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The Interbank FX exchange rate

Interbank and 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.