Forex Market Structure
The Forex market is close to being a textbook example of a perfect market that humanity created. Namely, a market is any place where buyers and sellers meet. Perfect competition is achieved when there are many buyers and sellers and they are all informed about who has the best prices. Imagine you can order your favourite pizza for the best price and get it delivered in less than a second. That is what the forex trading market can achieve, yet it only deals with the exchange of currencies.
When we have one seller, be it a bank or a pizza shop, they can set the price to what they think is appropriate, and even manipulate it at their leisure. This type of market is centralised. Obviously, a centralised market is not good for you, unless you are the one calling the shots. The good news is that today, the forex market is a decentralised one, so let us look at the structure of this dynamic market.
Forex Participants – Decentralised Market Structure
The Forex market structure was reshaped with the technology revolution and today, it is an even more efficient market. The Spot Forex market is decentralised and this means that no single or centralised participant is controlling the market. In addition, the many participants impact the price of a currency pair and as such, there is no single price for a given currency at any time. Quotes from different currency dealers vary and so the price you see when trading is the retail price, made by matching your request to buy or sell with the best price offered in the liquidity pool.
While this might all sound chaotic, the fact is, the forex market is well structured and can be likened to having layers or ladder rungs where each participant looks for counterparties. At the top of the ladder, you have the major banks whereas, at the bottom, you have the retail traders. Let us look at what can be found on each rung with the forex market structure.
The Interbank Market
Banks want to deal with huge volumes of forex and are looking for those who can meet their capacity demands. Of course, this is where other banks come in. This forms the interbank market layer of the forex market structure, right at the top of the ladder. The participants of this layer trade directly with each other or through electronic or voice brokers, such as Reuters Matching and EBS (Electronic Brokering Services). These brokers fiercely compete against each other, looking to bring the best rates that can only be achieved when you are connected to a larger number of interested parties. More parties mean better liquidity which leads to better rates. Therefore, some currency pairs are more liquid with one broker than with the other.
It is also interesting to note that all the banks within the interbank market can see the rates that each other is offering, yet this does not mean that any bank can make deals at those prices. Other factors come into play here such as reputation and credit standing.
The Institutional Market
On the next rung of the ladder, under the interbank market, are the hedge funds, retail market maker brokers, ECN brokers, and other financial institutions that are unable to make credit relationships with the major banks, and as such, they need to deal with commercial banks. This forms the bridge in the forex market structure that is in between the interbank market and retail traders. While still offering better rates than for retail traders, the rates here are slightly higher and more expensive compared to the interbank rates.
Moving down to the bottom of the ladder, we have the retail traders. Initially, retail traders were not able to participate in the forex market, however thanks to electronic trading, retail brokers, and the internet, even the person on the street can now trade forex pairs with ease. Retail traders are not always getting the best rates compared to the interbank markets, yet in the battle for clients, facilitated by technology, large reputable brokers can deliver spreads and conditions that make retail traders feel on par with the big banks. To put it into perspective, AvaTrade spreads can be as low as 0.01%. If you want to learn more, continue to our guide on how to trade Forex.
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