market. This market can be broken into two tiers—the interbank
market (wholesale) and the retail market.
The Forex OTC market has no physical centralized location. The
New York Stock Exchange (NYSE) has its imposing structure of pillars
and marble on Wall Street. The NYSE has a trading floor of blinking
lights and shouting traders. Even other exchanges or ECNs that don’t
have physical trading floors, such as the National Association of
Securities Dealers Automatic Quotation System (NASDAQ), have a
centralized network where all trade information is collected and
disseminated.
But the Forex OTC is formed by disconnected players who deal
directly with each other. Roughly two-thirds of all Forex transactions
occur between banks, financial institutions, and central
banks. This informal network of dealers and brokers is called the
interbank market. Trading in this market is primarily based on
credit and trading size, generally in the hundreds of millions. Over
200 international banks worldwide, representing every time zone,
have a presence in this unique marketplace.
Because of the trade size and credit requirements, most Forex
traders never get inside the interbank market. Instead, they trade
in what is called the retail or client Forex market. Speculators
trade with an intermediary who then moves the trades into the
interbank market. This accounts for roughly 18 percent of Forex
trading volume.
Since there is no centralized market, activity on the interbank
market gives investors the best sense of where currencies are moving
based on supply and demand.
But not all of this information gets out to investors. A true currency
rate therefore can be different than what some parts of the
market see. In short, there is not a single currency price at any one
time. Traders must take into account large trades that occur quietly
between large players on the inside.
An example is a deal between two major banks that is carried
out over the phone—or “voice-brokered.” Since the deal is between
two self-regulating agencies in an unregulated market, the trade
never has to be reported to a centralized institution or exchange.
The only two players who know the new price of that particular
currency can trade on the information.
Banks, however, have a view of these trades, so this gives them
a major advantage over the small retail investor scanning his computer
screen for news. Eventually, news of the trade gets out, but by
then the banks that participated in the trade already have anticipated
the move and have adjusted their investments accordingly.
The retail investor is the last to know. This “flow” trading plays a
critical role in price movement and this lack of transparency significantly
handicaps a retail trader.
(As an aside, although trading over the computer dominates the
current Forex market, phone calls still play an important role. It
might seem simple, but banks still pick up the phone and call one
another. There is a reason for this. Investors with unusual or large
trades sometimes prefer to keep their trades on the phone, where
they can be secure and private.)
This advantage, however, is not dominant. Retail investors
have incredibly fast access to the Forex market because of recent
developments in technology.
Technology has always been essential to the success of foreign
exchange markets. The term cable, a trading term for the British pound,
comes from the fact that decades ago a transatlantic communication
wire went from Britain to the U.S. for currency traders to trade.
One of the most dramatic shifts in the Forex markets has been
the rise of trading through computers, rather than the traditional
order over a telephone or electronic chat. The New York Federal
Reserve Bank reported in 2001 that the use of electronic trading
systems—such as EBS and Reuters 3000—accounts for more than
54 percent of total interbank spot Forex trading, up from less than
33 percent in 1998.
Most of these trades are carried on two platforms: EBS and
Reuters. Historically, large traders in the interbank market have
always preferred Reuters. This business news organization, based
in London, was among the first to establish a system that could
communicate electronically with counterparties all over the world.
EBS, a UK foreign-exchange solution provider launched in 1993,
claims to carry orders from 2,000 traders on 750 dealing floors
around the world. These two applications provided the usable
technology that ushered in the Forex revolution, making the traditional
phone conversation appear as modern as smoke signals.
EBS and Reuters technology harnessed the communications
power of the Internet and created the only semblance of a marketplace
for traders on the interbank. For the first time, traders could
access the global community, which provided unprecedented liquidity
and depth for spot transactions. Today, most retail platforms
you will encounter have been modeled after EBS.
Read More: The Interbank Market
