BUSTING THE MYTH OF A FOREX MARKET MAKER

BUSTING THE MYTH OF A FOREX MARKET MAKER

Trading Fx in itself is a pretty straightforward business. However, the overall interaction between the various participating groups adds up to a complex affair. The big question is – who is the forex market maker?

To answer the question, first we need to understand these players. The group of Fx participants is a big bunch. You see, the Forex market breaks down into a large number of speculators of varying sizes and with very different objectives.

You have Intraday traders, Swing traders, Long term Investors. And, if you add the HFT machines with their scalping methodologies into the mix, you can see how this, quickly becomes very complex.

 

The FX Marketplace structure in a nutshell

At the very top of the Fx pyramid there is an Interbank. This is the level where major financial Institutions are exchanging their currencies. Imagine this being as a wholesale place for buying and selling the currencies. It is here, where we can witness  the true power of the forex market maker.

Each Bank has a dedicated market-maker that is curating each major currency pair. It provides quotes at which the bank is willing to buy and sell currencies from their fellow bank partners in the Interbank network. Therefore, without the shadow of the doubt, we can say that the Institutions that are on the Interbank level are the primary market-makers of the FX arena.

One of the sophistications of the Interbank marketplace, and maybe one of the important factors, is the credit relationships that the major banks have among each other. The banks buy and sell currencies between each other with this credit-worthy approach.

Not to mention, the deal sizes on the Interbank level are typically very large. Definitely, out of reach of retail trader’s pocket. These combined nuances prevent, or should I say filter, most participants from directly accessing the Interbank market. In essence, the Interbank is self-regulating itself with the above mentioned factors.

image of an interbank logo implying relation to the forex market maker

Indeed, there was a time period, not so long ago, give or take, twenty years ago when the Fx marketplace was strictly the domain of large banking companies and genuinely well established financial Institutions. Thanks to the technological and the data processing revolution, that all has changed!

The rise of Retail FX was inevitable.

Nowadays, everybody can access the Forex market easily and compete with large banks for the share of Fx profits. This is done through the retail Fx brokers. Usually it is either an ECN, or an STP broker that plays the role of an intermediary between the “average Joe” and the Interbank. Later on we’ll be discussing the difference between the market-makers, but for now let’s focus on the role of the Forex market maker.

 

Market Maker’s Role

The primary role of the market-maker is to do what its name implies – to make the market!

A market maker sets two-way prices in a certain currency pair in order to make a market.

Essentially, a forex market maker does a couple of  things:

Sets two-way prices (bid/offer) prices in a particular currency pair.

Commits to accepting orders at the current market prices.

Since the Fx market maker is a counterparty to a trade, it takes the resulting exposure from the order-flow on to their own order-book. What this means, they are not matching the trade with another party in the way that an ECN or an STP broker would. An Interbank market-maker  may choose to hedge his exposure with another bank, if he is able to obtain a favorable rate.

How much of a risk they decide to take on, or to take off  the table, will be at their sole discretion.

Basically they are the “the 800 pound gorillas” of the financial jungle.

image of a gorilla that embodies the forex market maker

Obviously, the large banks see huge flows of foreign currency transactions from their daily operations. As a result, they’re able to achieve significant profit from just simply collecting the spread day, after day.

However, the Bank is not limited by this day-to-day activity of making the market and collecting the spread. A dealer bank may also choose to take a position in the Fx market if it decides to do so, because it can see his order-book across the board.

They can do this either, by making a trade with another member bank, or by quoting the currency accordingly in order to induce trades in a certain direction.

 

Ok, If you think that making a market is an easy business, think twice…

Actually, bank dealers have to consider a number of factors before making their prices.

Here are just some of them:

– current volumes at the prevailing market rate

– current rates that are being offered elsewhere on the Interbank network

– volume of the deal they are quoting

– their own exposure in the Market (the open positions they already have on their books)

– overall view on the future value of the currency pair

Obviously, there is a market-maker for each market: Stocks, Options, Bonds, Futures. So how these types of market-makers stack against each other. Let’s compare the two, Fx and Equities for example.

Right from the start, Equities are being traded on the exchanges, where trade information is publicly available. This means, that the true price and volume are available for speculators in these markets.

And this is a big plus, where the Fx dealings of large banks is considered a proprietary information, and on top of that there is no mandate for the info to be disclosed. The forex market maker is aware of large orders placed by financial Institutions before the rest of the participants. Hence, they are aware of the potential market-moving trades.

Essentially, this gives them an unfair advantage over the other market groups.

 

The difference between a Retail Fx Broker and a True Market Maker

A number of of the Retail firms are often times referred to as market-makers, however, in reality they do not actually perform the root functions of a true Market Maker. Some Retail companies may operate successfully as a broker. Meaning, they hedge their risk immediately with their liquidity providers. Others may take some of the risk on to their own books.

The key difference, they do not make their own prices as a true market maker. These Retail shops usually offer aggregated quotes for any particular pair. Simply put, they offer to their clients best bid/offer prices they have access to through the market making partners. These partners are the large banks from the Interbank level, who operate as prime brokers for these firms.

The way the partners grant the access to their liquidity is through the ECN – Electronic Communications Network.

An ECN software organizes bids and offers from larger banks, financial institutions and puts it into  an order book. Now, when you place a trade, the ECN will match your order against the very best price available. The ECN networks are operating with lightning speed. The orders are matched in milliseconds and the spreads are usually very competitive.

Also, there are STP – Straight Through Processing brokers as well. Despite the fact that ECN connects orders with those of other market participants as well as main liquidity providers, in the core they are very similar programs. The main difference, an ECN taps into a bigger pool of orders than a standard STP.

image of a liquidity aggregation scheme that describes forex market maker processes

Now, there are long debates in Retail Forex community, whether it is best to use ECN and STP brokers over a true market making Dealer Broker. The dealer broker – the one, that is taking the opposite side of your trades. To answer this question we need to step back and reflect upon what was going on during the Swiss National Bank debacle. Every Fx trader remembers that time period. Let’s not kid ourselves, it was a disastrous period for many of us…

On January 12th  2015, a financial tsunami ripped through the Fx Market, when the Swiss National Bank decided to unpeg its currency from the EURO.  This caused Swiss Franc to appreciate against the EURO for more than 30% in a matter of minutes.

“How is this relevant to the topic?” – you may ask…

Well, let’s put ourselves in the shoes of an STP Broker. What would happen in case of a lack of liquidity is as follows: you would accumulate orders in a matter of seconds, then as a Straight Through Processor you would want to transfer those orders to your liquidity partner, but guess what?!

There was nobody on the other side to pass on to…there was no Market Maker to fill your orders. I mean, there was, but the first bids on EUR/CHF pair were in the 0.8700-0.8800 area. And that is more than 3200 pips lower from where it fell. In other words, there were plenty of Market Makers ready to make the market, they just happen to be 3200 pips below. Lots of so called true ECN and STP brokerage houses went under on that day. The losses that they had on their books were gigantic.

To read more about this Black Swan event, please go here >>>

Also, read: Everything You Need To Know About The Hedge Fund Career Path

Market Maker and the Boogeyman, what they have in common?

image of a Boogeyman with his forex market maker female friend

Lots of traders simply just hate the Market Makers. They give them super-natural abilities of a Boogeyman. They blame them for their losses and for any unfortunate event that’s happening in their trading.

I personally can understand the frustration, we’ve all been there – market-maker’s stop hunts are really a pain in the neck! Bull and Bear traps are present in any Market…It is a part of the business…

However, let’s not forget, without the market-makers there would be no trading in the first place. The bottom line is that they are the most important component of the marketplace. Think about it for a second, they offer liquidity to the market by taking the opposite side of your trades.

They are committed to satisfy any size of the deal. On top of that, they provide effective market quotes to the participants. And yes, the market-makers are not going to quote a price that doesn’t suit their own position, nevertheless they do quote a two-way price.

 

To Conclude…

A true market-maker is there to make a market, without it we as speculators wouldn’t be able to trade. A true market-maker’s commitment to sell and buy the currencies forms a cornerstone of all the pricing in the Forex marketplace.

Despite heaving the huge volumes that go through the Interbank market, a large portion of Retail Forex participants simply do not have direct access to the liquidity. They use an ECN and STP Brokers, which in the cases of a “Black Swan” events prove to be vulnerable to the liquidity crunch.

The gap between an Institutional investor and a Retail trader has narrowed over the past decade. Now, the retail speculators have access to competitive spreads, the overall trading became less stressful and very convenient.

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