Forex Market Structure

At the very top of the forex market are transactions which are collectively called Interbank transactions. The “Interbank” is not, as some people may believe, an exchange. Rather, it is a collection or compilation of agreements between and among the major money center banks in the world.

An example may make it easier to understand this thing we’re calling the “Interbank” market. In most larger offices or business, perhaps even in your own home, there may be several computers which are inter-connected by means of a simple network cable. Now, each computer operates independently until the moment it needs a resource, program or file from one of the other computers. When that happens, computer A will contact computer B (or C or D, etc.) and request permission to access the needed resource. If the owner or operator of Computer B authorizes it, and if Computer B is functioning the way it should be, then the needed file or program can be accessed. Within minutes, Computer A’s request is fulfilled. It works the same way in the forex market; just substitute Computer A and Computer B for Bank A and Bank B and let resources substitute for currency. You now have the machinations for the relationships that exist within the Interbank system.

By the same context, if you’ve ever tried to locate resources from a computer that isn’t united by a computer network, you probably know full well what a time consuming, inefficient, sometimes futile effort it can be. You have to search each and every independent computer until you’ve found your resource, copy it and then download it to your own computer. Regarding prices and forex currency inventory, the same issue exists within the Interbank market system. If a bank in Taiwan occasionally transacts business with a firm in Sao Paula they need to exchange their currency. In this case, it can be quite difficult to determine what the proper exchange rate between the New Taiwan Dollar and the Brazilian Real should be. Because of situations such as this, the Electronic Broking Service (EBS) and Reuters established their services. For simplicity, we’ll refer to this service as ESB.

In a way, the EBS service acts as a blanket over the Interbank communication links. Through the EBS service, Interbank members are able to see how much currency trading is available, and the price(s) the other Interbank participants are willing to pay. It’s important to understand that the EBS is not in itself a market nor is it a market maker. The EBS system is merely an application allowing bank members to see offers and bids from the other members.

The forex market’s second tier essentially exists within each individual bank. If you were to call your local Citibank branch, they can arrange for you to exchange your U.S. Dollar for the foreign currency of your choosing. In all probability, they will likely just move the desired currency from one bank branch to another one. This is known as a single party micro-exchange, so you are pretty much at their mercy as it applies to the foreign exchange rate you’re quoted. You can either accept their “kind” offer or shop around for a better rate. Anyone who trades in the forex market should consider paying their bank a visit, at least once, to have an idea of their quotes. Certainly, it will be very “enlightening,” if not downright shocking, to see just how profitable these transactions are… for your bank.