The Forex market is an over-the-counter(OTC) market without a centralised exchange. Competition among market makers prevents monopoly prices within the market. And they try to distort prices; traders have to find another one.
Market makers do not change trading costs (like ask/bid spreads) because the market participants closely watch them. In contrast, many stock markets operate in entirely different ways. For example, the New York Stock Exchange is the only place where you can trade stocks of companies listed on the exchange.
The centralised market is operating by people called specialists. Prices presented by sellers and buyers arrange as a single top-priority asking price through transactions, and the counterparty becomes an exchange. Since the New York Stock Exchange is a centralised market, stocks traded on the exchange always have only one buy/sell price (single call price).
In decentralised markets, such as foreign exchange markets, several market makers offer prices that can provide different prices. Let’s look at how centralised and decentralised markets work!
A Centralized Market
An essential feature of the centralised market is that it tends to be proprietary (a single price at every point in time). Since only one specialist controls the market, they can easily distort the offered price from the specialist’s perspective, not from the traders’ standpoint.
For example, suppose a market overflows with sellers, and there are no buyers on the other side. Then specialists will be forced to buy from sellers, and they will not be able to sell shares that are falling in price due to increased selling.
In this situation, specialists will expand the spread widely, increasing transaction costs, which will delay new participants’ entry into the market. Specialists will change the price they offer to protect themselves.
A Decentralized Market
The foreign exchange market is decentralised, so there are many market makers, not just one specialist. However, participants in the foreign exchange market are composed of several classes, among which those with excellent credit, high trading volume and expertise are given priority.
At the top of the structure is the Interbank market, which trades on the highest scale (mostly G7 currencies). The large banks in the interbank market can directly deal with each other through interbank brokerage firm like EBS and Reuters systems. The Interbank market is a type of credit approval system that relies on credit relationships established between banks and trading parties.
They can see the exchange rate trading record. However, to deal with each bank’s exchange rate, one must have a specific credit relationship with the other bank in advance. Other institutions, such as Online FX Brokers, Hedge Funds, and Corporations, have to trade FX through commercial banks.
However, many banks (small local banks or banks in emerging economies), corporations, and institutional investors cannot trade at these interbank exchange rates because they don’t have a credit relationship with big banks in advance. As a result, small participants have no choice but to make foreign exchange transactions through only one bank. It will inevitably be provided with an uncompetitive exchange rate and become a lower class of market structure. The least competitive exchange rate is the bank’s customers and currency traders.
Recently, due to the development of technology, barriers that existed between end-users of foreign exchange services and the interbank market have been broken down. The development of online trading has opened the door to foreign exchange transactions for retail customers. It has efficiently linked to market makers and market participants at low costs alone.
Essentially, the online trading platform serves as an entrance to the liquidity-rich foreign exchange market. Ordinary traders can now trade orders at prices similar to those of the largest banks in the world. In games controlled and dominated by giant hands, individuals can make profits and enjoy the same opportunities as large institutions.
Dealing Station – Interbank Market
The majority of FX transactions are mainly through the Interbank market. Large banks worldwide trade with each other through computer platforms such as EBS and Reuters Dealing 3000-Spot Matching. While significant currency pairs are available through these two platforms, specific currency pairs are traded more fluidly or more frequently.
The two companies are continuously competing to increase their market share and introduce the most flexible currency pair in each company.
Generally known heterogeneous currency pairs are not traded on either platform but are instead calculated based on the exchange rate of key currency pairs and offset using LEGS (the currency used to create the currency pair’s asking price).
For example, if a customer wants to buy AUD/JPY, the Interbank Trader will buy AUD/USD on REUTERS D3000 systems, and the EBS system will inform the USD/JPY exchange rate.
These heterogeneous currency pairs, known as synthetic currencies, generally explain why the spread of these currencies is broader than that of major currencies.