Broker’s Blurb: MAJOR MARKET PARTICIPANTS IN THE FOREX MARKET

Since we have covered the evolution of currencies and its market size and liquidity, let us now move on to various market participants involved in the forex exchange market. Unlike a stock market, the foreign exchange market is divided into levels of access. At the top is the inter-bank market, which is made up of the largest commercial banks and securities’ dealers. Within the inter-bank market, spreads, which are the difference between the bid and ask prices, are razor-sharp and not known to players outside the inner circle. The difference between the ‘bid’ and the ‘ask’ prices widen as you go down the levels of access. This is due to volumes. If traders can guarantee a large number of transactions for large amounts, they can demand a smaller difference between the bid and ask price, which is referred to as a better spread.

The levels of access that make up the foreign exchange market are determined by the size of the ‘line’ (the amount of money with which they are trading). The top-tier inter-bank market accounts for 39 per cent of all transactions. From there onwards are the smaller banks, followed by large multinational corporations (which need to hedge risk and pay employees in different countries), large hedge funds, and even some of the retail market makers.

Commercial Companies

An important part of the foreign exchange market comes from the financial activities of companies seeking foreign exchange to pay for goods or services. Commercial companies often trade fairly small amounts compared to those of banks or speculators, and their trades often have little short-term impact on the market rates. Nevertheless, trade flows are an important factor in the long-term direction of a currency’s exchange rate. Some multinational corporations (MNCs) can have an unpredictable impact when very large positions are covered due to exposures that are not widely known by other market participants.

Central Banks

National central banks play an important role in the foreign exchange markets as they try to control the money supply, inflation, and interest rates. They can use their often substantial foreign exchange reserves to stabilise the market. Nevertheless, the effectiveness of the central banks’ ‘stabilising speculation’ is doubtful because they do not go bankrupt if they make large losses, like other traders would, and there is no convincing evidence that they do make a profit in trading.

Foreign Exchange Fixing

Foreign exchange fixing is the daily monetary exchange rate fixed by the national bank of each country. The idea is that central banks use the fixing time and exchange rate to evaluate behaviour of their currency. Fixing exchange rates reflects the real value of equilibrium in the market. Banks, dealers and traders use fixing rates as a trend indicator. The mere expectation or rumour of a central bank’s foreign exchange intervention might be enough to stabilise a currency but aggressive intervention might be used several times each year in countries with a dirty float currency regime. Central banks do not always achieve their objectives. The combined resources of the market can easily overwhelm any central bank. Several scenarios of this nature were seen in the 1992–93 European Exchange Rate Mechanism collapse and in more recent times in Asia.

Hedge Funds as Speculators

About 70 per cent of the foreign exchange transactions conducted is speculative. This means the person or institution that bought or sold the currency has no plan to actually take delivery of the currency in the end; rather, it was only speculation on the movement of that particular currency. Since 1996, hedge funds have gained a reputation for aggressive currency speculation. They control billions of dollars of equity and may borrow billions more, and thus may overwhelm intervention by the central banks to support almost any currency if the economic fundamentals are in the hedge fund’s favour.

Investment Management Firms

Investment management firms (which typically manage large accounts on behalf of customers such as pension funds and endowments) use the foreign exchange market to facilitate transactions in foreign securities. For example, an investment manager bearing an international equity portfolio needs to purchase and sell several pairs of foreign currencies to pay for foreign securities’ purchases. Some investment management firms also have more speculative specialists in currency overlay operations to manage their clients’ currency exposures with the aim of generating profits as well as limiting risk. While the number of this type of specialist firms is quite small, many have a large value of assets under management and, hence, can generate large trades.

Retail Foreign Exchange Traders

Individual retail speculative traders constitute a growing segment of this market with the advent of retail foreign exchange trading, both in size and importance. Currently, they participate indirectly through brokers or banks. Retail brokers, while largely controlled and regulated in the US by the Commodity Futures Trading Commission & National Futures Association, have in the past been subjected to periodic foreign exchange frauds.

To deal with the issue, in 2010 the NFA required its members that deal in the forex markets to register. Those NFA members that would traditionally be subject to minimum net capital requirements, FCMs and IBs, are subject to greater minimum net capital requirements if they deal in forex. A number of foreign exchange brokers operate from the UK under the regulations of the Financial Services Authority whereby foreign exchange trading using margin is part of the wider over-the-counter derivatives’ trading industry that includes contracts for differences and financial spread betting.

There are two main types of retail FX brokers offering the opportunity for speculative currency trading: brokers and dealers or market makers. Brokers serve as an agent of the customer in the broader FX market by seeking the best price in the market for a retail order and dealing on behalf of the retail customer. They charge a commission or mark-up in addition to the price obtained in the market. Dealers or market makers, by contrast, typically act as principal in the transaction versus the retail customer, and quote a price they are willing to deal at.

Non-Bank Foreign Exchange Companies

Non-bank foreign exchange companies offer currency exchange and international payments to private individuals and companies. These are also known as foreign exchange brokers but are distinct in that they do not offer speculative trading but rather currency exchange with payments (i.e. there usually is a physical delivery of currency to a bank account). It is estimated that in the UK 14 per cent of currency transfers/payments are made via foreign exchange companies. These companies’ selling point is usually that they will offer better exchange rates or cheaper payments than the customer’s bank. These companies differ from money transfer/remittance companies in that they generally offer higher-value services.

Money Transfer/Remittance Companies and Bureaux de Change

Money transfer companies or remittance companies perform high-volume, low-value transfers generally by economic migrants back to their home country. In 2007, the Aite Group estimated that there was USD 369 billion worth of remittances (an increase of 8 per cent on the previous year). The four largest markets (India, China, Mexico and the Philippines) receive USD 95 billion. The largest and best known provider is Western Union with 3,45,000 agents globally followed by the UAE Exchange.

Bureaux de change or currency transfer companies provide low-value foreign exchange services for travellers. These are typically located at airports and stations or at tourist locations and allow physical notes to be exchanged from one currency to another. They access the foreign exchange markets via banks or non-bank foreign exchange companies. In our next series we will be covering the various financial instruments like spot, forward, swap, futures, and options. Also, we will be looking at trading characteristics in the foreign exchange markets and the most traded currencies.

Disclaimer: The above opinion is that of Naveen Mathur, Associate Director - Commodities & Currencies, Angel Commodities Broking (P) Ltd. and is for reference only.