We now know why the foreign exchange market exists, so let’s look at how a forex transaction is actually facilitated.
At the very top of the forex market are transactions which are collectively called Interbank transactions. The “Interbank” is not, as some people may believe, an exchange. Rather, it is a collection or compilation of agreements between and among the major money center banks in the world.
An example (yes, another one) may make it easier to understand this thing we’re calling the “Interbank” market. In most larger offices or business, perhaps even in your own home, there may be several computers which are inter-connected by means of a simple network cable. Now, each computer operates independently until the moment it needs a resource, program or file from one of the other computers. When that happens, computer A will contact computer B (or C or D, etc.) and request permission to access the needed resource. If the owner or operator of Computer B authorizes it, and if Computer B is functioning the way it should be, then the needed file or program can be accessed. Within minutes, Computer A’s request is fulfilled. It works the same way in the forex market; just substitute Computer A and Computer B for Bank A and Bank B and let resources substitute for currency. You now have the machinations for the relationships that exist within the Interbank system.
By the same context, if you’ve ever tried to locate resources from a computer that isn’t united by a computer network, you probably know full well what a time consuming, inefficient, sometimes futile effort it can be. You have to search each and every independent computer until you’ve found your resource, copy it and then download it to your own computer. Regarding prices and forex currency inventory, the same issue exists within the Interbank market system. If a bank in Taiwan occasionally transacts business with a firm in Sao Paula they need to exchange their currency. In this case, it can be quite difficult to determine what the proper exchange rate between the New Taiwan Dollar and the Brazilian Real should be. Because of situations such as this, the Electronic Broking Service (EBS) and Reuters established their services. For simplicity, we’ll refer to this service as ESB.
In a way, the EBS service acts as a blanket over the Interbank communication links. Through the EBS service, Interbank members are able to see how much currency is available, and the price(s) the other Interbank participants are willing to pay. It’s important to understand that the EBS is not in itself a market nor is it a market maker. The EBS system is merely an application allowing bank members to see offers and bids from the other members.
The forex market’s second tier essentially exists within each individual bank. If you were to call your local Citibank branch, they can arrange for you to exchange your U.S. Dollar for the foreign currency of your choosing. In all probability, they will likely just move the desired currency from one bank branch to another one. This is known as a single party micro-exchange, so you are pretty much at their mercy as it applies to the foreign exchange rate you’re quoted. You can either accept their “kind” offer or shop around for a better rate. Anyone who trades in the forex market should consider paying their bank a visit, at least once, to have an idea of their quotes. Certainly, it will be very “enlightening,” if not downright shocking, to see just how profitable these transactions are… for your bank.
The third tier is the retail market. Established foreign exchange brokers such as Forex.com, Oanda and FXCM, etc. or any broker who wishes to set up a retail operation, needs first to find a liquidity provider. The large majority of these forex brokers sign an agreement with a single bank. This bank agrees to provide liquidity only under certain conditions: That is only if they can simultaneously hedge it on EBS, including their desired spread.
These spreads will be highly competitive, and that is because that volume will be much greater than any single bank patron would ever transact. Bear in mind, banks are in the business to make money, and third tier providers will almost never precisely match what actually exists on the Interbank system. Banks collect the spreads and no agreement between them and a forex retailer is going to alter their priority.
Think of retail forex as a kind of casino. Most of the participants have little or no knowledge of trading effectively or successfully and, as expected, they’re consistent losers. The forex broker has the house advantage because of the inherent spread system and the normal probability distribution of returns. What results, is a system that plays one loser against one winner and collects the spread. If there is a dis-equilibrium within their internal order book, a broker may hedge the exposure with their second tier liquidity provider.
Though it may not sound good, there are significant advantages to the speculators that work with them. Since it is “internal,” many features, such as high leverage on an account with only a small balance, a non-standard contract size, and commission-free transactions can be provided which may not be available through any other means.
An ECN or Electronic Communications Network operates similarly to a second tier bank, but it exists, rather, on the third tier. The ECN generally will establish a liquidity agreement with more than one second tier bank. Instead of internally matching the book orders, it just passes the quotes through from the banks, as they are, to be traded. You might look at it as an EBS, of sorts, intended for the little guys. While there may be several advantages to the model, it still isn’t the Interbank.
Understand this, the banks are either going to make their desired spread, or they won’t even bother trying. Depending on the bank and market conditions, this may take the structure of price shading or wider spreads. For its efforts, the ECN collects a commission for each transaction.
Beside the commission factor, other disadvantages need to be considered by a speculator before using an ECN. For example, most offer significantly less leverage and only permit full lot transactions. Under specific market conditions, a bank may pull out their liquidity, which will leave traders without the opportunity to get into our out of positions at a chosen price.
