The Foreign Exchange Market

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The Foreign Exchange Market Powered By Docstoc

                                  Peter Pontikis outlines the primary players in trading
                                      Forex. If you want to learn the game, it is vitally
                                         important to know who the other players are!

The	Foreign	Exchange	Market
          oreign exchange,’ ‘Forex’ or ‘FX’   ents. They also speculate in the currency      course, this is done for a fee. The value
          is the home of the inter-bank       markets should their dealer/traders have       to the banks using this service is that it is
          and wholesale market for ex-        a particularly strong view of the market.      usually done quickly because orders can
changing one currency for another and         What probably distinguishes them from          be placed and dealt in a matter of seconds,
thrives in what is an enormous sea of         the other players is their unique access to    and it avoids the bank having to deal on a
money. It trades across the globe in over     the buying and selling interests of their      competitor’s price and pay the ‘spread’ on
100 currency pairs in the largest of the      clients. This knowledge can provide them       the transaction.
world’s financial markets!                    with insight to the likely buying and sell-
                                              ing pressures on the exchange rates on a       Many of these brokering functions have
Institutional FX                              particular day or other small timeframe.       been significantly computerized, cutting
Basically, Institutional Forex is the big                                                    out the need for human handling of the
end of town when it comes to foreign          Deals are transacted by telephone with         orders.
exchange. Here, we are talking about a        brokers (we will talk about these people
market with daily transactions in excess      later) or via an electronic dealing terminal   Central Banks
of 3 trillion dollars. To be ‘big’ in this    connection to their counter party. The
business is to talk about huge amounts of     usual transaction time is somewhere be-        The majority of developed market econo-
funds being traded in an instant. While it    tween 5 and 10 seconds. The skills of the      mies have a central bank. The role of a
is standard to trade in 5 to10 million dol-   foreign exchange dealer demands agility        central bank tends to be diverse and can
lar parcels, quite often 100 to 500 million   of reflexes and decisiveness, particularly     differ from country to country. In Sin-
dollar parcels get quoted. But what is im-    when we are talking about transaction          gapore for instance, it is the Monetary
portant (and comforting) to note, is that     sizes of multi-million dollar amounts.         Policy of Singapore (or MAS for short)
even financial institutions are vulnerable                                                   and is charged with the responsibility of
to market moves and they are also subject     The ostensible role of the foreign ex-         maintaining an orderly market for the
to market volatility. In a practical sense,   change dealing desk in a bank or other         national currency, which is known as the
what this means is that because the mar-      financial company is to make profits trad-     Singapore dollar.
ket is simply too big, no one player can      ing currency directly and in the managing
hope to control this largest of the world’s   of in-house and clients’ trading positions.    In a practical sense this involves monitor-
financial markets.                            However, their roles will also include pe-     ing and checking the prices dealt in the
                                              riodic hedging or arbitrage opportunities.     inter-bank market. Sometimes, they even
No one is bigger than the market – not        (See the insert below)                         ‘test’ market price by actually dealing to
even the major global brand name banks                                                       check the integrity of the quoted prices.
can lay claim to being able to swing the                                                     In extreme circumstances where the cen-
markets. Thus, so-called ‘insider’ infor-     Brokers                                        tral bank feels prices are out of alignment
mation is not only very hard to come by,      The foreign exchange broker acts as an         with broad fundamental economic values,
it is quite doubtful that even if someone     agent in the same way that a stockbroker       the central bank may ‘intervene’ in the
had it would it be anything but a ‘blip on    acts in the equities market. The slight dif-   market to influence its level directly. The
the screen’ with minimal value.               ference being that they usually confine        intervention can take the form of direct
                                              their activities to acting between inter-      buying to push prices higher or selling to
The Participants                              bank market participants and they do not       push prices down. Another tactic that is
                                              accept orders from corporate clients.          adopted is stepping into the market and
Banks                                                                                        ‘jawboning,’ or commenting in the media
Whether big or small scale, banks par-        Through their extensive and direct elec-       about its ‘preferred’ level for the currency.
ticipate in the currency markets from the     tronic contacts with the banks, brokers
point of view of managing their own for-      take and match currency buying and             Bankers, fund managers and companies
eign exchange risks and that of their cli-    selling orders of their bank clients. Of       all tend to respect the opinions of the cen-

                                                                                                             NOVEMBER 2007                   77
     tral banks (if not always agreeing) as their   Major Dealing Centers                           session, it is normal to keep an eye on the
     sheer financial power to borrow or print       This list of participants does not neces-       course of action emanating from the To-
     money gives it a huge say in the value of      sarily reside in the one geographic center.     kyo market, which is to our north as it
     a currency. The opinions and comments          Indeed, as the global Forex clientele is        takes its part in influencing the course of
     of a central bank should never be ignored      quite dispersed and, as a consequence, so       Asian currency trading trends.
     and it is always good practice to follow       is the market as a whole. When it comes
     their comments, whether it in the media                                                        Do not forget, the above applies not just
                                                    to Forex it is simply not possible, as is the
     or on their website.                                                                           to market activity, but also inactivity. So
                                                    case for the equities markets, to be located
                                                                                                    if these centers are together or separately
                                                    on particular formal exchanges or nation-
                                                                                                    on holiday, do not be surprised when
     Corporations                                   al center points. In practice, the foreign
                                                                                                    trading tends to go quiet. Holidays, like
     As the name implies, this represents com-      exchange market is made up of a network
                                                                                                    economic statistics have a bearing on the
     panies and businesses of any size from a       of dealers and traders clustered in various
                                                                                                    general flow or lack of business and price
     small importer/exporter to a multi-billion     hubs around the globe. They are linked
                                                                                                    activity. Hence it is a good idea to keep
                                                    via computer terminals, telex, telephone
     dollar cash flow enterprise that are com-                                                      a calendar of major international holidays
                                                    and even the Internet or Internet-based
     pelled by the nature of their business to                                                      near when doing your market research
                                                    dealing platforms to form a diverse global
     engage in commercial or capital transac-                                                       and within easy reach to help you recall
                                                    market where prices and information are
     tions that require them to either purchase                                                     them in planning particular trades.
                                                    freely exchanged. Simply put, there is no
     or sell foreign currency.
                                                    single ‘center’ in this market.
                                                                                                    The Inter-Bank World and Direct
     Fund Managers                                  Despite this, the foreign exchange market       Dealing
     These participants in the currency markets     has prominent and major dealing centers         To be considered a foreign exchange
     are basically international and domestic       located in London, New York and Tokyo.          market marker, a bank must be prepared
     money managers. They tend to deal in           We generally call these the ‘major centers,’    to quote a two-way price (i.e. a bid and
     the hundreds of millions, as their pools       not just because of the sheer size of the       offer). Of course, the bid is the market
     of investment funds tend to be very large.     volumes and number market participants          makers ‘buying’ price and their offer
     Because of their investment charters and       in their vicinity, but also because the hap-    price is their ‘selling’ prices to all enquir-
     obligations to their investors, they are       penings in these places tend to influence       ing market principals, whether or not
     constantly seeking the best investment         other dealing centers around the world.         they are themselves market makers in a
     opportunities for those funds.                                                                 particular currency. The price rates are
                                                    These other smaller centers include such        quoted over the telephone, electronically
     In short, they invest money across a range     cities as Sydney, Singapore, Hong Kong,         via digital dealing platforms or, less fre-
     of countries and class of investments on       Switzerland and Frankfurt and they tend         quently nowadays, by telex to dealers in
     behalf of a range of clients including         to take up the remaining balance of trad-       other countries.
     pension funds, individual investors, gov-      ed global currency flow. Thus, these three
     ernments and even central banks. This          main and five minor trading centers are         Market markers ‘earn’ their money by
     segment of the foreign exchange market         the major regions that set the pace of cur-     the difference between their buying price
     has come to exert a greater influence on       rency transaction across the globe.             and their selling price, which is called
     currency trends and values as time moves                                                       their ‘spread’ and these spreads are ex-
                                                    Now, it is also worth mentioning that this      tremely fine for large inter-bank parcels.
                                                    list has practical implications for Forex       For instance, in the $Australian dollar on
                                                    dealing regardless of ones level of sophis-     a parcel of say 10 million $US dollars,
     Hedge Funds                                    tication. It forces everyone, including the     the spread is only ‘5’ in the fourth deci-
     This is a special class of fund manager and    small retail trader to be aware of the most     mal place. In such a case, it is quoted as
     has come to be referred to by their more       recent leading center’s trading activity. In    0.8005 / 10, the difference between the
     appropriate name of ‘absolute return           the case of a Forex trader in Asia, it means    two prices adds up to $5,000 (US) dollars
     funds.’ These high-end funds are general-      at the start of the trading day, looking        profit to the market maker.
     ly more concerned with managing the to-        to the U.S. market action will give some
     tal risk of a pooled investment, than just     clue as to the likely direction of the local    This is an example of a typical Reuter’s ter-
     relative performance, which preoccupies        morning session. A few hours into the           minal based conversation. It shows how
     traditional fund managers. They tend
     to be more aggressive in their investment
     approaches, and will be found adopting
     investment strategies such as borrowing
     to realize leverage potential and will ex-
     ploit the use of derivatives. But they are
     relatively small (though high in profile) in
     comparison to traditional funds.

78                 NOVEMBER 2007
clipped the conversations sometimes are        traders can input their prices directly into    This cuts out the middleman and reduces
between inter-bank dealers. It may also        the computer without the need for a hu-         costs substantially.
look a little like jargon. However it not      man broker to take their prices down. This
really that hard to follow once you under-     is the process of collecting prices from all    These platforms are undeniably in their
stand the basic intention of either side.      contributing banks automatically. And           market infancy and for this reason, they
                                               because of the instantaneous method of
                                                                                               exhibit a large diversity of available struc-
Briefly, Bank A in this conversation is        these platforms, prices are not just indica-
the price taker, that is, he/she is asking     tive, but they are the actual dealing prices.   tures. For example, a bank usually man-
for Bank B’s price in the Australian dol-      This has, in turn, significantly increased      ages a bi-lateral Forex platform, but the
lar versus the US dollar, simply by saying     the speed of the process of price discovery     prices that displayed are those of its cus-
‘oz.’ The amount that they wish to trans-      and also contributed to the market’s over-      tomers. Conversely, a multi-lateral sys-
act is 10 million Australian dollars as the    all transparency, while at the same time        tem has no managing bank or agent and
base currency in the quote.                    reducing the costs to participating banks.
                                                                                               is purely an unofficial foreign exchange
                                                                                               trading system. Naturally, there are regu-
The answer that Bank B provides is simply      Online Portals and the Rise of
the two-way price quote as the last two                                                        latory and privacy issues in dealing with
                                               Electronic Brokers
decimal places. In this case, it is ‘5 –10.’                                                   these innovative platforms and their of-
                                               As if the changes in the Forex brokering
However to avoid ambiguity, Bank A has                                                         ferings, but certainly in the absence of a
                                               industry were not enough, increasingly
requested confirmation of the big figure                                                       worldwide ban, they have emerged as a
                                               and with the unstoppable advances in
of the price. Bank B responds with 8005-                                                       market fact of life that is probably here
                                               technology, as evidenced by the emer-
10, which is the long form of the price.
                                               gence of electronic brokering platforms         to stay. One thing is certain though; the
                                               such as EBS and Reuter’s dealing systems,       marketplace for foreign exchange has
At this point Bank A states what ‘side’ it
                                               the task of customer/order matching is          changed allowing the retail Forex trader
would like to deal; ‘at 5’ meaning the bid
                                               being systematized. This has led to the
side. Now, we know that Bank A wants                                                           to participate and to actively trade Forex.
                                               entire human element of the brokering
to sell 10 million Australian dollars at
                                               process being virtually dispensed with
0.8005 US per Australian dollar. Bank                                                          Conclusion
                                               altogether. This does not mean that hu-
B confirms the deal as ‘done’ and politely     mans do not decide to put on an order or
thanks him. Bank A simply replies with         take them off – that still stays – but the      The global currency markets are inhabited,
‘bye bye for now’ short formed to ‘bib-        people involved between when an order is        but not necessarily controlled by banks. Other
ifn.’                                          put to the trading system up until when         players include brokers, corporations, fund
                                               it is dealt and matched by a counter party      managers, hedge funds and central banks
The New Generation of FX Brokering             is being reduced by technology. This is
                                                                                               as well as retail investors. Though their scale
and Trading                                    called ‘straight through processing’ or, in
                                               other words, the automatic processing of        is huge compared to the average retail Forex
One of the great challenges to the institu-
tional foreign exchange market ha s been       an order as soon as it becomes ‘live.’          trader, their concerns are not dissimilar to those
the emergence of the Internet and Inter-                                                       of the retail speculators. Whether a price maker
net based trading platforms. Not just in       Forex Internet portals do this automated        or price taker, both seek to make a profit out of
terms of enabling access to Forex markets      processing and, in doing so, they have          being involved in the Forex market.
for the retail trader and investor, these      made Forex trading available to a much
changes have challenged the very domain        wider audience of traders and not just          We saw how market makers in the financial
of the institutional investor and how they     bank traders either. Because of the com-        markets are forced to provide competitive two-
handle their foreign exchange business.        petitive pressures of the market place, Fo-
                                                                                               way prices to their clients and are not immune to
                                               rex participants of all types are being given
                                               a choice of available trading and process-      the technological changes afoot in the industry.
On the electronic brokering side, systems
                                               ing systems for all scales of transactions.     These changes pave the way for a lot of inter-
like EBS, which is short for ‘electronic
brokering system’ and price information        Some these new trading platforms include        bank dealing now being brokered electronically
vendors like Reuters are providing com-        FXall, FXconnect, Atriax,,        using various platforms. A phenomenon that
puter platforms where bank dealers and         and all of them are easily available on the     merely mirrors what is already seen at the retail
                                                          web for your further research.
                                                                                               level of Forex trading as the benefits of the new
                                                           These portals provide a crucial     technologies spread democratically.
                                                           step for the retail trader. They
                                                                                               Peter Pontikis is the Group Treasury Strategist for
                                                           allow foreign exchange market
                                                           participants (importantly the       Suncorp Banking. He has also authored a book
                                                           corporations and fund manag-        on trading foreign exchange and is the current
                                                           ers) to by-pass bank dealers in     treasurer of the International Federation of
                                                           being able to access the market     Technical Analysts (IFTA) He can be reached on
                                                           for foreign exchange directly.

                                                                                                                  NOVEMBER 2007                      79

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