3. How Trading Works - Interbank and the Forex

The forex market has many players, large and small

As discussed before, like most markets, the forex essentially works because many participants are buying and selling a fairly uniform product. Currency contracts at the retail level are most often denominated in 100,000 or 10,000 units of the base currency in the pair. There are many dealers who will break a lot into units smaller than that, but a full-size 100K or mini-size 10K lot is the most common.

Forex dealers can be classified as over-the-counter market makers. That means that when you are buying a currency pair, they are the seller. Likewise, when you are selling a currency pair, they are the buyer. The quotes you see on a trading platform are the prices the dealer is willing to buy or sell the currency contract for.

That seems pretty straight forward, but you may wonder how the prices offered by all the dealers are virtually identical if they (the dealers) are independent. That question causes a lot of confusion in the market, even for experienced traders. Oddly enough, the source of that confusion is, in some cases, the dealers themselves.

That's why it's vital to educate yourself on the dealing process, and to carefully investigate a dealer before opening an account.

To get a better idea how all this works behind the scenes, let’s take a look at forex market participants and how they relate to each other.

Banks—The "Interbank Market" is one of the most misused terms in the retail forex market. The interbank market is what it sounds like; a network of banks that trade currencies with each other. There are a lot of banks in the network, and many of the largest forex dealers are considered part of the interbank market. Each of these banks trades with the other banks in the intermarket through the use of dealing, or trading, desks. Each bank’s dealing desk is in contact with the other banks’ desks as though they were on an exchange floor. So many transactions take place throughout the day that the interbank market participants have very uniform pricing. In other words, if you froze time, the prices available for a forex pair would be virtually identical from bank to bank.

Forex Dealers—Institutions who service the retail market and have access, through brokerage agreements, to one or more of the banks involved. The dealer receives current pricing on each forex pair from the banks they have relationships with. The price one dealer sees is the same as the price the other dealers see, because they all have access to the interbank market. In fact, many dealers use the same major banks—like Goldman Sachs or Deutsche Bank—to access the interbank market. A forex dealer will then send these prices through to you, the retail trader, in your trading station.

Dealers make money through the "spread." The spread is the difference between the price a dealer will buy a currency contract from you (the bid price), and the price it can sell that contract to you, or another trader (the ask price). Spreads are an important factor for forex traders to understand, both in picking a dealer, and managing trades. 

The forex dealer may modify currency prices in a couple of ways. First, some dealers offer fixed spreads. The industry term for this practice is “consistent spreads.” Fixed, or consistent, spreads are wider than the spread these dealers pay the banks they are using as a broker and represents a major portion of their revenue. Alternatively, a dealer may offer a variable spread to you the retail customer, which is usually narrower than a consistent spread but may widen considerably when market volatility increases.

When you make a trade with your dealer, they are in turn offsetting that risk through their prime brokerage accounts. For example, if you enter a trade long the EUR/USD, your dealer does not want to be remain short that position as the seller of that lot. Their business is providing liquidity not taking positions. They will offset their customer's positions by trading an opposite position with another participant in the interbank. The actual process can be quite complicated with so many orders coming and going but that is how they manage their risk.

Retail customers—This is you. The retail customer has access to the forex through his/her dealer. Although they are one level removed from the primary interbank market, it is not usually a disadvantage for the retail trader.

Forex Dealer Myths

Now that you know the parties involved in the spot forex market, it is time to talk about some of the myths associated with these participants. Dealers will try to differentiate themselves from each other in the market, but sometimes what they want you to think is not really true. Knowing how dealers occasionally bend perceived reality will help you make informed decisions about what dealer you want to work with.

Myth #1: Direct access to the interbank market

Many dealers promise that they will give you access to the interbank market directly. What they want you to think this means is that you are getting wholesale pricing on your spread. Unfortunately, this isn’t the case. Regardless of your dealer’s specific arrangement with its broker banks, your dealer is still acting as an intermediary. Whether your dealer is filling your order itself using pricing data from its broker banks, or it's sending your order through so its broker banks can fill the order themselves, the access and pricing is the same. The dealer will still be compensated for that service and therefore the process will cost you.

Myth #2: No dealing desk

A dealing desk is the place at an institution where contracts are bought and sold. Your dealer may imply that by trading with them you will not have to work through a dealing desk, giving you better pricing. This is not true. It may be correct that your order won’t be handled by your dealer’s own dealing desk, but your order will eventually wind up on someone’s dealing desk at one of your dealer’s broker banks. If it is going to cost you the same amount of money in the end, does it matter to you whether your order is handled on your dealer’s own dealing desk or Goldman Sachs’ dealing desk? The dealer you work through and your dealer’s broker banks will be compensated for the service they offer, and it will be a cost to you.

Myth #3: ECNs are better than a dealing desk

ECNs are electronic clearing networks that list the orders from professional and retail traders in one place. This adds some nice transparency into where orders are listed, but the actual fills you will get are not usually any better than working with a dealing desk.

The idea behind ECNs is that it should be possible for a retail customer to save some money by setting a limit order in between the normal bid and ask spread. However, you can do the same thing using a regular dealer. Just because an ECN shows you that there are bid and ask orders above and below the current price of the currency pair does not mean that you have any better chance of being filled at one of those levels by trading through an ECN. Those same orders are influencing prices at regular dealers too, even if you can’t see them displayed.

ECNs are managed by clearing firms, which are similar to dealers. And just like dealers, the clearing firms that operate ECNs are looking to be compensated for the service they provide. That translates into a trading cost for you. Watch the video for a detailed visual explanation.