The boring stuff that you probably ought to know - if you’re going to make a successful trader.

There’s quite a few people who trade on the retail forex market every day, who watch their charts go up and down, click on their trades, but only have the very vaguest idea of what’s happening in the big wide world out there. Here’s the very simple version – how the retail forex market works in relation to the world of the big players, banks, institutions, the people we love…

Two quick points to clarify first (which you may well know already).

1. Watching pairs go up and down – you aren’t seeing ‘the forex market’ – you’re seeing your chosen broker’s version of that market. Which is a completely different thing.
2. Liquidity. If you buy something, there must be someone willing and able to sell you it first – the stuff has to a) exist and b) be owned, even if it is a fairly notional ownership at times. Otherwise, no forex deal.

The Interbank Level
The top level of the fx market is known as the Interbank level. It’s not a centralised exchange, in the same way as stocks usually will have an exchange, with intermediate brokers entering the market on behalf of clients – the Interbank level is essentially a collection of bids and offers existing at any one time in order to make potential currency transactions.

So how do they know? How do they communicate?

EBS/ICAP & Reuters
The Interbank market is held together, mainly, by 2 large communication systems, Electronic Broking Services (EBS) currently owned by ICAP, and the snappily-named Reuters Dealing 3000 Spot Matching (also known as Reuters D2).

EBS is used predominantly for the various EUR, USD, JPY and CHF crosses, while Reuters D2 concentrates on the GBP, and commonwealth currencies AUD, NZD crosses – it’s just the way they work.

With these systems, a participating bank can see the immediate, spot, prices that other Interbank members are prepared to make transactions on.

The Internal Level
The next level of the market exists within each bank – given the supply and demand for individual currencies, they’ll juggle balances around, between branches say, between accounts in currencies other than their home currency (whatever that happens to be), and over-the-counter. Transact business with a bank in this way, and you just have take or leave what they offer in terms of a deal.

A few US citizens, just a few, don’t get out and about very often, and might find it amusing to get on down to their local mainstreet bank and ask about changing some currency – and when you find out the commission + spread they operate on over the counter, will probably feel a bit happier about 4 pip spreads…

Retail Forex market
And this is where the retail forex market comes in. Your online broker, whoever they are, will have a deal set up with one of the Interbank players (usually it’s only one, occasionally more). What the online forex broker (strictly, they’re forex dealers) needs is immediate liquidity to cushion moves either way and keep their overall position under some kind of control. Ultimately, the bank will be hedging these positions built up via EBS.

The brokers aren’t getting the same deal as if they were on the Interbank level directly, but they’re getting something closer to it. They will, firstly, match up their internal orders from us guys – one says buy, another says sell, and the broker must collect on the spread – then, secondly, if things get too far out of balance, the broker has access to their liquidity provider to secure any overexposure in the position.

So essentially, although going down through the various tiers the transaction terms get worse, flexibility does increase – allowing us smaller guys and gals to trade without commission, in nonstandard lot sizes and higher leverage than otherwise possible (if you think this last is a good thing)…

There’s another twist to the spot forex market – dealing via Electronic Communications Networks, or ECNs, which we’ll look at shortly.