In: Finance
For retail trader understanding the structure of forex market is something that is often overlooked.
This is critical element that needs to be considered when designing and implementing any trading plan. The forex market differs other global markets due to tha way it is structured. The main factors affecting the structure of the forex maket are the ways the forex products are traded, the participants and their motivation, regulation and sheer size of the market. Since transaction in the forex market are done over the counter (OTC) and not though the central exchange.
OVER THE COUNTER
The first thing to understand the about structure of the forex market is the way in which products are traded. Forex is the most part an over the counter market. This means that there is no central exchange though which instruments are traded. When we refer to the instruments we are referring the different forex products participants use to conduct transactions. Whether they be corporate, speculative or hedging. These products include : spot forex, outright forwards, forex swaps, forex options.
When product is traded OTC it is done so through a market maker. Market maker in forex is effectively a banker or broker that facilitates currency trades by providing buy and sell quotes and then taking orders. Orders can be hedged or passed on so that there is no exposure, wached with the internal order book or held by market maker.
Other commonly traded instruments such as shares and futures are exchange traded products, this means that any transaction involving these instruments is done through an exchange such as New York Stock Exchange
Lets Expand what OTC means in case of forex market. Since there is no central exchange through to process orders and transactions, a sophisticated network has been established in order to allow the participants to communicate and transact.. this nework has different levels, each with own institutions serving different functions within the forex market.
Interbank market is essentially a network between larger banks. This network is made possible through electronic banking services and Reuters spot maching systems.
These two networks effectively aggregate the orders of the banks, showing the various bids, offers and amounts that each is willing to transact at.
THE PLAYERS
At the top of the food chain we have the foreign exchange dealers. These are the dealer banks which conduct foreign exchange buiness for their clients or themselves.
On the next level of the forex market we have market that for financial and no financial participants. These may include smaller banks, business, hedge /mutual /pension funds, CTAs and large investors.
Traditionally the majority of foreign exchange turnover has been the result of international flows, this trend has changed In recent years with the majority of turnover being result of capital flows., speculative and hedging activities. This shift reflects the increasing recognition of foreign exchange as a means of generating returns by all market participants, and the need to manage the foreign exchange risks through hedging activities.