How the Market Work

Unlike any other market, the foreign exchange market does not have any central clearinghouse where buyers and sellers meet to make a transaction. Instead, international banks known as “interbanks” help set the price for currencies around the globe.

The foreign exchange market is labeled as an “over-the-counter” market since there is no central exchange. Investors, speculators, and currency earners and spenders agree to buy and sell to each other.

Trickle Down Currencies

The prices you see quoted for the foreign exchange markets aren’t set by a centralized exchange, so how do we know what the price is for any currency?

The interbanks set currency values for everyone else. These currency values trickle down from the interbanks to the dealers, brokers, and finally, the individual investors.

The graphic above shows how this information flows through the market. Here are a few key points:

1. The interbanks at the top are the ultimate source of information as they act individually.
2. Electronic Brokering Services & Reuters Dealing 3000-XTRA services distribute currency quotes from the biggest banks to smaller players and brokers.
3. Smaller banks pay to link up to EBS and Reuters services. Banks use this data internally, but also use it to interact with forex brokers.
4. ECN services and forex brokers operate between individual clients and the banks. Orders are routed from us, the retail traders, to the smaller banks, which process the orders.

FX & Over the Counter Markets

Surely there has to be a better way to create a currency market than to break it into pieces, right?

Well, not exactly. Even though news breaks on Twitter, and emails can go from China to the US in mere seconds, there still isn’t an easy way to move money between borders. Each country has its own laws, regulations, and procedures for moving currency. Thus, it makes much more sense for forex prices to trickle down from the major wholesale players to retail traders.

In forex, the information and liquidity trickles back and forth from top to bottom. The major banks set prices, and fulfill orders, but they don’t do it directly. Instead, smaller banks work with major banks as a middle man to the ECNs and forex brokers. Brokers are then the middle man to the individual trader.

Whereas middlemen are commonly seen as inefficient in other businesses, middlemen are very valuable to the foreign exchange market. These middlemen enable the market to function, and allow small traders to get in on foreign exchange trading.

Forex has been in existence for a very long time. It wasn’t until technology improved and the internet came about that the market could justify allowing in small traders. Now small traders are the fastest growing part of the market.

In the next article we’ll show you other ways that FX trading differs from other major financial markets.