Understanding the Forex Market Structure

To draw a clear comparison, let's begin by examining a market that most people are likely well-acquainted with: the stock market.

Here's how the stock market's structure typically appears:

Naturally, the stock market tends to operate with a significant degree of centralization. There exists a single entity, a specialist, that holds control over pricing.

Every trade must pass through this specialist. This arrangement presents an opportunity for prices to be manipulated in favor of the specialist, potentially at the expense of traders.

How does this manipulation occur?

In the stock market, the specialist is obligated to fulfill the orders of its clients. Now, consider a scenario where the number of sellers suddenly surpasses the number of buyers.

The specialist, in this case, is compelled to fulfill the orders of its clients (the sellers), which can leave them holding a surplus of stocks with no buyers in sight.

To prevent such a situation, the specialist may choose to widen the spread or increase transaction costs, discouraging sellers from entering the market. In essence, specialists can adjust the quotes they provide to suit their needs.

Trading Spot FX: A Decentralized System

Unlike trading stocks or futures, where you must navigate a centralized exchange like the New York Stock Exchange, with a single prevailing price, the forex market operates differently.

In the forex market, there is no singular price for a given currency at any given time. This means that quotes offered by various currency dealers can vary.

While this might initially appear complex, it's what makes the forex market truly remarkable!

The forex market is vast, and the competition among dealers is intense, ensuring that you typically receive the most favorable deal nearly every time.

And let's be honest, who wouldn't want that?

Another fascinating aspect of forex trading is its versatility. It's akin to trading sought-after items like Jordans or rare handbags.

Just as you'd seek out the best deal for a mint condition Air Jordan 4 Retro Eminem Encore 2017, in forex trading, it's up to you to find the most advantageous opportunities out there.

The Forex Market Hierarchy

Despite its decentralized nature, the forex market is not a realm of pure chaos. It operates within a structured hierarchy, with participants organized into a ladder. To illustrate this concept clearly, consider the following illustration:

At the pinnacle of the forex market ladder lies the interbank market. Comprising the world's largest banks, participants in this market engage in direct trading with one another ('bilaterally') or through voice and electronic brokers like EBS Market and Reuters Matching.

The competition between these two entities, EBS and Reuters (now rebranded as Refinitiv), can be likened to the rivalry between Coke and Pepsi. They continually vie for clients and strive to outdo each other in terms of market share. While both platforms offer most currency pairs, certain currency pairs tend to be more liquid on one platform compared to the other.

For the EBS platform, EUR/USD, USD/JPY, EUR/JPY, EUR/CHF, and USD/CHF exhibit higher liquidity. On the other hand, for the Reuters platform, GBP/USD, EUR/GBP, USD/CAD, AUD/USD, and NZD/USD are more liquid.

All banks that participate in the interbank market can view the rates offered by one another. However, this does not necessarily mean that everyone can execute deals at those prices. Similar to real life, the rates depend largely on the established CREDIT relationship between the trading parties. It's akin to requesting a loan from your local bank: the better your credit standing and reputation with them, the more favorable the interest rates and the larger the loan you can secure.

Descending down the ladder, we find hedge funds, corporations, retail market makers, and retail ECNs. As these entities lack close credit relationships with interbank market participants, they must conduct their transactions through commercial banks. Consequently, their rates tend to be slightly higher and more expensive than those within the interbank market.

At the bottommost rung of the ladder, we encounter non-professional traders, commonly referred to as retail traders. In the past, it was quite challenging for individuals to participate in the forex market. However, thanks to the internet's advent, electronic trading, and the emergence of retail brokers, the formidable barriers to entry in forex trading have been dismantled. This has provided us with the opportunity to engage with those at the higher echelons of the ladder and influence their activities.

Now that you're familiar with the forex market's structural hierarchy, let's delve into the fascinating world of forex market participants!