Abstract:

Institutional foreign exchange is the big end of town when it comes to the FX market, but what they do as a group has a large bearing on short to medium moves in the currency markets. Knowing who they are, what they do and why they do it gives us little trading people the chance to survive

This is the big end of town when it comes to talk about the foreign exchange. Don’t forget we are talking about a more than $2 trillion a day size business; so to be ‘big’ in this business is to talk about huge amounts of funds being traded at the bat of an eye. While it is standard to trade 5-10 million dollar parcels, very often 100-500 million dollar parcels get quoted. Compare that with your likely size trading position, so you can see we are dwarfs of a market for giants. It is important too to note, that even these guys are vulnerable to market moves and are also subject to market volatility. That is, no one controls this largest of the worlds financial markets.

George Soros and his quantum fund for instance, though famous for winning in the FX market against the Bank of England in 1992, in its turn lost substantial amounts (many 100s of millions of dollars) of his hedge funds money betting against the USD/YEN exchange rate in 1995. He too was not as big as the market. The thing to remember, no one is bigger than the market – even the major global brand name banks so ‘insider’ information is not only hard to come by, but it is also quite doubtful that even if you did have the information, that it would be anything but of passing value.

The Players

Banks
Whether big or smaller scale, banks participate in the currency markets both from the point of view of managing their own foreign exchange risks and that of their clients. They also speculate should their dealer/traders have a particularly strong view of the market. What probably distinguishes them from other players is their unique access to the buying and selling interest of their clients that gives them an insight to the likely buying/selling pressures on the exchanges rates on a particular day or some such other like small timeframe.

Deals are transacted by telephone, broker (we will talk about these people later) or via electronic dealing terminal connection to their counter party. The usual transaction time is somewhere between 5 to 10 seconds, so the skills of the foreign exchange dealer demands agility of reflexes and decisiveness particularly when we are talking about transactions of multi-million dollar size transactions.

Brokers
The foreign exchange broker acts as an agent in the same way to that a stock broker acts in the share market. The slight difference being that they usually confine themselves to acting between inter-bank market participants, and do not accept orders from corporate clients. 

What the broker does from all his markets, he selects through their extensive and direct electronic bank contacts the highest bid and lowest offer and combines them to establish the best two-way price ‘the market’ can provide and displays  or verbalizes this for all to see and hear.

As if the changes in the FX broking industry were not enough, increasingly and with the unstoppable advances in technology (as evidenced by the emergence of electronic broking platforms such as EDS and Reuter dealing systems) the task of customer/order matching is being systematized and dispensing with the human element altogether.

Central Banks
The majority of developed market economies have a central bank. The role of a central bank tends to be diverse and can differ from country to country. In Australia, its central bank is the Reserve bank of Australia (i.e. the ‘RBA’, see also www.rba.gov.au) and is charged with the responsibility of maintaining an orderly market for their national currency.

In a practical sense this involves them monitoring and checking the prices dealt in the inter-bank market. Sometimes they even ‘test’ market price by actually dealing on them to check the integrity of quoted prices. In extreme circumstances where the Reserve bank feels prices are out of alignment with broad fundamental economic values, it may ‘intervene’ in the market to influence its level directly. The intervention can take the form of direct buying (to push the price up) or selling (to push the price down) or as often ‘jawboning’ by commenting in the media about its ‘preferred’ level for the currency.

Bankers, fund managers and companies all tend to respect the opinions (if not always agree) as the sheer financial power of a central bank to borrow or print money gives it a huge say in the value of a currency. Their opinions and comments should never be ignored and it is always good practice to follow their comments be it in the media or on their website and can be powerful indirect influences on the currencies value at any particular point in time. Particularly as money and currency markets are very sensitive to rates of return being offered by various markets (i.e. interest rates).

Corporations
As the name implies they represent companies and basically businesses of any size (from small to multi-billion dollar cash flow enterprises) that engage in commercial or capital transactions that require them to either purchase or sell foreign currency.

Traditionally they have been divided between those who need to buy the local currency ‘exporters’ (i.e. they have foreign currency to sell) and those who need to sell  the local currency to buy foreign currency known as ‘importers’.

Hedge fund
Are a special class of fund manager and are now referred to their more appropriate name of ‘absolute return funds’ as they more concerned with managing the total risk of a pooled investment, than just relative performance which preoccupies traditional fund managers. They tend to be more aggressive in their investment approaches (which include borrowing through leveraging and the use of derivatives) but are relatively small (though high in profile) in comparison to traditional funds.

Major dealing centres
The above participants do not necessarily reside in the one geographic centre, indeed as a global market it is quite dispersed as indeed is the market as a whole. It is as such not like say the equities markets that are located on formal exchanges or national centre points. The foreign exchange market is made up of a network of dealers and traders clustered in centres across the globe. They are linked via computer terminals, telex, fax, phone or event the internet or internet based dealing platforms to form a market where prices and information are freely exchanged. In word there is no single ‘centre’ in this market.

The foreign exchange market though has dealing centers roughly geographically located in London, New York and Tokyo. We generally call these ones the major centers, not just by their sheer size of volumes and market participants, but also as they tend to influence other dealing centers. These other smaller centers include such cities as Sydney, Singapore, Hong Kong, Switzerland and Frankfurt that take up the remaining balance of traded global flows. These are the centers that in essence set the pace of currencies across the globe.
Now the above has practical implications for FX dealing regardless of ones level of sophistication. It forces one to be aware of the most recent leading centers trading activity. In the case of an Australia it means at the start of our trading day, the US market action gives us a clue as to the direction of the morning session, and then after a few hours, the course of action of the Tokyo market (to our north) would then take its part in influencing the course of Australian currency trading trends.

Don’t forget market holidays, like economic statistics have a bearing on the general flow (or lack of) business and price activity. Something worth noting in planning of trades, the settlement days for deals and your holidays!

The inter-bank world and Direct dealing - Price ‘discovery’

What is meant by ‘price discovery’ is that the market place is the place where buyers and sellers want to trade their side of a transaction. Given the ‘grade’ of their transaction is pretty clear (i.e. their currency), all that the FX market really serves to do is provide a ‘price’. This is where market makers come in. Market makers are almost always a bank.  Their job is to provide a price to the market. In that process a FX currency price is revealed or if you will ‘discovered’.

In order to be a market marker means that a bank is prepared to quote a two way (i.e. a bid & offer). Their bid of course is the market makers ‘buying’ price and their offer price, is their selling prices to all other enquiring market principals, whether or not they are themselves market makers in that particular currency, The price rates are quoted over the telephone, electronic via electronic dealing platforms or to less frequently now days by telex to dealers in other countries.

To be a market marker, reputation is important, you must be reliable and of the highest integrity, otherwise clients or other market makers will not deal with you. The people who actually by or sell the currency is called a foreign exchange dealer or a trader. These traders make their money by the difference between their buying price and their selling price called their ‘spread’. These spreads are extremely fine for large inter-bank parcels. For instance in the $Australian dollar on a parcel of say 10 million dollars it is only 5 fourth decimal places. Quoted as say 0.7305-10, the difference between the two prices adds up to $5,000 dollars profit to the market. Not a bad profit if all you do is quote the price and people buy and sell off both sides.

The above Reuters terminal based conversation shows how clipped are the conversations sometimes between inter-bank dealers. It may also look like a little like jargon, however it not really hard to follow.

Briefly, Bank A in the above conversation is the price taker, that is, he/she is asking for Bank B’s price in the Australian dollar versus the US dollar, simply by saying ‘oz’. The amount is 10 million Australian dollars (as the base currency in the quote).

The answer that bank B gives is simply the two way price (as the last two decimal places), here it is 5 –10. However to avoid ambiguity, Bank A has asked for confirmation of the big figure of the price. Bank B responds with 7305-10, the long form of the price.

At this point Bank A states what ‘side’ it would like to deal; ‘at 5’ meaning the bid side. We now know, Bank A wants to sell 10 million Australian dollars at 0.7305 US per Australian dollar. Bank B confirms the deal as ‘done’ and politely thanks him. Bank A simply says ‘bye bye for now’ short formed to ‘bibifn’.

As can be seen, because of the pressures of time and the sensitivity of foreign exchange rates changing at any moment it is in the interest of both parties to transact almost immediately. The above transaction would normally take all of about 15-20 seconds. As you gather this is not a place for the indecisive.

Clearly this price making function does not come risk free. The risk of course is that they may be give or ‘taken’ on their price and may alternatively be forced to sell at lower (or buy at higher levels). Indeed this risk is not just a theoretical risk, it is a very real risk that prices may move against the dealer, so avoid this their prices are constantly adjusted to reflect either their risk or their view of the market (while at the same time not providing a price that may otherwise lead to an arbitrage).

Don’t forget that the banks are not charities, they are there to make a profit and will seek to do so when a market opportunity presents itself. An example could include that they have a large order to buy to $A, and will on the basis of this order also seek to accumulate $A. Crucially they will not necessary be in a position to tell you either (for ethical, privacy and commercial) reasons. Take it as a given they have access to more information than you do, and may not always be in a position to tell you (or indeed be willing) to you!

Conclusion

Well as you can see we have had a look at the various big scale participants, such as the banks and fund managers to be players in the global currency markets (but not necessarily controllers) of the FX market. Though their scale is huge compared to us, their concerns are about the same. As such we see the big end of town FX dealing though is not immune to the technological changes afoot in the industrial with a lot of inter-bank dealing now brokered electronically usually various platforms. A phenomenon that merely mirrors what is already seen at the retail FX trading level as the benefits of the new technologies spread democratically.