Let’s expand on what OTC means in the case of the Forex market. Since there is no central exchange through which to process orders and transactions, a sophisticated network has been established in order to allow participants to communicate and transact. This network has different levels, each with its own institutions serving different functions within the forex market.
The interbank market is essentially a network between larger banks. This network is made possible through EBS (electronic broking services) and Reuters spot matching systems. These two applications effectively aggregate the order books of the banks, showing the various bids, offers and amounts that each is willing to transact at. This allows proper market function to occur by providing sufficient liquidity and efficient processing. The interbank market is only accessible to larger banks with the highest of credit standings, this is to eliminate any counterparty risk and reduce competition. By restricting access to the interbank market the big banks are continuing to maintain their share of forex turnover and thus profits.
At the top of the food chain we have the foreign exchange dealers. These are the dealer banks which conduct foreign exchange business for their clients or themselves. The major banks include; Deutsche Bank, UBS, Citigroup, Barclays Capital, RBS, Goldman Sachs, HSBC, Bank of America, JP Morgan, Credit Suisse and Morgan Stanley. These banks handle approximately 2/3 of the daily forex volume and along with others form what is known as the interbank market. These banks deal with each other on behalf of clients or for themselves, providing much needed liquidity to the market so large transactions whether corporate or speculative can be facilitated and proper market function can occur. The dealer banks that form the interbank market are effectively the market makers of the forex market, they set the prices and manage the volume for the rest of the market to feed off.
On the next level of the forex market we have the market that exists for financial and non-financial participants. This may include smaller banks, businesses, hedge/mutual/pension funds, CTAs and large investors. Traditionally the majority of foreign exchange turnover has been the result of international trade flows, this trend has changed in recent years with the majority of turnover being the result of capital flows, speculative and hedging activities. This shift reflects the increasing recognition of foreign exchange as a means of generating returns by all market participants, and the need to manage foreign exchange risks through hedging activities.
On the next level we have forex brokers and retail ECNs (electronic communications network). Traditionally forex brokers were the intermediary party between buyers and sellers, meaning they facilitated the transaction between the end user and their liquidity provider (market maker bank). For the most part this is still the case today, however, some brokers will run a book and trade against their clients. Brokers and ECNs will usually have an agreement with one or more liquidity providers, through which they can hedge positions on their book and manage any exposure they might have. A liquidity provider could be any one of the above mentioned major banks, or even another retail broker depending on their needs.
In the background of all this we have the central banks. The central banks follow their respective currency, making sure it’s price movements aren’t to erratic and promoting stability. They are participants in the market to diversify their currency reserves, influence the value of their exchange rate (less common nowadays) and make international payments on behalf of the government. To do all this the central bank has its own dealers who use a number of larger banks to help facilitate these flows of funds. Central bank intervention used to be far more common and have greater affect than it has nowadays. Rather than actively participating in the market buying and selling their currency, central banks instead use verbal intervention to affect the value of their currency.
To see a full overview of the structure of the fore market please watch the webinar recording below.