt and volume traded. There is usually one central place back to which all trades can be traced and there is often a centralized network of market makers. The forex or currency market, however, is a decentralized market. There isn't one "exchange" where every trade is recorded. Trading takes place all over the world on multiple exchanges without the single characterization of an exchange listing. Instead, each market maker records his or her own transactions and keeps it as proprietary information. The primary market makers who make a bid and ask spreads in the currency market are the largest banks in the world. As such, they form a significant part of the comprehensive forex market overall.
These banks deal with each other constantly either on behalf of themselves or their customers – and they do so through a subsegment of the forex market known as the foreign exchange interbank market. This market can be compared to institutional trading market platforms for advanced derivatives or dark pool trading. It combines elements of interbank transacting, institutional investing and foreign exchange market pricing. Its uses are primarily institutional and involve banks but also can involve institutional traders.
The competition between institutions ensures tight spreads and fair pricing. For individual investors, the foreign exchange interbank market is a primary factor for fueling price quotes as it can be tied to the pricing of the forex market overall. Most individuals are unable to access the pricing available on the forex interbank market, because the customers at the interbank desks tend to be the large banks and then include the largest mutual funds and hedge funds in the world, as well as large multinational corporations who have millions (if not billions) of dollars. Despite this, it is important for individual investors to understand how the interbank market works because it is a factor in how retail spreads are priced, and a variable for ensuring fair pricing from your broker or forex trading platform. Read on to find out how this market operates and how its inner workings can affect your investments.
Who makes the prices?
Trading in a decentralized market has its advantages and disadvantages. In a centralized market, you have the benefit of seeing volume in the market as a whole but at the same time, prices can easily be skewed to accommodate the interests of the investors, especially when large multi-million and multi-billion dollar transactions are made. The international nature of the interbank market can make it difficult to regulate, however, with such important players in the market, self-regulation is sometimes even more effective than government regulations. For individual forex investment, a forex broker must be registered with the Commodity Futures Trading Commission (CFTC) as a futures commission merchant and be a member of the National Futures Association (NFA). The CFTC regulates the broker and ensures that he or she meets strict financial standards. (For more insight on determining whether you're getting a fair price from your broker, read Is Your Forex Broker a Scam? and Price Shading in the Forex Markets.)
Most of the total forex volume is transacted through about 10 banks. These banks are the brand names that we all know well, including Deutsche Bank (NYSE:DB), UBS (NYSE:UBS), Citigroup (NYSE:C) and HSBC (NYSE:HSBC). Each bank is structured differently, but most banks will have a separate group known as the Foreign Exchange Sales and Trading Department. Government banks have some of their own centralized systems for forex trading but also use the world’s largest institutional banks as well. The elite group of institutional investment banks is primarily responsible for making prices for the bank's interbank and institutional clients and for offsetting that risk with other clients on the opposite side of the trade.
Similar to all institutional trading, there is a foreign exchange group, with a sales and a trading desk. The sales desk is generally responsible for taking the orders from the client, getting a quote from the spot trader and relaying the quote to the client to see if they want to deal on it. This process is quite common because even though online foreign exchange trading is available, many of the large clients who deal anywhere from $10 million to $100 million at a time, will be cautious in their trades for risk management reasons. Institutional traders internally must also consider the size of the trade as it can affect pricing.
On a foreign exchange spot trading desk, there are generally one or two market makers responsible for each currency pair. That is, for the EUR/USD, there is only one primary dealer that will give quotes on the currency. He or she may have a secondary dealer that gives quotes on a smaller transaction size. This setup is mostly true for the four majors where the dealers see a lot of activity.
This is important because the bank wants to make sure that each dealer knows its currency well and understands the behavior of the other players in the market. Usually, the Australian dollar dealer is also responsible for the New Zealand dollar and there is often a separate dealer making quotes for the Canadian dollar. Institutional traders usually don’t allow for customized crossing. Forex interbank desks generally deal only in the most popular currency pairs. Additionally, trading units may have a designated dealer that is responsible for the exotic currencies or exotic currency trades such as the Mexican peso and the South African rand. Just like the forex market comprehensively the forex interbank market is available 24 hours.
How do banks determine the price?
Bank dealers will determine their prices based upon a variety of factors including the current market rate, how much volume is available at the current price level, their views on where the currency pair is headed and their inventory positions. If they think that the euro is headed higher, they may be willing to offer a more competitive rate for clients who want to sell euros because they believe that once they are given the euros, they can hold onto them for a few pips and offset at a better price. On the flip side, if they think that the euro is headed lower and the client is giving them euros, they may offer a lower price because they are not sure if they can sell the euro back to the market at the same level at which it was given to them. This is something that is unique to market makers that do not offer a fixed spread.
How does a bank offset risk?
Similar to the way we see prices on an electronic forex broker's platform, there are two primary platforms that interbank traders use: One is offered by Reuters Dealing and the other is offered by the Electronic Brokerage Service (EBS). The forex interbank market is a credit-approved system in which banks trade based solely on the credit relationships they have established. All of the banks can see the best market rates currently available; however, each bank must have an authorized relationship to trade at the rates being offered. The bigger the banks, the more credit relationships they can have and the better pricing they will be able access. The same is true for clients such as retail forex brokers. The larger the retail forex broker in terms of capital available, the more favorable pricing it can get from the forex market.
Both the EBS and Reuters Dealing systems offer trading in the major currency pairs, but certain currency pairs are more liquid and are traded more frequently over either EBS or Reuters Dealing. These two companies are continually trying to capture each other's market shares, but also have certain currency pairs that they focus on.
Cross currency pairs are generally not quoted on either platform, but are calculated based on the rates of the major currency pairs and then offset through the legs. For example, if an interbank trader had a client who wanted to go long EUR/CAD, the trader would most likely buy EUR/USD over the EBS system and buy USD/CAD over the Reuters platform. The trader then would multiply these rates and provide the client with the respective EUR/CAD rate. The two-currency-pair transaction is the reason why the spread for currency crosses, such as the EUR/CAD, tends to be wider than the spread for the EUR/USD and often less commonly traded.
The minimum transaction size of each unit trade is approximately 1 million of the base currency. The average one-ticket transaction size tends to be 5 million of the base currency. This is why individual investors can't access the forex interbank market – what would be an extremely large trading amount (remember this is unleveraged) is the bare minimum quote that banks are willing to give – and this is only for clients that trade between $10 million and $100 million. These types of clients are trading against their balance sheets, for institutional portfolios or potentially for corporate global transactions.
The forex interbank market is a subset of the forex market overall, which in turn comprises the largest trading market globally. The forex interbank market is a driver for all pricing and activity across the entire market, primarily because of its volume, net worth and institutional expertise.
Trading desks for this market are well capitalized and have advanced expertise in forex currency movements and pricing. Just as in global trading markets all over the world, clients in the forex interbank market have some transaction fee advantages due to the large values of trades executed.