Understanding the Decentralised Interbank Foreign Exchange Market

 

Introduction
As we noted in our article ‘What is the Foreign Exchange Market’, the FX market has an average daily volume of roughly $2 Trillion making it the largest financial market in the World. It is not just the size of the market that makes it interesting but also the way it operates; the forex market is completely decentralised. This means that, unlike centralised exchanges such as the NYSE and LSE, there is no central location where each transaction can be traced and recorded nor do currencies have specialist market makers responsible for providing quotes for the entire market. Instead, the entities that act as market makers for the currency market are the World’s largest banks. These banks carry out transactions between each other on a regular basis, hence the term ‘interbank market’.

What Does This Mean For Us?
The vast majority of individual speculators and traders do not have access to interbank prices the same way a bank does. Access is reserved for large hedge funds and corporations that have established credit relationships with the banks. One example of such a corporation are the retail forex brokers that service the individual trader. These are the brokers that you open an account with when you want to trade FX. Examples include Easy Forex, Capital Spreads and FXCM. These brokers use the interbank prices as the basis for the quotes they offer to you, their customers.
Although forex brokers are essentially operating in a decentralised, and in part deregulated market, they are governed and monitored by organisations such as the Commodity Futures Trading Commission and the National Futures Association (NFA) in the United States and the Financial Services Authority (FSA) in the United Kingdom. Strict financial standards and processes are imposed on retail brokers by these official bodies.

How Are Interbank Prices Determined?
A study conducted by “wall Street Journal Europe” in February 2006 concluded that 73% of all forex volume is done through ten large banks. These banks are the large brand names that we are all familiar with such as HSBC, UBS and Citigroup etc. The constant competition between these banks is what ensures tight interbank spreads. (Incidentally these spreads are passed on to a certain degree through retail brokers because of the increasing competition that exists in their market place. Of course spreads are slightly larger because brokers attempt to earn a profit from their spread).
At every large bank there is a designated Foreign Exchange Sales and Trading Department whose job it is to make prices for clients of the bank and to offset the risk created by any transaction by dealing with other banks.
The Foreign Exchange department is comprised of two teams; the sales desk and the trading desk. The sales desk is responsible for taking client orders (frequently in the $10 to $100 million bracket) while the trading desk is responsible for monitoring and executing these orders on behalf of the client. The process of placing an order via a bank is as follows:

Stage 1	Client calls the sales desk with an order stating size, currency and direction.
Stage 2	The sales desk checks with the trading desk for a quote based on the client's specific requirements.
Stage 3	The sales desk relays the quote to the client for a final decision.

 

On a trading desk there are usually one or more market makers responsible for each currency pair. The number of dealers depends on the amount of volume seen during the trading day. For example, EURUSD (Euro US Dollar) and USDJPY (US Dollar Japanese Yen) currency pairs are likely to have two dealers each; one primary who gives quotes for the largest orders and a secondary who quotes for smaller orders. These dealers will act as specialists for their particular currency pair so that they become ultra familiar with the other players in the market and the way the pair moves. In general the dealer responsible for the USDJPY pair will make quotes for all JPY crosses such as CADJPY (Canadian Dollar Japanese Yen) and GBPJPY (Great Britain Pound Japanese Yen). The trading desk team also includes one dealer who handles AUD (Australian Dollar) and NZD (New Zealand Dollar) (out of Pacific trading hours, there are likely to be more during Australian and New Zealand working hours) and one final dealer responsible for exotics such as South American and African currencies. In order that client positions can be monitored 24 hours a day, each bank’s trading desk will pass on client position information to their foreign counterparts. i.e. At London close orders are passed to New York and so on.

• Current market rate
• Required order size
• Volume available in the market
• Current bank inventory positions
• Perception of current market direction
  

Electronic Brokerage Service (EBS) and Reuters Dealing
There are two main electronic platforms that are used by banks to view the interbank market. Electronic Brokerage Service (EBS) and Reuters Dealing provide these services. They work in much the same way as a retail broker that provides an ECN service, although it should be noted that the quotes and order sizes seen on ECN feeds are not an accurate representation of the interbank market.
Every institution using Reuters Dealing or EBS can see the best market rates currently available. However, due to the ‘approved-credit system’ in operation on the interbank market you may only deal at that price if you have an existing credit relationship with the bank quoting the rate. As you would imagine the larger the bank or financial institution the more credit relationships they have in place, therefore the greater their access to the most competitive rates.

How Do Retail Brokers Fit In?
The way that retail brokers fit into this system is fairly simple. The larger the FX broker (in terms of capital available and credit relationships) the higher the number of banks they can deal with and the greater their access to the best possible quotes. Therefore you would assume that, as an individual speculator, you would have access to the best quotes if you have an account with one of the largest FX brokers. It is also the case that more credit relationships bind the bank to provide liquidity during periods of high volatility such as economic data releases. This means that the largest retail brokers should enable you to trade during the news without requites and freeze-outs. The diagram below shows the relationship between the interbank market and the individual trader.