Before getting into the Structure of the Forex market, let us analyse the structure of the stock market for a better understanding of the concept.
The stock market is centralised and tends to be very monopolistic. In this market, there’s solely one entity/specialist that controls prices. And, every trader must go to this specialist to place their trades.
The shortcoming of the stock market is that the prices can be altered to benefit the specialist and not traders.
In the stock market, the specialist is compelled to fulfil the order of the clients. Now, for example, let’s say the number of sellers suddenly increases compared to the number of buyers. In other words, the sellers are left with some of the stocks even after selling all to the buyers. So, to avoid the occurrence of this scenario, the specialist simply widens the spread or increases the transaction costs to prevent the sellers from entering the market. Moreover, the specialist even manipulates the quotes it is offering according to its needs.
Thus, this is how a centralised market works. Now, let us get into the structure of the forex market.
Forex Market Structure
Trading the spot Forex market is decentralised. That is, here, you don’t have to purchase security through a centralised exchange like the New York Stock Exchange with merely one price.
The uniqueness of the Forex market is that there is no single price for a currency pair at a time, i.e., the quotes from different currency dealers always vary.
And since this market is so vast and the competition between the dealers is extremely intense, you can get the best prices almost every time.
The Forex market Hierarchy
The contributors to the Forex market can be organised linearly. Below is an illustration that is for the same.
Forex market Hierarchy
Electronic Broking Services (EBS) | Reuters Dealing
Medium-sized and Small-sized Banks
Retail market makers | Retail ECNs | Hedge funds and Commercial Companies
From the above ladder, we can see that the major banks are on the top. These major banks are composed of the world’s largest banks and some comparatively smaller banks. These participants trade directly with each other or electronically through the EBSs or the Reuters Dealing. This market is also referred to as an interbank market.
All banks that come under the interbank market can see the rates each other are offering. However, this doesn’t mean that any bank can make deals with those offered prices. The dealing is largely dependent on the credit relationship between the trading parties. So, the better the credit relationship between parties, the better are the chances for the deal to be made.
Below the major banks in the ladder are the hedge funds, corporations, retail markets, and retail ECNs. These institutions do not have strong credit relationships with the interbank market, so they have to make transactions via commercial banks. Hence, their rates are marginally higher and more expensive than the ones who are part of the interbank market.
Finally, at the bottom of the ladder are the retail traders. Back in the day, it was very difficult for small traders to engage in the forex market. But, the creation of the internet provided them with a path to enter into the market by demolishing all the barriers that existed before.
Hence, this completes the lesson on forex market structure. In the coming lesson, we shall go into more detail about the market movers.