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.