limited by the number of participants, which, in turn, limits quantities that can be traded at a given price. Real-time streaming prices ensure that market orders, stops, and limits are executed with minimal slippage and no partial fills.
Since the foreign exchange market is an OTC market without a centralized exchange, competition between market makers prohibits monopolistic pricing strategies. If one market maker attempts to drastically skew the price, then traders simply have the option to find another market maker. Moreover, spreads are closely watched to ensure market makers are not whimsically altering the cost of the trade. Many equity markets, on the other hand, operate in a completely different fashion; the New York Stock Exchange, for instance, is the sole place where companies listed on the NYSE can have their stocks traded. Centralized markets are operated by what are referred to as specialists. Market makers, on the other hand, is the term used in reference to decentralized marketplaces. Since the NYSE is a centralized market, a stock traded on the NYSE can only have one bid–ask quote at all times. Decentralized markets, such as foreign exchange, can have multiple market makers – all of whom have the right to quote different prices. Here is an illustration of how both centralized and decentralized markets operate.
Centralized Markets
By their very nature, centralized markets tend to be monopolistic: With a single specialist controlling the market, prices can easily be skewed to accommodate the interests of the specialist, not those of the traders (see Figure 1.2). If, for example, the market is filled with sellers that the specialists must buy from but no prospective buyers on the other side, the specialist may simply widen the spread, thereby increasing the cost of the trade and preventing additional participants from entering the market. Or, specialists can drastically alter the quotes they are offering, thus manipulating the price to accommodate their own risk tolerance.
Figure 1.2 Centralized Market Structure
Hierarchy of Participants
While the foreign exchange market is decentralized, and hence employs multiple market makers rather than a single specialist, participants in the FX market are organized into a hierarchy; those with superior credit access, volume transacted, and sophistication receive priority pricing in the market (see Figure 1.3). At the top of the food chain is the interbank market, which trades the highest volume per day in relatively few currencies. In the interbank market, the largest banks can deal with each other directly, via interbank brokers, or through electronic brokering systems like EBS or Reuters. The interbank market is a credit-approved system, where banks trade based solely on the credit relationships they have established with one another. The banks can see the rates everyone is dealing at, but each bank must have a specific credit relationship with that bank in order to trade at the rates being offered. Other institutions such as online FX market makers, hedge funds, and corporations must trade FX through these banks, although some have created their own liquidity pools through the years. Many banks (e.g., small community banks or banks in emerging markets), corporations, and institutional investors do not have access to these rates because they have no established credit lines with big banks. This forces smaller participants to deal through just one bank for their foreign exchange needs, and oftentimes this means much less competitive rates for the participants further down the participant hierarchy. Those receiving the least competitive rates are customers of banks and physical currency exchange companies. Recently, technology has broken down the barriers that used to stand between the end-users of foreign exchange services and the interbank market. The online trading revolution opened its doors to retail clientele by connecting market makers and market participants in an efficient, low-cost manner. In essence, online trading platforms serve as a gateway to the liquid FX market. Average traders can now trade alongside the biggest banks in the world, with virtually similar pricing and execution. What used to be a game dominated and controlled by the “big boys” is slowly becoming a level playing field where individuals can profit and take advantage of the same opportunities as big banks. FX is no longer an old boys club, which means opportunities abound for aspiring online currency traders.
Figure 1.3 Decentralized Market Structure
Dealing Stations – Interbank Market
For serious traders who want to know more about the interbank market, the majority of FX volume is actually transacted primarily through the interbank market. The leading banks of the world trade with each other electronically over two platforms – the EBS and Reuters, dealing 3000-spot matching. Both platforms offer trading in the major currency pairs; however, certain currency pairs are more liquid and generally more frequently traded over one versus the other. Some cross-currency pairs are traded over these platforms as well, but others are calculated from the rates of the major currency pairs and are then offset using the “legs.” For example, if an interbank trader had a client who wanted to go long NZDCAD, the trader would most likely buy NZDUSD and USDCAD separately. The trader would then multiply these rates and provide the client with the respective NZDCAD rate, creating a synthetic quote and trade.
Chapter 2
Historical Events in the FX Markets
Before learning how to trade currencies, it is important for every new and seasoned market participant to have some understanding about the most important historical events that have shaped the currency market. To this day, these events are often referenced by professional traders.
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