Main market players

Market participants with different objectives trade huge forex volumes on a daily basis. One can think of the foreign exchange markets as a pyramid structure. Small traders are at its core. They are many but have limited resources. Their transactions are aggregated by brokers into larger orders to medium-sized banks. They, in turn, control their foreign exchange exposure through deals with the large international banks that stand at the top of the pyramid. The more significant the particular market player, the better the terms on which it executes its transactions.

Central banks

Central banks execute a large volume of foreign exchange transactions to carry out their monetary policy. Many central banks possess foreign currency reserves. Sometimes the direct target of their policies is the exchange rate itself.

Monetary decisions have an impact on the entire financial system and trigger considerable trading volume in the financial markets, including currency exchange.

Big international banks

The large international banks are the most significant foreign exchange trader. Their position can be called privileged. They possess enormous financial resources and are backed technically and expertly. As a result of this position, they execute their transactions at low trading costs.

In many cases, these banks play the role of FX broker-dealers, providing bid/ask quotes to clients and trading as a counterparty with their own capital.

Big banks play an important role in the foreign exchange trading system as liquidity providers for smaller banks and foreign exchange brokers. The profit they make is the bid/ask spread and/or commissions. If they themselves experience a shortage for a particular currency, they can easily enter into a foreign exchange transaction with another large bank on the so-called interbank market.

Big banks are a key player in the financial system. They act as a transmission mechanism of the central bank’s policies towards the real economy, are primary dealers of government bonds, manage IPOs, etc. As a result of these and other activities, they are extremely active in foreign exchange markets.

Medium-sized commercial and investment banks also offer a variety of asset management services. Their clients are often brokers, hedge funds, institutional investors and small businesses.

Institutional investors

This category includes other active participants in the financial markets such as pension funds and insurance companies. Their activity involves portfolio management, which results in the need to buy and sell certain currencies.

For example, a European pension fund may hold shares of US companies denominated in dollars. At the Fund’s discretion, the risk of dollar depreciation can be mitigated through derivatives such as forwards. These transactions are most often made with medium or large international banks.

The trading volumes realized by institutional investors are significant for financial markets. As a result, they benefit of favorable trading terms.

Multinational corporations

The business is also actively engaged in foreign exchange trading. Big international companies have virtually no national borders. In today’s world, even small companies are optimizing their trade cycle by taking advantage of global access to goods and services.

The participation in the foreign exchange market of this group tends to be motivated by the desire to hedge currency risk.

Forex brokers

Forex brokers offer the service of exchanging one currency for another. Their business model puts them into two categories – dealing desk brokers (market makers) and non-dealing desk brokers.

Dealing desk brokers are known as market makers because they are the counterparty to their clients’ transactions. They have their own trading facilities and offer their own quotes for buying and selling (usually close to those on the interbank market). The fact that they create the market themselves allows them to offer fixed spreads.

For market makers, the risk is lowest when their clients’ positions net each other – when buyers and sellers trade identical volumes. In this case, the broker will generate revenue from the spread without incurring currency risk itself. However, when one group prevails (larger buy volumes, for example), the dealing desk broker will have two options: to take the risk of being a counterparty (as a seller of the FX pair), or to hedge the excessive exposure (through a deal with, for example, a bank or other market maker).

Non-dealing desk brokers are those who meet buyers and sellers without trading themselves.

There are two basic business models for non-dealing desk brokers.

Straight Through Process (STP) brokers fall into the first category. They offer a direct link between their clients and their liquidity providers (usually banks). End-client transactions are executed at the best prices delivered by the liquidity providers. The broker is just the bridge between buyers and sellers. STP brokers are compensated for their services either by a commission or by a slight increase in the quoted spread (compared to that of the liquidity provider).

In the second model, the broker participates in an electronic communication network (ECN) in which various market participants, including other brokers, enter into transactions. This pool of foreign exchange liquidity creates good trading conditions for all participants in the electronic network. Usually, commissions are the main source of revenue for ECN brokers.

Nowadays, most non-dealing desk brokers use elements of STP and ECN. For their clients, they quote small but variable spread. The spread could increase significantly in a volatile market (around key news).

Which business model is better?

This question has no answer. The fact that brokers with different business models have been operating in the markets for decades is indicative of their resilience. From the traders’ point of view, the choice depends on the trading strategy.

Non-dealing desk brokers offer narrower spreads most of the time. However, when markets become volatile, these spreads increase significantly. So, they will be suitable for traders who enter into a lot of transactions during the quiet part of the day. When trading takes place around significant events, a dealing desk brokers’ fixed spread would be more appropriate.

According to many people, broker-dealers have an interest in trading against their clients in order to profit from their losses. These practices are rare nowadays, if they exist at all. For the modern broker, it is the active client that matters most, not the former one. Competition in this business is fierce and reputational risk is of the utmost importance.

There are countless reputable brokers. They comply with regulatory requirements and their shares are often traded on the stock exchange. Their clients’ funds are in many cases subject to additional legal protection. Of course, there is no 100% security, neither for brokers nor for other financial institutions such as banks.

Retail traders

Retailers are individual traders looking for an opportunity to make speculative profits from the FX market. As a rule, they have limited financial resources. Transactions are executed by a broker. Retailers pay a high price for trading, mostly reflected through the bid-ask spread. Access to premium software products, analytics and data is limited or too expensive for retail traders.

Individual traders who conduct foreign exchange transactions for personal reasons (tourism, shopping) can also be included in this group.

Electronic systems

Although not a direct participant in trading, electronic systems are becoming an increasingly important part of the financial markets and foreign exchange markets in particular. Thanks to technological advances, financial trading is constantly evolving. Various electronic solutions ensure faster and more secure execution of transactions under increasingly better trading conditions. Electronic trading systems have practically provided a sort of exchange for larger players such as market makers, investment banks and large international banks. All market participants benefit from easier access to liquidity. There is a visible trend that technology is becoming more integrated into all stages of the trading process.

The modern technological world and the high competition among brokers facilitate the access to the foreign exchange markets for small players.

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