Trading in the forex market through an online forex broker affords most traders only a small slice of the enormous foreign exchange market. The majority of trades made on the $3 trillion a day foreign exchange market come from banks and large financial institutions, with retail online foreign exchange brokers making up just a fraction of overall volume.
Because trading in the forex market does not occur in any one particular location, the forex is considered a decentralized market. Trading information is kept among the participants instead of recorded and published such as in a centralized market.
Banks, large financial institutions and their clients, which consist of the largest global corporations, are responsible for a large part of dealings in the forex, which is why the market where these transactions occur is called the interbank market.
Online Trading and the Interbank
Trading through an online forex broker gives individual traders the opportunity to trade with the big players of the forex market, the banks. Most foreign exchange brokers will often offset their own currency positions with banks and other major forex market makers.
The principal difference between interbank trading and trading through an online forex broker consists in the size of the transactions — which can run in the billions in the interbank market — and how trades are funded and get executed.
Banks and market makers on the interbank market represent more than 70 percent of all foreign exchange volume by some estimates, and are held to clearly established rules and defined lines of credit among themselves before they are allowed to trade.
Nevertheless, a trader using an online trading account would do well to learn how the interbank market works to understand how prices are determined and how spreads get priced in the online forex market.
The Dealing and Sales Desk
Trading on the interbank market has traditionally been by large financial institutions or banks. These institutions will generally have a sales desk, where their corporate clients can enquire about markets and place orders, and a dealing desk, where the orders are routed and offset in the market.
The bank will generally have one or two traders for each major currency on the dealing desk, to ensure that each trader can focus completely on their currency and market. Other traders will specialize in forwards, crosses and exotic currencies.
How Banks Price and Offset Trades
A number of factors will determine how a bank prices currencies. These include the current market rate, the bank’s previous market position and outlook on the currency, and the volume available to buy or sell at any given price.
The bank market maker’s outlook on the currency affects how the bank will show its bid/offer markets to clients. For example, if they favor a currency, the bank will often adjust their markets upward to accommodate accumulation. If the bank is a better seller, they will generally make their markets lower as they lean on the offer side of the bid offer spread.
Once the bank has established a trading position, the bank can either hold the position or offset the position immediately using direct lines to other market makers or electronic systems like either the Reuters Dealing system or the Electronic Brokerage Service or EBS. Both services are proprietary trading systems specifically designed for the Interbank forex market.
Most online forex exchange brokers trade with the Interbank market to some degree to offset trades and to position themselves in the market. Trading in an online trading account does not access the Interbank market directly. Nevertheless, the more credit lines established by your forex broker, the tighter the spreads they can offer their customers.