Sunday, 9 October 2016

How does the FX market actually work?

I get this question all the time. " How does the FX market actually work?"  It is the biggest traded market in the world, bigger than the combined equity turnover of New York and China stock markets and yet little is known about the FX market. The volume is so huge but how is it that we don’t even see a fraction of the  volume being traded?

In the FX market, there is no regulated exchange where trading takes place like the stock market.  It is more like a network of banks operating among themselves. There is less transparency and that is why the FX market place remains so secretive and elusive.
At the heart of the FX market place is the electronic broking system. This is a electronic system, where buyers and sellers try to find each other through price discovery. Buyers will place bid for amount they want to buy in the respective currency pair. They can also buy  the offers put up by the sellers.

There are a few electronic broking systems in use today like FXall,  Reuters dealing system and Bloomberg just to name a few. Banks may also call another bank over a dealing system to ask the other for a direct quote on a specific currency pair and a specified amount. This is how dealing and trading takes place between banks.

Have you ever wondered why FX has no daily volume reported? Trading takes place across different platforms as well as direct bank to bank dealing. Competitors are not going to report the volume they are handling and  there are no regulation for the banks  to report their trading volume. As a result,  there is no daily volume available to FX market participant. The volume we know is reported by the Bank of International Settlement (BIS). This is a survey done every three years based on the currencies handled for clearing by the BIS.  All the trading done by banks are cleared and settled at the BIS.

  Some banks are market makers and they provide prices and quotes to a variety of customers. These customers include central banks, private banks, hedge funds, corporate as well as online brokers. A well known bank platform is the UBS Neo.  UBS clients from corporate to financial institutions, from central banks to hedge banks to private banks can use this platform for their FX needs.

Don’t central banks go directly to the electronic brokering system? No, they do not use the electronic broking systems. They usually transact with banks in their domicile. They will go directly to a bank or a couple of banks and ask for a direct quote.  Corporate like Keppel Corporation and Tiger Airway also tend to use a bank's treasury services. They have currency needs that may be for delivery in 5 months time but they want to convert at the present moment to hedge their revenue or payment. Or they may be interested to swap  one currency for another currency. These are services provided by a bank's treasury and contributed to the FX daily volume.

You have heard of online brokers whose liquidity and spread are good because they use a multi banks liquidity quotes. These brokers get quotes and prices from multiple banks to give  a narrower spread for their retail clients. Almost all the online brokers clear their requirement with banks. I am sure you have come across many brokers who have no dealing desks.

Some FX brokers  are clients of another bigger online broker. In this industry, there are many " white label". A white label means you set up a company and use the service, platform and product of another big broker. 

It is important for retail players to choose their broker wisely . Retail players are not going to get USB Neo unless they have more than US$5m to spare.  It is important to choose a broker with not just strong financial but also strong financial backing from its parent holding.  However retail players tend to choose leverage and spread as their main criteria. And these are how smaller brokers tend to draw clients. The difference in spread is small compared to the daily range. High leverage is a symptom of over trading.

1 comment:

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