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Forex Market Structure
For the sake of comparison, let us first examine a market that you are probably very
familiar with: the stock market. This is how the structure of the stock market looks like:
By its very nature, the stock market tends to be very monopolistic. There is only one entity,
one authority that controls prices. All trades must go through this specialist. Because of
this, prices can easily be altered to benefit the authority, and not traders.
How does this happen?
In the stock market, the specialist is forced to fulfill the order of its customers. Now, let us
say the number of sellers suddenly exceeds that of the buyers. The specialist, the sellers
in this case, is left with a bunch of stock that he cannot sell-off to the buyer side.
In order to prevent this from happening, the specialist will simply widen the spread or
increase the transaction cost to prevent sellers from entering the market. In other words,
the specialists can manipulate the quotes it is offering to accommodate its needs.
Trading Spot FX is decentralized.
Unlike in trading stocks or features, you do not need to go through a centralized exchange
like the Johannesburg Stock Exchange (JSE) and New York Stock Exchange with just one
price. In the Forex market, there is no single price for a given currency at any time, which
means quotes from different currency dealers, will definitely vary.
Below is an example of what the decentralized Forex market structure might look like:
This structure may seem overwhelming at first, but this is what makes the Forex market
so unique! The market is so huge, and the competition between dealers is so fierce that
you get the best deal more or less every single time.
Furthermore, one cool thing about Forex trading is that you can do it anywhere, as long as
you have an internet connection and access to your trading platform.
The FX Ladder
Even though the Forex market is decentralized, it is not pure and utter chaos! The
participants in the FX market can be organized into a ladder, better referred to as Tiers to
professional traders. To better understand what we mean here is a clear illustration:
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At the very top of the Forex market ladder is the interbank market. It is made up of the
largest banks of the world and some smaller banks, and the participants of this market
trade directly with each other or electronically through the Electronic Brokering Services
(EBS) or the Reuters Dealing 3000-Spot Matching.
The competition between the two companies - the EBS and the Reuters Dealing 3000-Spot
matching - is similar to Samsung and iPhone. They are in constant battle for customers
and continually try to one-up each other for market share. While both companies offer
most currency pairs, some currency pairs are more liquid on one than the other.
For the EBS platform, EUR/USD, USD/JPY, EUR/JPY, EUR/CHF, and USD/CHF are more
liquid. Meanwhile, for the Reuters platform, GBP/USD, EUR/GBP, USD/CAD, AUD/USD,
and NZD/USD are more liquid.
All the banks that are part of the interbank market can see the rates that each other is
offering, but this does not necessarily mean that anyone can make deals at those prices.
Like in real life, the rates will be largely dependent on the established CREDIT relationship
between the trading parties.
Next on the ladder are the hedge funds, corporations, retail market makers, and retail
ECNs. Since these institutions do not have tight credit relationships among the participants
of the interbank market, they have to do their transactions via commercial banks. This
means that their rates are slightly higher and more expensive than that who is part of the
interbank market.
At the bottom of the ladder are the retail traders. It used to be very hard for individuals
to engage in the Forex market but thanks to the advent of the internet, electronic trading,
and retail brokers; the difficult barriers to entry in Forex trading have all been taken down.
This gave the individuals a chance to play with those high up the ladder.
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