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FOREX Inner Workings

FOREX Market Structure

Every trading requires a counterparty or a liquidity provider. For a small trader (meaning an ordinary man, not an institution or company) with available risk money not exceeding a few thousands USD, trading via a retail broker is the only option. Some banks offer such service as well, but usually with much higher capital requirements.



Forex Market Hierarchy

There are three types of layers through where transaction are facilitated:

  1. Top tier layer: the Interbank level where big banks transact with each other;
  2. Second tier layer: the EBS services which aggregates the bids and offers from different Banks, but also you can see in what size they are willing to transact at each level and other ECN platforms.
  3. Third tier layer: the Retail Brokers.

Even though you enter a transaction through your broker's platform, it's important to know that you're not trading directly on the Interbank level as retail brokers are only a third tier layer.


Retail Brokers

Each retail broker needs a liquidity provider, like Deutche Bank, UBS, CitiBank, GS, before establishing their operation. Most of this retail brokers have signed an agreement with 1 or more of this liquidity provider. In the following figure you can see the different types of FX brokers.



Broker Types

In the case of the Dealing Desk Brokers (DD), they are the market for your trades and most of the time they are the counterparty of your trades, and don't hedge your exposure in the Interbank market since the majority of retail traders are losers it make sense to book the trade for themselves as when you lose the profits goes in their pockets. Because of this it's well known that majority of Broker runs a hybrid type of books named the A book and B book:

  1. "A book": Is where they keep the trades of winner clients, this is "marked risk" book where client position is hedged with their liquidity provider in the Interbank market.
  2. "B book": Is the "normal book" where they keep the trades of those who are consistently loser. Here the orders are kept internally and either they match the clients orders between themselves or they are the counterparty. But there are some cases when in order to maintain the risk tolerance of the company intact, which is based on capital requirement set by the regulators agencies they hedge the next exposure with their liquidity provider.

This Brokers act as counterparty to the losing traders up until their risk threshold is breached. After this threshold is breached they hedge their overhead risk in the actual market. Market Makers only hedge for two reasons: first when it exceeds their maximum risk level, as determined by their risk absorbing capital, as mandated by their regulatory body, and second they hedge the book that contains the winner clients. So they just hedge the risk of the entire book, because if they try to hedge each individual trade and be in an out of the market is an extra cost for them as they are giving away the spread, pay extra commissions, so in this regard they only hedge to bring the risk limit in line with the permitted risk levels set by the company.


No Dealing Desk Brokers (NDD) are the opposite of Dealing Desk Brokers and provide traders with a direct access to the interbank market. Since they do not set their own prices like the Dealing Desk brokers, they profit by adding a markup to the bid/offer prices which the liquidity provider quotes. An NDD broker will not enter an opposite position when a client places an order with it, rather match it with a counter-party. In this case the broker only serves as an intermediary. They can be an STP (Straight Through Processing) or STP + ECN (Electronic Communications Network) broker. There is no requoting of prices, which makes it available to trade during economic announcements without restrictions, but the spreads are not fixed and may spike during increased volatility.


Straight Through Processing Brokers – an STP broker is a type of an online NDD broker who is connected with a single or multiple liquidity providers. In this mode, clients’ orders are fully computerized and immediately forwarded without any broker intervention to the interbank market, where they are processed.


Electronic Communications Network – an ECN broker uses an electronic communications network to put its clients directly in touch with other traders. They provide real-time order book information, featuring processed orders and offered prices by banks on the interbank market, which helps improve market transparency by sharing information with all participants. This enables ECN brokers to offer their customers more competitive spreads and since the spreads are narrow, they profit by charging a fixed commission per transaction.


Order Books and Order Matching Systems

In the FOREX market, contracts are typically traded over-the-counter (directly between two parties), or on Electronic Communications Networks (ECNs) like Reuters Dealing, FXAll, Hotspot, EBS and Currenex. Most ECNs use a continuous auction style called a Central Limit Order Book. The software at the heart of an exchange that manages the order book is called a Matching Engine, and must be very fast and reliable. The order book is divided into two halves. In the upper part are the Asks (sellers), and in the lower part are the Bids (buyers). Each side shows the total liquidity (amount available to buy or sell) at each price level.



Broker Types

The gap in the middle is called the Bid-Ask Spread. In stressed market conditions—for instance, global economic events or natural disasters—the spread widens, as the risk of loss increases and participants withdraw their liquidity. If an order crosses over, then a trade is executed, and the orders that were filled are removed from the book. At times of high trading activity the order book is very dynamic and orders are matched and filled within a small fraction of a second. The shifts towards lower or higher prices are determined by immediate excess of supply (Asks) or demand (Bids). Seeing the book thus can help, at least to some extent, predict the price's next move. However, order books of interbank ECNs are not available to public. Some ECN brokers provide their own live order book as a part of their trading platform.




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