How does the Forex market ?

Hello friends, traders! We all know that Forex - is an interbank, decentralized market, almost not regulated by anyone. But how do things work in reality? In this article we go through the main aspects: market participants, quotes sources, why Forex has become available to mere mortals, we’ll analyze brokers’ work models and what we can do with it.

Market scheme

Why is Forex market called ‘inter-bank’? It’s very simple - because initially, there was no one other than banks.

Forex was originally conceived as means for the development of commerce and trade between states. The US company buys spare parts, for example, in Japan. Accordingly, the company needs the yen. And if it is a very large company, you need a lot of yen. And where to get it? Buy through a bank. And where the bank will take it? Will buy from colleagues through Forex and sell to the company for a little less favorable rate - will take spread for their services.

If you go to the bank to change dollars or euros to some other currency, you will see that the rates are fixed. They do not change throughout the day.

Through a better understanding of the market, the bank can fixate quotes: take the obligation to carry out an operation at the current rate, in other words, to carry out hedging on the market until the client appears ready to buy at a given price. This process enables the Bank to increase its net profit. The unfortunate consequence is that liquidity could be redistributed in such a way that sometimes it is not possible to complete certain financial transactions.

Only, for this reason, the market had to be opened for non-banks. Banks wanted to have a greater number of orders on the market; so that a) they could profit from less experienced participants, and b) less experienced participants could provide a better liquidity for international business hedge operations. Initially, only hedge funds with big capital were admitted to currency transactions (for example, the Soros Foundation and others), but after a while retail brokerages and ECNs were admitted to currency transactions.

All Forex is in fact, a large and multi-level system of electronic applications for the purchase and sale of foreign currency. The prices that you see – are just the best offers from liquidity providers.

Why is FX market so poorly regulated? One of the reasons - the reluctance of countries to interfere the international trade, which is necessary as air for the healthy functioning of the economy.

Market participants

The participants in the currency market are:

1. Big banks
2. Commercial Corporations
3. Central banks
4. Governments
5. Hedge funds
6. Speculators

Quotes

Primary sources of quotes

Forex market is interbank and most liquidity in Forex is provided by banks. At the same time, only a few of the world’s largest banks provide Forex retail services. Almost a third of the world trade turnover belongs to Citi and Deutsche Bank.

The question of a fair price in the Forex market is very delicate because the foreign exchange market has no concept of a single price as the true value of the currency. Market Decentralization allows making transactions at the same time in different quotes, often invisible to other bidders. The appearance of aggregators (such as Integral, Currenex, LMAX, etc.) not only contributed to the development of the Forex retail market but later allowed to make the business more transparent.

Forex is a decentralized currency market, market prices are formed on the basis of supply and demand and are provided by large market participants (providers of liquidity). Each participant offers his own price, the best of them comes to the platform. The difference in prices is normal as to achieve absolute unity at the prices in the presence of a large number of counterparties is impossible.

Almost always, rates provided by banks, are indicative and do not imply the one hundred percent possibility of the transactions at the offered price. The real value of the contract may depend on many factors, including customer status, ask volume, value dating, trade delays, etc. At the same time, the fulfillment of your orders can be significantly improved by adding to the price of the transaction some markup, that is, intentional deterioration of prices. The less competitive prices you offer, the closer to the real quotes you get. As a result, an attempt of trading at the best prices in the Forex market is almost always fraught with the risk of partial execution or rejections (canceled order).

In fact, all the quotes in Forex are indicative, except the ECN client liquidity. If ECN liquidity has grown so much that could cover the needs of all customers at least within the same broker, it would be possible even to get rid of the concept of indicative quotations at all.

Banks and hedge funds exchange quotes through specialized intermediaries in the form of information systems, such as Reuters, Bloomberg, Tenfor, DBC, etc. At the same time, quotes derived from information systems do not mean the fact of the transaction execution for whatever price, and the result of some real transactions might even not get there.

Liquidity aggregators

In comparison with the stock market, the Forex market has a much higher turnover and, therefore, greater liquidity. This means that you can buy or sell a particular currency on the foreign exchange market as quickly as possible, regardless of volume or time of the trading session.

Brokers providing retail forex services, use the services of aggregators, connecting directly to the liquidity providers (banks) by dedicated electronic communications protocol (FIX). The task of aggregators is to bring together the major banks, financial institutions and funds into a single stream of quotes.

Using aggregator service gives great advantages since it is obvious that it can not offer prices worse than the liquidity of a separately selected provider. Therefore, brokers and dealing centers, as a rule, either use the services of the major aggregators or create their own ones. At the same time, some brokers, for example, may additionally provide their own quotes from customer transactions within the company, thus creating some kind of dark pool’s.

Models of brokers work

Market making

Market-maker is usually a broker or dealing center that is directly involved in the transactions. Its main task is to maintain the two-sided requests for purchase and sale, corresponding the spread size requirements (the difference between the purchase and sale prices), given by the bank.

Brokers operating on the principle of dealing (Dealing Desk), are both buyers and sellers. The main income, in this case, comes from fixed spreads and clients’ trade operations. Such brokers are called dealing centers (DC), or as they say - “kitchens”. DC clients’ applications do not appear for the external contractors and, as a rule, are performed by counter-orders of the broker.

In this case, the broker is a contractor himself and fully monitors and controls all the trading operations of its customers. Earning customers play against the broker and, accordingly, bring him an immediate loss. Therefore, the activity of market makers means the application of various schemes of profitability constraints, including a delay of trading orders, cancellation of transactions, etc.

Today, the pricing on the market is controlled by algorithms. It is obvious that the task of the algorithm used by the market maker is to achieve the maximum difference between the loss and the earnings of its customers. MM algorithms perfection facilitates the presence of insiders, because the banks know the current position of their clients and how they traded previously. At the same time, you can become the owner of MM algorithm. The main objective remains the same - to squeeze as much money as you can out of losing traders.

Toxic Flow

The toxic flow (or toxic) in the Forex market is called an unwanted flow of orders, or rather, any trading activity, which makes a bank or broker start to lose money. This term is used by market makers, and virtually 100% of the toxic flow comes from Algo traders earning on the ineffectiveness of market-making algorithms.

Therefore, it is not possible to create a pure interbank market. For this reason, maintaining fair business in the Forex is possible only through toxic disguise in the general flow of trade orders, when the use of modern ECN/STP aggregators helps. This allows you to create independent dark pool’s where customers’ order can match to each other and become invisible to external counterparties.

ECN/STP

In contrast to market makers, brokers, working on the principle of an intermediary between the client and the contractor, don’t trade directly with customers and don’t earn their profit or loss. They receive the main income through markup and commissions. Further, such brokers are divided into two subspecies: STP (Straight Through Processing) and ECN (Electronic Communications Network) + STP. Fully independent ECN systems do not exist yet.

The main feature of STP broker is direct binding the customer and the liquidity supplier. Typically, aggregator acts as a supplier that may include a plurality of providers, thus providing best prices and increasing liquidity. This type of broker provides a choice between floating or fixed spread. Despite the fact that the major liquidity providers are big banks with a fixed spread, the aggregator has a choice of the best prices of all the offers for sale and purchase. In some cases, this can lead to a zero or negative value of the spread.

The addition of an ECN system provides the possibility of making direct deals between customers of one company. In fact, in this case, the broker provides a platform where banks, market makers, and individual traders can make transactions directly with each other, which sometimes makes it possible to make transactions at the best price, rather than using external contractors. Moreover, it allows almost completely get rid of trade delays (latency) and rejections that give almost perfect performance in case of sufficient liquidity. It is also profitable to the broker because it allows him to take a full transaction fee, not sharing with the main liquidity supplier.

A-Book and B-Book orders

“As soon as I started earning, orders began to be performed worse! Broker started interfering me, Forex is a scam! “- Such cries can be found on the network. What actually happened? Did brokers track your account?

In fact, everything is very simple. Inside one brokerage model (including ECN) there is an automatic distribution: small orders of new and not earning traders are a performer on the basis of B-book - within the company. That allows you to get significantly better performance. Large orders and orders of consistently profitable traders are executed by A-Book - displayed on counterparties. That is causing the delay in the execution, slippage, etc.

So, if after you have started to earn, the performance has deteriorated – it is normal. So your orders were just closer to the “Interbank”.

Conclusions

Forex Market is really huge. One can not say if it is bad or good – you just need to know the nuances and rules of the game to leave it as a winner.

As for the broker work models, it is important to understand that the main factor in the selection of a model to work with, is a profitability of a trading system, rather than the nuances of orders execution. At the same time, the market-making model has its advantages, as it can give a better performance. On the other hand, ECN/STP model gives the best price. At the same time, this model is clearly more transparent, and using markup can significantly improve performance.

Take care, Michael

ForexTraderPortal.com