Where are you trading when you trade forex? You learned in the last lesson that retail forex traders DO NOT trade in the “genuine” FX market.
If that’s the case, where exactly are you trading? Where do your orders go when you click “Buy” or “Sell” on your forex broker’s trading platform? That is what we will discover in this lesson.
To understand where your trades go, we must first understand where retail forex brokers and traders (such as yourself) belong inside the FX market ecosystem.
The foreign exchange market is fragmented and complex, but we will attempt to present a simple and stylised summary.
Assume there is a massive body of water…a massive lake.
A lake the size of an ocean.
The biggest lake ever. Assume that this massive lake symbolizes the “FX market.” This massive body of water is not empty. It has boats! The boats come in various sizes. These boats represent the FX market participants.
Assume there are thousands of these boats in the water. These market participants typically include banks, non-bank financial institutions (“NBFIs”), multinational corporations (“MNCs”), large institutional investors, algorithmic trading firms such as high-frequency trading (“HFTs”) and electronic market makers, hedge funds, and high-net-worth individuals (“HNWIs”).
The massive vessels are enormous commercial banks. Barclays, Citigroup, Deutsche Bank, HSBC, JP Morgan Chase, and UBS are among the banks involved. Because they have a lot of money, their yachts are massive.
The large ships occasionally trade directly with one another. This is referred to as “bilateral trading.” As a result, two boats can “trade bilaterally.”
When these large ships trade bilaterally, only the two market participants involved know what the quotations were and what the final price was. Other market participants (boats) have no access to this information.
Banks offer different quotes to different customers, and agreed-upon costs and quantities are sometimes not made public. This makes it more difficult for any market participant to determine if their trade was at a good (or bad) price.
But there aren’t only boats on this giant lake.
There are lots of islands!
Trading venues, in general, are places where market participants can meet and deal with one another.
When trading on one of these islands (trading venues), market participants must follow the rules of the island.
The island has a marketplace where market players can trade. Some even offer anonymous trading, which allows you to place orders without revealing your name to the other traders.
For example, if a buyer wants to purchase 10 million USD/JPY units at 110.00 and a seller wishes to sell 10 million USD/JPY units at 110.00, the orders are matched. All without disclosing the identities of the buyer or vendor.
As you can see, there is no single island where ALL commerce occurs. And the prices at which dealers buy and sell are specific to each island.
For example, if a ship were to “island hop,” it might discover that the ask price for USDJPY is 110.00 on one island and 110.01 on another. The foreign exchange market is fragmented, which means that the USD/JPY market on one trading platform is distinct from other trading venues. Depending on the venue, each currency pair will have its own pricing, liquidity, and trading volume.
FX trading takes place in numerous locations at the same time. So there isn’t a single “FX Market.” The “FX Market” is made up of several different markets. When you think about it, the “FX Market” is more of a NETWORK of different venues to trade than a single location.
The size of islands varies. The size symbolizes the quantity of trade that takes place on an island. Different boats trade on several islands. While some vessels are wealthy enough to trade on every island, the majority are not. Only particular boats are permitted on each island.
There are some boats that are so wealthy that they own their very own island! No other large boats (banks) are permitted if a boat owns an island. Only specific, smaller boats (bank clientele) are permitted.
Another example is the two large islands in the middle, where only the largest boats are permitted to trade. Dealers are the ones who trade aboard these large vessels. As a result, on these islands, dealers conduct extensive trading. This is referred to as the “interdealer market.”
The prefix “inter” signifies “among” or “between.” Because most dealers work for major international commercial banks that serve global clientele, the interdealer market is sometimes known as the “interbank market.” These massive banks are also referred to as “bulge bracket” banks.
The interdealer part of the foreign exchange market is where trading take place between FX dealers rather than between dealers and their end customers, which include exporters and importers, asset managers, hedge funds, and even certain retail forex brokers.
Previously, only the largest vessels were permitted on these large islands. This is because large ships wanted to trade mainly with other large ships. Smaller vessels were judged too dangerous to deal with.
However, medium-sized boats can now trade there as well by “attaching” themselves to one of the large boats.
To keep things simple, we won’t get into details right now, but the large boat (bank) authorizes the smaller boat (hedge fund) to trade in its name. This is how the medium boats can reach these enormous islands and trade with the larger vessels.
The large boat often charges the medium boat a fee based on the number of deals done in exchange for the privilege of trading in its name. This is referred to as a “prime brokerage” arrangement, with the large boat serving as the “prime broker” (or “PB”) and the medium boat serving as the prime broker’s client.
Despite their low credit history or greater risk profile, prime brokers enable these smaller (but not too small) market participants to use the prime broker’s higher credit rating and trade practically anywhere and with anyone in the “lake.”
Essentially, the previously clear separation between the interdealer market and the rest of the market has now been blurred.
The interdealer market is a global network (of trading venues) used by banks and major non-bank financial institutions (“NBFIs”) to exchange currencies between themselves. Electronic or spoken transactions take place. This “market” functions in a highly decentralized manner as a loose network in which banks and non-bank financial institutions make bilateral deals without central supervision. This ostensible “market” is actually a network.
When you hear the terms “interdealer market” or “interbank market,” they simply refer to a network where currency transactions are negotiated between financial institutions and other large corporations.
The interdealer rates are subsequently propagated (like gossip) to the other boats and smaller islands (the remainder of the FX market) and utilized as “reference” rates by other market participants.
These are the rates that your retail forex broker will (ideally) display to you. Typically with a markup.
Now that we’ve covered retail forex brokers, let’s look at where they fit into the picture. One of the little boats is a retail forex broker.
Naturally, because some retail forex brokers are larger than others, their boats are likewise varied sizes. Large retail forex brokers exist. There are even smaller ones.
Retail forex brokers are not permitted to trade directly with other boats. To trade, a retail forex broker must “attach” to a larger boat that will let it to trade in its name. A prime broker (“PB”) relationship is a specific form of relationship. The huge yacht becomes the PB for the retail FX broker.
A PB is a company that will represent a retail forex broker in all of its trading activities in the lake and settle the trades in its name.
Large boats, on the other hand, are picky.
A large boat can enter into a prime broker (“PB”) agreement with the major retail FX brokers.
Smaller brokers are deemed too dangerous for big ships. They do not meet strict standards and are unable to acquire a primary broker relationship, preventing them from trading with others in the FX market. Fortunately, there are particular sorts of boats that already have a prime broker relationship with a large boat and provide a service to smaller brokers that allows them to “piggyback” on this relationship. A “Prime of Prime,” or “PoP,” is a specific form of medium-sized boat.
Fortunately, there are particular sorts of boats that already have a prime broker relationship with a large boat and provide a service to smaller brokers that allow them to “piggyback” on this relationship.
A “Prime of Prime,” or “PoP,” is a specific form of medium-sized boat. As you can see, it is already tough for retail forex brokers to gain access to the FX market.
Why would other ships want to interact with individual retail FX traders if they already consider them too unsafe to trade with them directly without some form of chaperone (PB or PoP)?
A typical retail FX trader is NOT a boat.
A retail forex broker is a boat. But…
On their boat, YOU are in an aquarium.
Retail forex traders do not engage in “market” trading.
Your broker establishes its own market in which you can trade.
You only trade through your FX broker.
When you place an order, it is taken by your broker.
When you place an order to buy or sell a currency pair as a retail forex trader, the forex broker becomes the counterparty to the deal. This applies to EVERY retail FX broker.
You can confirm this by reading any well-regulated broker’s “Customer Agreement.” Your forex broker may set up a trading environment that “looks and feels” like you’re trading on a massive lake.
Consider it a simulation. Your broker “imitates” the real FX market so that it appears authentic. For example, the prices displayed on your trading platform may be comparable to those displayed in the actual “market.”
However, you are not trading with other traders….your forex broker is your only counterparty. It is taking the other side in ALL of your transactions. Your broker is the lone “execution venue” for ALL of your orders.
An execution venue is simply a location where orders are given and carried out. It’s a different, but parallel, market because you only deal with the broker.
When it comes to “trade,” You’re simply playing in your forex broker’s “internal market” or aquarium.
There is no money leaving the broker.
Real money is only utilized by the broker when it needs to hedge trades. However, the broker makes these hedging trades, not you. Your trade never “enters the market.”
You also do not trade with other traders. Not even with other forex traders who use the same broker as you.
For example, if you and another trader both use the same broker, you will NEVER deal with each other; you will always trade with the broker.
You and the other trader are not in the same tank.
You are both in SEPARATE aquariums on the SAME boat.
Retail traders do not have access to the foreign exchange market. They solely use their retail FX broker to trade.
You must be an institutional FX trader in order to deal with other FX traders, which means trading against a counterparty who is NOT your broker.
As a result, we prefer to refer to the true FX market as the “institutional FX market.”
Retail forex brokers are known as retail aggregators in the institutional market.
They are so-called because retail forex brokers frequently aggregate their customers’ net holdings for hedging purposes. They then transact in the institutional FX market to manage their market risk exposure.
Be careful of any retail forex broker who promises you can trade directly in the “interbank market” or institutional FX market, or that they would do so “on your behalf.”
You cannot participate in the institutional FX market, but your broker can. You’ve been stranded aboard your broker’s boat. And you can only trade what your broker offers.
The electronic trading interface provided by your broker is exclusively linked to your FX broker. The trading platform is only an electronic connection to your broker; you are NOT accessing the “FX market.” You only use that trading platform to transact with your broker. Again, you are not dealing with any of the broker’s other customers.
Simply put, the retail forex broker is the buyer when you sell. When you buy, the seller is the retail forex broker. Retail forex brokers’ role is to act as “market makers” for retail traders.
Because retail traders cannot access the wholesale (institutional) FX market, the retail forex broker is literally “creating a market” for you to speculate on currency exchange rates.
It accomplishes this by providing you with an online trading platform that displays quotes on various currency pairs that you can “buy” or “sell.”
You can only open and close positions with your broker.
When you open a position, you are entering into a contract that is a private agreement between you and your forex broker.
These are known as CFDs or rolling spot FX contracts.
Contracts entered into with your broker can only be closed by your broker.
This means you will be unable to close a deal with another party.
The prices provided by your forex broker may be informed by or possibly come directly from the institutional FX market, but you are still trading against your broker. No one else.
Why is this crucial to understand?
Because the broker is taking the other side of your trade, there is a possible conflict of interest.
If your trade is profitable, your broker loses money. And even if you lose money trading, your broker profits from the transaction. So it is in your broker’s best interests if your trades lose money.
Take note of how we highlighted a “possible” conflict of interest. The word “potential” is used since there are options to resolve this issue between you and the broker.
Counterparty Risk in Forex Trading
Because your broker is your lone counterparty, there is a risk that it will fail to meet its obligations to you.
This is referred to as counterparty risk.
A counterparty is the other person who participates in a transaction, and every transaction requires a counterparty in order to be completed.
Counterparties are the buyer and seller in a transaction.
- The buyer is the counterparty to the seller.
- The seller is the counterparty to the buyer.
A counterparty is the other person who takes part in a transaction, and every transaction must have a counterparty in order to take place.
A counterparty is simply the opposing side of a trade in trading. A buyer, for example, is a counterparty to a seller.
You (the buyer) and the seller (the forex broker) are both referred to as “principals.”
A principle is a party to a contract. As the purchaser, you are a principle. The forex broker, as the seller, is also a principal.
You are the major trader. Your broker also trades as principal. Trading between principals is referred to as “principal-to-principal” trading.
This is why a forex broker is actually a forex “dealer” rather than a forex “broker.”
A broker is expected to act as your agent, merely “brokering” a trade between you and another counterparty (principal). Alternatively, matching your order with a buyer/seller. As a result, by definition, a forex broker cannot be a legitimate broker because it is your counterparty because it accepts the opposing side of the transaction as principal.
Counterparty risk, also known as default risk or counterparty credit risk (CCR), is the risk that a contract’s counterparty will not pay as agreed.
For example, if two people agree to trade and no one else can verify the transaction, one person may back out of the arrangement or be unable to produce the funds to hold up their end of the bargain.
If you open a position with your broker and then profitably close it. What if the broker does not have enough funds to pay out your winning trade?
What if other traders had a similar position as you and ended up profiting as well?
The total benefit from all of these trades causes the broker to incur such a large loss that it “goes bust” and lacks the capital (money) to fulfill the winning contracts.
You are screwed since the position was a transaction between you and the broker, and you cannot relocate or transfer the position to another broker.
You have money deposited with the same broker, which you believe is safe, but if the broker’s money is gone, the money owing to this successful trader may come from your money!
Unlike an exchange-traded market such as stocks or futures, which has a “clearinghouse” that works as an intermediary between a buyer and seller to ensure that both parties follow their contractual obligations, the FX market does not.
This is due to the fact that the foreign exchange market is an over-the-counter (“OTC”) market. There is no third party ready to step in and ensure you collect the money owing to you in an OTC market.
Consider an OTC transaction to be similar to a face-to-face transaction. A deal of this nature is planned, and pricing are set and are negotiated by two parties. ( buyer and seller)
There is no third-party or escrow service as an added layer of safety for both parties, just like in a face-to-face transaction.
So, if your broker goes out of business or is unable to honor your winning trade, your funds are forfeited.
At that point, your sole option for attempting to recover cash is to register a complaint with the regulatory agency that controls the jurisdiction in which your broker is legally licensed to operate.
Next Lesson: How Forex Brokers Manage Their Risk and Make Money