From Institutional to Retail Investors: An Overview of Market Participants
Market participants with different objectives trade huge forex volumes daily. The FX markets can be visualized as a pyramid structure, with retail traders forming the core. They are numerous but have limited resources. Brokers play a vital role in the market, aggregating the transactions of small traders into larger orders for medium-sized banks. These banks, in turn, manage their foreign exchange exposure through deals with the large international banks that stand at the top of the pyramid. The more significant the market player, the better the terms on which it executes its transactions.
Central Banks
Central banks are powerful entities that execute sizeable foreign exchange transactions to carry out their monetary policy. Many central banks possess foreign currency reserves, and their policies can directly impact the exchange rate. Their monetary decisions significantly influence the financial system, triggering considerable trading volume in the financial markets, including currency exchange.
Big International Banks
The large international banks are the most significant FX traders. Their position is considered privileged. They possess enormous financial resources and are supported by advanced technical solutions and skilled professionals. As a result, they execute their transactions at low trading costs. In many cases, these banks act as forex broker-dealers, providing bid/ask quotes to clients and trading as counterparties with their capital.
Big banks play a crucial role in foreign exchange trading by providing liquidity to smaller banks and other participants like forex brokers. They profit from the bid/ask spread or commissions. If they experience a shortage of a particular currency, they can quickly enter into a foreign exchange transaction with another large bank on the so-called interbank market.
Major banks are key players 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, and are highly active in foreign exchange.
Medium-sized commercial and investment banks also offer various asset management services. Their clients are often brokers, investment funds, institutional investors, and small businesses.
Institutional Investors
This category includes active market participants, such as pension funds and insurance companies. Their activity involves portfolio management, which includes buying and selling 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 generated by institutional investors are significant for financial markets.
Multinational Corporations
Businesses are also actively engaged in foreign exchange trading. Big international companies have virtually no national borders. Even small companies optimize their trade cycles today by exploiting global access to goods and services. This group’s primary motive for trading forex is hedging currency risk.
Forex Brokers
Forex brokers provide currency exchange services. Their business model divides them into dealing desk (market makers) and non-dealing desk brokers.
Dealing desk brokers
Dealing desk brokers are known as market makers because they are the counterparty to their clients’ transactions. They have their trading facilities and offer their quotes for buying and selling (usually close to those on the interbank market). By creating the market, they can 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 taking risks. 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
Non-dealing desk brokers connect buyers and sellers without trading themselves. They have two primary business models.
Straight Through Process (STP)
STP brokers fall into the first category. They directly link clients to their liquidity providers, topically 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 earn compensation through a commission or a portion of the trading spread, typically a fraction of what the liquidity provider offers.
Electronic Communication Network (ECN)
In the second model, the broker participates in an ECN where various market participants, including other brokers, enter transactions. This pool of foreign exchange liquidity creates good trading conditions for all participants in the electronic network. Commissions are usually the primary 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 spreads, which could increase significantly in a volatile market (around important events).
Which Business Model is Better?
There is no definitive answer to this question. The longevity of brokers with different business models in the market indicates 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. A dealing desk broker’s fixed spread is advantageous during volatile market conditions but less favorable in stable markets.
Many believe that broker-dealers trade against their clients to profit from their losses. The active client matters most for the modern broker, not the former. Competition in this business is fierce, and reputational risk is paramount. Unfair practices are likely to undermine the credibility of such brokers quickly.
There are countless reputable brokers. They comply with rigorous regulatory requirements, and their shares are often traded on the stock exchange. Their clients’ funds are usually subject to additional layers of protection.
Retail Traders
Retail traders are individuals looking to make speculative profits from the forex market. They generally lack significant financial resources. Their transactions are executed through brokers. Small traders pay a high price for trading, mainly reflected through the bid-ask spread. Access to premium software products, analytics, and data is limited or expensive.
This group also includes individuals who conduct forex transactions for personal reasons (e.g., tourism or shopping).
Electronic Systems
Although not direct trading participants, electronic systems are becoming increasingly important in the financial and forex markets. Thanks to technological advances, financial trading is constantly evolving. Various electronic solutions ensure faster and more secure transaction execution under increasingly better trading conditions. Electronic trading systems have effectively created an exchange for major players, such as market makers, investment banks, and large international banks. All market participants benefit from that pool of liquidity.
There is a clear trend of technology becoming more integrated into all stages of the trading process. The modern technological world and the high competition among brokers facilitate small players’ access to foreign exchange markets.
Conclusion
Banks, international corporations, and institutional clients trade large forex volumes daily. They determine the dynamics of supply and demand in the FX market. Small investors aim to capitalize on the opportunities that arise.
