A Structural Analysis of the Forex Market – How the Market Works?

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structural analysis of Forex market

In case you happen to initiate a conversation with your friends and family member about trade markets, they would automatically assume that you are talking about the Stock Market.

When it comes to Forex vs Stock Market, they have very different structures. Let us have an elaborate look at how the Forex Market structure differs from that of the Stock Market and what are the benefits and drawback of each of the two markets. 

The Centralized Market

There is a “Central” medium of operation in the centralized markets. 

Every order that is placed in the centralized market must go through its housing exchange for it to be executed irrespective of the size of the company, or whether you are deciding to open a long or a short position. No matter if you are a small retail trader with limited resources or a large multi-national company with a far-reaching hand, you need to deal with the housing exchange to make transactions in the Centralized market. 

All transactions are handled via the central exchange. 

Benefits:

The potential to Track Transactions

One of the best advantages of a centralized market is that it allows you to track your order and their volume with extreme precision at any given point in time. 

This unique feature lets the centralized markets to produce precise statistical data of all the transactions that go via the central hub to the respective participants of the Forex Market.

The Stock market is capable of producing accurate data on the volume of the transactions which is not possible for the Foreign Exchange market.

Drawbacks:

The Central Hub Controls Everything

The central hub in the stock market through which all transaction take place has the potential to influence prices, increase market spreads and initiate bans on short positions. 

Situation 1: Suppose, due to certain reasons, there are more sellers in the Forex Market than there are buyers. Every seller needs a buyer, however, just for the sake of argument, there is no buyer left in the market who can help with a large number of incoming selling orders. 

Faced with such a scenario, the Central exchange might intentionally increase the market spread to stop more sellers from coming into the market.

Situation 2: There is an imminent economic crisis that has made the traders worried. Now they want to sell off all their stocks. To stop the chaos, the central exchange might decide to raise the spread to prevent the traders from selling their share.

However, at this point, the traders are desperate to sell off their stocks at any cost no matter how high the spread prices are before the market collapses completely.

A point comes when the there are just too many sellers in the market and to stop the market from becoming overwhelmed, the central exchanges put a temporary ban on opening a new selling position in the market.

Just the traders who already hold stocks in the market are permitted to sell their shares. However, in the absence of any buyers in midst of the market crash, the traders are left with little choice but to see their money vanish from right in front of their eyes. 

Restricted Timings

Traders can only trade in centralized markets when the exchange is operating which are usually during the business hours of the exchange’s time zone, from Monday to Friday. 

For instance, it is at 8 am when the New York Stock Exchange opens its gates and closes down at 5 pm in New York time.

You simply cannot trade outside the trading hours due to the simple fact that no transaction can take place without the facilitation of the order of the Central Exchange. 

The Decentralized Market

A market that does not have a central exchange to manipulate all its market activity is called a decentralized market. The Forex Market is an example of a decentralized market.

Instead of a central hub that controls everything, there are a number of hubs and channels that are interconnected with each other. Rather than depending on a single agency, the traders can utilize the multiple channels to make a trade. 

The Internet is a good example of a decentralized network. 

The internet signals that emit from your computer can take one of the million routes to reach their predetermined destination. If there are any issues in one route or if it is blocked, the signal can take an alternative route to reach its destination. The Forex Market too has a similar mode of operation.

Like I said, the Foreign Exchange Market is an example of a decentralized network market. To have a better understanding, take a quick look at the picture below which can give you an idea of the interconnectedness of the Forex Market and how the Forex trading actually works.

The Foreign Exchange market network is organized in a tier system. The large banks that play a central role in the system capture the top-most tier while the retail Forex traders who work from their home are located on the bottom layer. 

Let us see what happens with our trade when we place an buy or sell order.

First Tier: The Interbank Network

Consisting of all the major and central banks, this interbank network is represented in black ink in the chart above. The players in this tier form the basic part of the Foreign Exchange network.

Every order placed in the Foreign Exchange market must go through at least one of the members of this interbank network for it to take effect. It is the Central and the major banks that have the money and provide liquidity to other players in the market to make the trades flourish. The players in the first tier can be likened to the glue of the interbank network that holds everything else together. 

Second Tier: The market makers

Everybody is on the internet today. In case you too like surfing the internet, you need to have an “internet service provider” or ISP who you pay a monthly subscription fee to get access to the World Wide Web and enjoy the many facilities offered by it. 

The Forex Market is not unlike this. In order to make trades in the Foreign Exchange market, you need to sign up with a Forex broker. The broker is like the Internet Service Provider. He is your link to the interbank network that would let you initiate your trading activities on a global scale.

Brokers are the market makers when it comes to the Foreign Exchange market. The broker has his unique ways of earning his profit. For instance, suppose you place an order in the Forex market. The broker first tries to match your order with some other client that he has, thereby completely removing the interbank network from the equation. 

If his endeavor bears fruit, then the broker has successfully made a hedge trade and runs no risk of being at a loss. However, if he cannot make a trade between his clients, he will open a trade that is in the opposite direction of your trade which is also known as a hedge trade. This is done to safeguard him against any potential losses that he may incur because of your trade.

Like the shopkeepers who get their products at a wholesale price which is lower than the market price, similarly the market makers in the Forex Market have access to cheaper interbank network market prices. The market makers get their commission from the difference between the bid and the ask price which is known as the spread. They add their own commission rate to the interbank prices (bid price) and sell the currency to you at a slightly higher price (ask price).

Bid Price: Interbank Networks are ready to sell the currencies to the market makers or brokers at a price which is known as the Bid price. 

Ask price: The price at which the brokers or market makers sell the currency to you is called Ask price.

The broker’s main income is through the Bid-Ask Spread. You can only purchase a currency from the Forex Market at the broker’s predetermined ‘ask’ price. The ask price varies from broker to broker. 

After you place your order in the market, the brokers will then forward it to the interbank network in exchange of a cheaper price. This is how the retail Forex traders earn their commission. 

Every trade placed in the Forex market by the retail traders must go via the brokers. In each trade, the brokers levy a small amount of commission. With the huge amount of transactions that take place on a daily basis, the small commissions add up to a large number and the brokers bank a sizeable portion of the trade. 

ECN Brokers

The ECN broker is quite like the market makers and holds a similar position in the Forex market. 

However, there is a key difference between the ECN brokers and the retail brokers. Unlike the retail Forex brokers, the ECN brokers do not raise the ask price thereby getting a commission on the spread, or at least that is what they claim. 

Rather than the ask price, ECN brokers directly provide you the bid price offered by the interbank network that is quite normally much cheaper. 

So, why does the ECN broker provide the currency at such prices and how do they make their profit? Instead of the spreads, the ECN brokers get their commission from your trades. 

Hedge Funds and Commercial Companies

The second tier position is occupied jointly by the larger speculators such as the Hedge Funds and Commercial Companies.

With bigger bank balances and good spending potential, these players contribute to a significant portion of all the trading activities that happen in the Forex market.

Large speculators are not like retail forex traders who trade through the Forex brokers. They have a mutual understanding and a credit system with the large commercial banks on the interbank network. 

The large banks execute the large trade orders that are placed by the bigger companies to carry on with their everyday business and the hedge funds use for the purpose of speculative trading, that is, to make money from money. 

The Small Speculators

The Small Speculators are made up of retail Forex traders. The difference lies in how deep the pockets are. Smaller speculators have much less investing power than the large speculators such as commercial banks and hedge funds. 

Retail Forex traders only occupy a small percentage of the Forex market volume. However, retail traders too can manipulate large volumes of money through minimal capital because of the leveraging system provided by the brokers. It is the concept of leverage that helps us, retail traders, to successfully make trades from our homes and earn good profits.

The brokers provide the leverage by borrowing the money from the banks on a temporary basis. This provides liquidity for leverage, enabling us to trade with more money than we actually have. However, small speculators have a very high failure rate in the market that has given them the name “dumb money”.

As a matter of fact, around 95% of Forex traders lose money instead of gaining any profit. 

You never want to become a failure statistic in the Forex market. To prevent that from happening, you should always maintain a Forex trading journal and a Forex checklist before you start trading with your money.

With this, we come to an end of this chapter. Now that you are acquainted with the structure and basic principles of the Forex Market, let me tell you how to choose the best Forex trader for yourself. With the market filled with so many wrong choices, trust me on this, you do not want to take your chances and gamble your money away with the wrong Forex broker. 

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