ForexRX - Market Structure

The foreign exchange market is the generic term for the worldwide institutions that exist to exchange or trade currencies. Foreign exchange is what is referred to as "Forex" or "FX." The foreign exchange market is an over the counter (OTC) market, meaning that there is no central exchange and clearing house where orders are matched. FX dealers and market makers around the world are linked to each other around-the-clock via telephone, computer, and fax, creating one cohesive market. Since there is no centralized exchange, competition between market makers prohibits monopolistic pricing strategies. If one market maker attempts to drastically skew the price, then forex traders simply have the option to find another market maker. Moreover, spreads are closely watched to ensure that market makers are not whimsically altering the cost of the trade.

Many equity markets, on the other hand, operate in a completely different fashion. The New York Stock Exchange, for instance, is the sole place where companies listed on the NYSE can have their stocks traded. Centralized markets are operated by what are referred to as specialists; market makers, on the other hand, is the term used in reference to decentralized marketplaces. Since the NYSE is a centralized market, a stock traded on the NYSE can have only one bid-ask quote at all times. Decentralized markets, such as foreign exchange, can have multiple market makers - all of whom have the right to quote different prices.

Forex Trader -Centralized Markets

By their very nature, centralized markets tend to be monopolistic. With a single specialist controlling the Fx market, prices can easily be skewed to accommodate the interests of the specialist, rather than those of forex traders. If, for example, the foreign exchange market is filled with sellers from whom the specialists must buy but no prospective buyers are on the other side, the specialist will be forced to buy from the sellers or be in a situation where they cannot sell a commodity that is being sold off and falling in value. In such a situation, the specialist may simply widen the spread, thereby increasing the cost of the trade and preventing additional participants from entering the market. Or, specialists can simply drastically alter the forex quotes they are offering, thus manipulating the price to accommodate their own needs.

While the foreign exchange market is decentralized and employs multiple market makers rather than a single specialist, participants in the FX market are organized into a hierarchy. Those with superior credit access, volume transacted, and sophistication receive priority in the market. At the top of the hierarchy is the Interbank market, which trades the highest volume per day in relatively few, mostly G7 currencies. In the Interbank market, the largest banks can deal with each other directly, via Interbank brokers or through electronic brokering systems like EBS or Reuters. The Interbank market is a credit-approved system where banks trade based solely on the credit relationships they have established with one another. All the banks can see the rates everyone is dealing. However, each bank must have a specific credit relationship with that bank in order to trade at the rates being offered. Other institutions such as online FX market makers, hedge funds and corporations must trade FX through commercial banks. Many banks (small community banks, banks in emerging markets), corporations, and institutional investors do not have access to these rates because they have no established credit lines with big banks. This forces small participants to deal through just one bank for their foreign exchange needs, and oftentimes this means much less competitive rates for the participants further down the participant hierarchy. Those receiving the least competitive rates are customers of banks and exchange agencies.

Recent technology has broken down the barriers that used to stand between the end-users of foreign exchange services and the Interbank market. The online trading revolution opened its doors to retail clientele by connecting market makers and market participants in an efficient low cost manner. In essence, online trading platforms serve as gateways to the liquid FX market. Average Fx traders can now trade alongside the biggest banks in the world, with virtually similar pricing and execution. What used to be a game dominated and controlled by the "big boys" is becoming a level playing field where individuals can profit and take advantage of the same opportunities as big banks. FX is no longer an old boys club, which means opportunity abounds for aspiring online currency traders.

taken from: 1worldfrorex.com