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MAKING MONEY IN FOREX

FOREX PARTICIPANTS



Forex has a diverse population of participants, ranging from Japanese
housewives to powerful central bankers. The objectives of the participants
differ, and their individual actions may have dramatic affects on
the market. It is important to remember that the forex market is an offexchange
marketplace; there is no central exchange where all orders are
cleared, as on the New York Stock Exchange or the Chicago Mercantile
Exchange. The bulk of trading is done between trading partners on the
interbank; however, small retail traders are unable to trade directly with
partners on the interbank. Therefore, some participants in the forex market
exist to create a marketplace for others. Currency dealers create a
market for smaller retail speculators and offset their risk by trading with
their larger partners on the interbank. The hierarchy of forex participants
is illustrated in Figure 1.1. There is a definite food chain among forex
market participants, with interbank members on top and retail speculators
on the bottom.

The Interbank

Interbank is a loose term held over from the early days when banks traded
for clients and themselves over the telephone. Today trading is conducted
electronically, with quotes from buyers and sellers matched up on the interbank
market automatically. Many interbank members act as market makers
for the currency pairs traded on the spot currency market and offer the
quotes that ultimately drive the pricing you see in your trading software.
Among the largest market makers on the interbank are banking giants such
as Citigroup, UBS, Goldman Sachs, and Deutsche Bank. Lehman Brothers
was a major interbank market maker prior to its demise in September 2008.
Participants on the interbank are big-dollar players, since the lowest
accepted trade size is set at an even $1 million. It isn’t uncommon for orders
larger than $100 million to be executed on the spot forex market due to the
global size and liquidity of the interbank market. Many banking participants
on the interbank fill orders for customers who actually intend to take delivery
of the currency being traded; however, most interbank members also
trade the bank’s money as speculators attempting to make a profit just like
any other currency trader. The advantage interbank market makers have
over a regular retail trader is access to order flow information. If you are
the market maker and you see all the orders, you have insider information
about the direction of the prices. Taking a trade against that information
provides a significant source of revenue for many financial institutions.
Interbank members trade only with partners with which they have
arranged credit agreements. This is an important point to understand
because it affects the pricing you receive from your currency dealer. The
quotes flowing from interbank trading partners ultimately drive the pricing
you see through your currency dealer’s trading software. The more trading
partners a dealer has, the more quotes at which they can execute a

trade, resulting in more competitive pricing for you. You should look for a
currency dealer with multiple liquidity feeds.
Institutional Traders

Institutional traders represent corporations or hedge funds trading directly
on the interbank or through retail currency dealers. Hedge funds may participate
as speculators while corporations participate to protect their interests
against exchange risk. Corporations conducting business globally
face a potential issue of fast-moving exchange rates, devaluing their profits
made overseas. These corporations may participate in the currency market
by hedging their risk directly in the currency market rather than waiting for
a bank to exchange the currency for them. Most institutional traders representing
corporations are involved in some kind of hedge to protect the
value of their goods or services from exchange-related risks. Institutional
traders may include professional money managers looking to diversify and
hedge against the risk of loss in the equities market.
Central Banks
Central banks play an important role in guiding the forces of supply and
demand for a country’s currency on the forex market. Their monetary policy
statements, interest rate decisions, and ability to intervene in the forex
market should make every trader pay close attention to their actions. Central
banks are also tasked with controlling the money supply of a nation’s
currency, which directly affects supply and demand. Low supply and high
demand tend to increase the value of a nation’s currency, whereas high
supply and low demand will devalue it. Balancing growth with inflation is
the typical goal of central bank policies. Central banks may also change
their overnight lending rates as a tool against inflationary pressures. The
interest rate set by a central bank can influence the value of a currency
based on yield. The higher the central bank rate, the higher becomes the
yield for holding that currency, influencing demand.
Table 1.1 lists the central banks and their Internet addresses for major
currencies traded on the forex market.
Retail Currency Dealers
The average retail trader doesn’t have the credit or capital required to participate
directly with interbank trading partners. Retail currency dealers
act as market makers for small-volume currency traders. Currency dealers
manage their risk by balancing their portfolios of retail orders among
the customers for which they are making a market. When they are overexposed
to market risk due to an imbalance of short or long orders, they

offset their risk by taking positions with their trading partners on the interbank.
It is important to understand that currency dealers do not operate
the same way stockbrokers do. The spot currency market does not have an
exchange; therefore, the currency dealer often fills a customer’s order by
itself assuming the risk. This is commonly known as taking the other side
of the trade. In other words, the currency dealer is betting against your
ability to make money. If you lose, the dealer wins and collects the spread
for doing the transaction. This is significantly different from a stockbroker,
who is paid a commission for brokering your order to the exchange, where
it is matched with an anonymous third-party order on the exchange.
There is an inherent conflict of interest when your dealer is profiting by
taking the other side of your trade. Traders have historically complained
about poor order execution, excessive quoting, or stops being “gunned,”
and there is probably some basis for these complaints. Forex after all is
an unregulated market, and shady dealers do exist. Currency dealers are
aware of these perceptions as well and are now marketing no dealing desk
execution or direct interbank trading as an alternative order execution
strategy to taking the other side of the trade. These trading platforms suggest
the dealer is not involved with your trade, and passes the order directly
to a trading partner. Whether every order is matched anonymously or not
is a matter of trust, but it doesn’t hurt to do business with a dealer who
offers an alternative to taking the other side of every trade.
Retail Speculators
Retail speculators may be trading their own account or client funds
through a managed account program. Some speculators at the retail level
may be trading for clients looking to hedge risks; however, most are
looking to generate profit. Retail speculators are too small to trade directly
on the interbank and clear their trades through one of the many retail dealers
available to make a small-volume market for them. For the most partretail speculators represent people like you and me, trading small-volume
accounts purely for the sake of making a profit. The number of retail speculators
involved in forex worldwide continues to grow as the popularity of
currency trading grows.