I received the following concern from among my list members today:
“… you referred to the currency exchange cash market and the fact that this is generally a market in between banks throughout nations. Does this mean that, for example, the EURO/USD exchange rate is set in between the Federal Reserve and the ECB? Is that how a rate is established without the advantage of any trading on any noted exchange anywhere else? Thanks for the quick education on this particular point.” – Joe Z.
The Forex spot market is mainly an “interbank” market. That suggests the majority of the trading volume is done bank-to-bank such as between Citibank and Goldman Sachs. This trading is normally done on behalf of banking clients such as international corporations, though the banks likewise trade with each other both to hedge their currency direct exposure and to take on trading positions.
This sort of market structure is the same as the one for the majority of cash market government debt trading, such as that for United States Treasury Bonds and so forth. You can think of it like the over-the-counter market for stocks. Those trades don’t go through an exchange, however are done straight broker-to-broker.
In both Forex and fixed income there are big players like hedge funds that participate together with the business and financial investment banks. The world’s central banks are likewise significant participants at this level in their attempts to influence exchange rates ( Forex) and/or rate of interest (set earnings).
The deal sizes in the interbank market are big – typically $5 million and up. Clearly, the average private trader is not going to be trading anywhere near that huge. That’s where the online brokers and Forex dealers can be found in to play. They permit small traders to do deals in significantly lower quantities. In fact, there is at least one which will do trades as little as $1.
Numerous of these Forex dealerships in fact act as market makers with their clientele. This is something which can sometimes take place in the stock market as well, especially with OTC stocks. Is a dealer who will be taking the other side of your trade going to be acting in your finest interest when you put on a trade?
While it might be true that some deceitful dealerships might make the most of their clients because way, I am rather confident that most of them are not acting versus their clients. They just provide liquidity to the market and make the infect do so. When they have an extreme exposure to any specific currency, they offset it by hedging in the interbank market or with another dealer. That’s essentially the same as a flooring trader on any exchange.
Getting to the question of how rates get set, the market does that, not the reserve banks. Each individual bank and dealer is actually setting its own rate. That may sound a bit unusual in that it would create various rates all over the place. The reality of the matter is, however, that costs in between dealerships and banks are almost always going to be extremely, extremely close. There are services such as Reuters where dealer costs are aggregated and presented in data feeds, permitting everyone to understand the current (and historic) market rates. Arbitrage trading keeps dealers from pricing estimate rates too far from each other.
There is likewise selling the futures market, and the reasonably brand-new currency exchange traded funds (ETFs). The activity there, while only a little portion of the worldwide market volume, also adds to keeping costs in line across the board.