Market Makers on Forex – do they hunt for your money?

The person who first came to Forex and started trading does not think much about who he buys the currency from and whom he sells. For a trader, the quality of the trading platform, the speed of execution of orders, the size of the spread, the availability of currency pairs and other financial instruments are more important. But, when losses start because of unexpected trend reversals and lightning-fast changes of exchange rates, it seems to the trader that the market is against him.

And, the mysterious gray cardinals of the market – Market Maker – control the market from behind the scenes. Who are they? How do they trade? Do they really follow your every stop? Let’s try to understand it.

The search for a specific culprit begins. Of course, is easy to find them. They are brokers and market makers. Most traders do not understand these terms or understand them wrongly. Moreover, on the Internet, you can find many stories of “authoritative traders” about how market makers and brokers manipulate prices and try their best to rob their customers.

The reason for such sentiments is ignorance of the functioning mechanism of the currency market, the role and goals of each of its participants. The beginning trader should understand his role in this market, and what happens after he pressed the “Buy” or “Sell” button. Who gets the order to buy or sell a currency, at what price the order will be executed, who determines this price, as well as who sells and who buys the currency.

Who is the Market Maker?

In the classical definition, a market maker is a financial institution that undertakes to provide liquidity for certain securities on the stock exchange. The stock market makers include large commercial banks and brokerage companies. They are required to comply with the rules of the exchange and financial legislation. The market maker literally means “the creator of the market” – this is the most important participant in the market process, ensuring its viability.

Although the Forex market is decentralized, all its participants are interconnected. Ordinary traders trade through intermediaries – brokerage companies and market makers. If the broker does not have enough of a currency to make an exchange transaction, he refers to liquidity providers, or more precisely – takes the customers’ orders to the interbank market. Brokers also issue orders for liquidity providers when they do not want to risk their own money.

There are many market makers on stock exchanges and everyone has their own tasks. The market maker enters into an agreement with the stock exchange, under which he undertakes to provide liquidity for certain securities or currencies. Under the contract, he must sell or buy financial instruments in cases where there are no other buyers or sellers. And, the main activity of MM is mediation in transactions between sellers and buyers. By collecting bids for sale and purchase, they form the prices.

Market makers have been known since the foundation of stock exchanges. But, after the organization of the market for the international exchange of currencies, their influence increased significantly. The turnover of the Forex market is about 5 trillion dollars a day and most of the operations are conducted by market makers.

More than 50 percent of all currency turnover is provided by four banks. The first in terms of volume is the American Citibank, followed by German Deutsche Bank, slightly smaller are the British RBS (Royal Bank of Scotland Group plc) and Barclays, as well as the Swiss UBS. A fairly significant share is held by the US Bank of America, Morgan Stanley, JP Morgan. Asian markets are dominated by Standard Chartered Bank and Mizuho Bank.

The standard contract on the interbank market is $ 5,000,000. Only a few banks can operate with such capital. Therefore, market makers collect smaller orders in larger ones, called “pool”. Applications for “pools” are submitted by large intermediary companies (prime brokers).

A prime broker is a bank directly connected to trade channels. It is also a part-time market maker, who has obligations to the broker who has concluded an agreement with him on the supply of liquidity. Prime brokers accept applications worth $ 10,000 (and in some cases even less). Such applications are submitted to them by retail brokers, who provide services to ordinary traders-speculators.

Working as an intermediary, the broker makes money on a markup (surcharge to the spread) and commissions. In their turn, Forex clients get access to interbank quotes with relatively small deposits. It turns out that this scheme is extremely beneficial to both the broker and his clients: the first does not risk his capital, and the second gets access to liquidity.

Thus, in the current forex market, the role of market makers has changed somewhat. Market makers have the right to enter into contracts for the exchange of currencies for their own funds. So, there were rumors about the manipulation of prices. In fact, market-maker banks buy or sell currency in cases where the volume of purchases or sales is greatly reduced in the market. So, they stabilize prices, preventing chaos. Market makers fulfill their task of providing liquidity, but do not move prices.

Overlapping of orders (matching)

Forex is a large multi-level system of requests for currency exchange. Most independent traders work at the lowest level through intermediaries. These intermediaries are distinguished by schemes for obtaining quotes and processing orders. There are brokers who only receive quotes from information systems, but do not issue traders’ orders to the interbank market. They are also called dealing centers by the name of this scheme called Dealing Desk.

Many brokers summarize the positions for buying and selling for each financial instrument, and the difference is taken to the interbank market. This is called “matching” and occurs in the automatic mode.

The brokerage company Exness is one of the small market makers. However, it is a prime broker that collects applications from retail brokers. In this picture, you can see how 112 lots of orders for sale overlap within the company, and 122 of 234 lots for purchase are redirected to the interbank market.

Thus, the dollar selling order of trader Joe from the US may be overlapped by the buy order of Mr. Chen Li, who trades at a Chinese broker.

There are also brokers in the A-Book and B-Book schemes. The scheme of the broker’s work, when all customer transactions are moved to the interbank market, is called A-Book. Earnings of the broker consists of commissions or from margins to the spread of the market maker. Under such a scheme, it is profitable for a broker to have traders with large deposits. The minimum deposit at such brokers can be $5000- $10,000.

If the broker operates according to the B-Book scheme, then the transactions do not reach the interbank market, and the broker’s profit is the loss of the client. The reason for this work can be low maintenance costs, which gives advantages in competition. There are also hybrid models, when both schemes are used simultaneously. In this case, the trades of successful traders are taken to the interbank market, and the rest are traded within the brokerage company.

Insurance of risks by market makers

According to the rules of the exchange, a market maker is obliged to buy when no one wants to buy and sell when no one wants to sell. This is a significant risk, and to compensate it and generate income, banks and brokers offer a purchase price higher than the selling price. This difference is called spread. Buying currency is cheaper, and selling is more expensive, a market maker gets an income. The size of the spread may vary depending on the situation on the market. Reducing the difference between the prices of buying and selling is called a spread reduction, and an increase is the spread expansion.

The spread can be fixed in the case of highly liquid or floating currencies depending on supply and demand. Spreads expand during periods of volatile market, as well as before important economic or political events. A wide spread helps reduce market activity and compensates for losses of banks and brokers. For insurance of risks, in addition to expanding the spread, market makers apply hedging, that is, making a compensating transaction. For example, if a bank sells a contract on its exchange, it buys the same contract on another one.

Prohibited Strategies

The undesirable flow of orders in the trader’s jargon is called a “toxic stream” or “toxic”. Toxic, as a rule, is generated by traders who earn on the imperfection of MM-algorithms, or the underlying trading infrastructure.

Almost 100% of the toxicity comes from the algotraders, or rather from their high-frequency trade (HFT). Roughly speaking, it is a very large number of transactions in a very short period of time.

The prohibited strategies include:

• Arbitration on the quotations difference of suppliers;
• News trading;
• One-sided large-volume tearing.

Despite the large overall volumes, the positions do not stay long in the market, which is why ordinary traders do not have time to take advantage of additional liquidity. Such a trade leads to an imbalance in the positions of the market maker and, finally, to losses.

Market makers can fight such trading strategies by changing or stopping pricing for customers creating a toxic stream. It does not matter whether you are trading through a broker or directly with a bank. Some advantages in this regard are given by ECN, since your bids are mixed with the rest, which makes it more difficult for a market maker to identify a specific trader.

Manual trading is almost impossible to classify as toxic, provided that you do not trade through the dealing center. Therefore, trading in a measured way, you will never become a problem for a market maker.

Conclusion

Do not blame market makers for all failures. They provide the Forex with liquidity so that you can buy or sell currency at a reasonable price at any time. In the case of ordinary trading for a market maker, it does not matter whether you won or lost. Problems can arise in the case of high-frequency algorithmic trading or during the news release. But, if you do not use risky strategy for the market maker, then the problems of large players won’t concern you.

Regards, Michael

ForexTradePortal.com