Forex trading and prices explained

Forex trading and prices explained

I got the following question from one of my list members today:

"... I sent the money exchange market and the fact that this is basically a market between banks across countries. Does that mean that, for example, the euro / USD exchange rate is set between the Fed and ECB? Is it as the price is established without the benefit of any trading on any listed exchange anywhere else? Thank you for a brief education on this point. "- Stan Z..

The Forex spot market is primarily "interbank" market. This means that most of the volume is done bank to bank, such as between Citibank and Goldman Sachs, for example. This trading is generally done on behalf of banking clients such as multinational corporations, although banks trade with each other and to hedge their currency exposure and to take trading positions.

This type of market structure is the same as that of most money market government debt trading, such as that for U.S. government bonds and the like. You can think of it as over-the-counter market for stocks. Those trades did not go through the exchanges, but are done directly broker-to-broker.

In both Forex and fixed income there are big players like hedge funds, which are part along with commercial and investment banks. Central banks worldwide are also major participants at this level in their attempts to influence foreign exchange (FOREX) and / or interest rates (fixed income).

Transaction sizes in the interbank market are large - generally $ 5 million and up. Obviously, the average individual trader is not going to be trading near that big. That's where online brokers and forex dealers come to play. They allow small traders to make transactions in significantly lower amounts. In fact, there is at least one that will be traded as low as $ 1.

Here is where some people are a little nervous. Many of these forex dealers actually act as market makers with their clientele. By that I mean that the other side of trades carried out by their customers. This is something that can sometimes happen in the stock market, especially with OTC stocks. Concern that people have with this is the means conflict of interest in terms of price execution that creates. Is the dealer who will be taking the other side of your trade will be acting in your best interest when you put the trade?

While it may be true that some unscrupulous traders can take advantage of their customers, thus, I am quite convinced that most of them act against their clients. They simply provide liquidity in the market and earn the spread to do so. When they have excessive exposure to any particular currency, they offset by hedging in the interbank market or with another dealer. It is basically the same as a floor trader on any exchange.

Getting to the question of how prices are set, the market does, not central banks. Each individual bank and dealer is actually setting a price. It might sound a little strange that you create different rates anywhere. The fact of the matter is, however, that prices between dealers and banks are almost always going to be very, very close. There are services such as Reuters where dealer prices are aggregated and presented in data feeds, allowing anyone to know the current (and historical) market interest rates. Arbitrage trading keeps dealers from quoting prices too far from each other.

There is also trading in the futures market, and relatively new exchange traded currency funds (ETFs). Activity there, while only a small part of the global market volume, also contributes to keeping prices in line across the board.