Structure of Forex Market: Who is the King of Forex Tribe

Ever wondered why price quotes from brokers vary or why a trading system return profits on one broker and loses money on another broker account?

Most fellow traders think it is connected with the spread, the execution time or the brokers which manipulate the price feed. Well, some may manipulate the price quotes but the main reason is the decentralized structure of the foreign exchange market.

Let me show you how the “4 trillion USD chaos” is structured, how the hierarchy looks and how you can benefit from it.

Before examining the major “patient,” the Forex market itself, let’s get to probably the world’s first monopolist in prices – stock markets.  It is a whole public entity (a loose network of economic transactions) for the trading company and derivatives at an agreed price.

Exactly, the price agreed. This is where jack-in-the-box leads to total centralization! All of stock trades MUST go through the single specialist. It totally controls the trades and prices being able to manipulate the quotes it is offering to accommodate its needs. For example, too many seller’s VS few buyers and there is a big chance that stocks left unsold. No deal here for the specialist who here widens a spread or increases the transaction cost to please the sellers. And yes… new sellers are unwelcome in the market.

Stock market = centralized, Forex = decentralized

Stock market counts many “team players” across the Globe: the New York Stock Exchange, that one in London, Hong Kong and other million-citizens-cities. Though different nations, there is only one price that each stock deals with.

The Forex market structure is quite different: there is no single price for a given currency at any time. As result, quotes from currency dealers vary.

In this globalized economy where many businesses have an international exposure the currency exchange does matter for completing transactions.

For example, Honda makes cars in Japan. Then it ships those certainly brilliant machine pieces to the U.S. were common Americans will exchange those cars for their green dollars. And there are the Japanese workers in the country of the rising sun – they expect those dollars to be exchanged for Yens and be paid in their national currency.

And so the companies turn to Forex. Basically, it makes up the whole currency trading “galaxy” where there is a tough struggling between dealers for the best deal.

And there is a big chance to catch a good fish with a daily Forex market turnover of about $4.0 trillion.

That is more than $500 a day for every man, woman and child on this planet.

The huge trading volume represents the largest asset class leading to very high liquidity. The variety of factors affecting exchange rates really struck the mind. And again, in comparison to stocks, you can trade Forex wherever you are – with Internet at hand.

The Forex Hierarchy

Even such looking chaos can sometimes be put into order and have its levels. It is also about Forex market.

The “top level” party of the FX hierarchy belongs to the major/smaller banks and securities dealers. They trade with each other, directly or via the Electronic Brokering Service (EBS) or Reuters Dealing 3000-spot Matching. This two electronic trading has always been struggling for clients and getting bigger market share. Leaving the technical issue behind you as a trader could be interested in what they are offering in pair’s trading.

EBS platform provides high liquidity on majors while Reuters excellent market depth on cross pairs.

Like in real life, the rates will be largely dependent on the established credit relationship between the trading parties. The better your credit standing and reputation with them, the better the interest rates and the larger loan you can avail.

The next Forex hierarchy level belongs to market makers, hedge funds and retail Electronic Communication Networks (ECNs). As these institutions provide speculative operations, they don’t have tight credit relationships with the participants of the interbank market. So, their rates are slightly higher and more expensive.

The bottom Forex hierarchy level is occupied by the retail traders. They can become a part of this Forex herd indirectly through brokers or banks. As the Internet, electronic trading platforms and retail brokers saw the light of the day, Forex is kindly opening its doors to practically everyone who wants to be a trader.

At the bottom are we retail traders who deal through Market Makers and ECN Brokers on the Forex market.

Different brokers = different quotes = different results = bee in the pants?

Because of the very specific Forex market structure we traders have to deal with different price feeds. This spring I tested the same system with the same settings, on the same VPS on 3 different broker platforms and “surprise”. The results were quite different.

On the first account the system banked +296 Pips, on the second +210 Pips and on the third -47 Pips. It has to be said that I used a short term trading system for testing. Those kind of trading systems are in general more sensitive but even with a long term system the results will vary from broker to broker.

To avoid bad surprises I suggest that you trade with minimal lot size whenever you start using a new system or switch to new broker.

Although the fact of different price feeds are somewhat like an unwelcome bee in the pant, there is one awesome way, we can make them work for us to bank large profits. And I mean REALLY LARGE. I will share my “detailed insider knowledge” in one of my next blog posts. So, make sure you subscribe to the blog and stay tuned.

Read more about Forex market structure and Forex Hierarchy on Pipburner blog.