How Forex Trading Works – The Forex Market Structure

Whenever you talk about the markets to your friends and family, they will generally assume that you’re talking about the stock market.

In terms of ‘forex vs stocks‘ structure, the stock market is much different to the Forex market, let’s take a look and see how they differ in structure, and the advantages/disadvantages of each.

The Centralized Market

Centralized markets operate through a ‘central’ exchange.

This means any orders that are placed on a centralized market MUST go through its housing exchange. Doesn’t matter if you’re a large company with big pockets or just a small retail trader, whether you’re going long or short.

Everything is processed through the central exchange.

Pros:

The ability to track all transactions

One cool thing centralized markets can do is track the amount of orders, and their volume at any given time with full accuracy. This allows centralized markets to provide more accurate analytic data of all the transactions that go through the central hub to their market participants.

For example; the stock market offers true volume data, where the foreign exchange market cannot.

Cons:

You’re at the mercy of the central ‘market king’

When trading on the stock market, all your orders are executed through the exchange central hub, which has the ability to manipulate prices, increase market spreads and enforce short bans.

Scenario 1: There are more sellers than buyers in the market, and remember for every seller there must be a buyer, but let’s say there are no buyers left to facilitate a rapid amount of sell orders coming in.

The central exchange will deliberately increase the market spread in an attempt to discourage more sellers from entering the market.

Scenario 2: Traders are spooked about an economic crisis, and want to sell off their stocks. First the central exchange raises the spread to discourage the traders from selling.

However the traders are desperate to get rid of their stocks due to a progressing market crash and are not discouraged by the high spread prices.

The selling pressure becomes overwhelming, so the exchange issues a short sell ban. Now no new short orders can be opened.

Only traders currently holding stock are allowed to sell them, but generally there are no buyers during market crashes and traders have no choice but to watch their money disappear.

You can only trade when the central exchange is open

Trading hours in centralized markets are restricted to their exchange’s trading hours, which are typically the normal business hours of the exchanges time zone, Monday to Friday. The New York Stock exchange opens at 8am and closes at 5pm New York time. If you want to trade outside of those hours, tough luck, without the central exchange there is no one to facilitate your trade order.

The Decentralized Market

Now let’s have a look at how Forex trading works by talking about the decentralized market. This is a market that doesn’t have one central exchange that controls all market activity.

The decentralized market has many hubs and channels that interconnect with one another. Trade orders can take multiple paths to “make a trade”.

An example of a decentralized network is the internet.

Internet signals from your computer have many possible routes to reach their destination. If the preferred route is blocked or not working, your signal is re-routed through the next best available route. The Forex market works in a very similar way.

The Foreign Exchange market is a decentralized network market; take a look at the model below to get a visual representation of how the market is connected together. The diagram below will give you a good visual representation on how Forex trading works.

The Foreign Exchange can be thought of as a network structure that operates on a tier system, the major banks located on the top tier, and us retail traders trading from our computers at homes are on the bottom tiers.

So what happens to our trade when we place our order?

Tier 1: The Interbank Network

The interbank network contains the central and major banks, represented by all the black entities on the chart above. These guys are the core of the Foreign Exchange network.

All orders must pass through one of the members of the interbank network to be executed. The guys on the interbank network are the ones with the money, and they provide the liquidity to the other market participants.

This is the core of how Forex trading works, the interbank networks is the ‘glue’ that holds everyone together.

Tier 2: The market makers

You are connected to the internet right now reading this article. To get access to the internet you were required to sign up with an ‘internet service provider’, which you pay a service fee to, and they provide you with the means to browse the internet.

The Foreign exchange is very similar, to be able to start making trades you need to sign up to a broker, the broker is your means to access the interbank network and start making trades with the rest of the world.

When you think about how Forex trading works, Brokers are the market makers. When you place a trade order, the broker will first try to match up your trade with another client of the brokers, bypassing the interbank network all together.

If this is successful the broker now has a free hedge trade and is at no risk of loss. If the broker can’t match up the trade amongst its own clients, they will usually open a trade in the opposite direction to yours (a hedge trade) on the interbank network.

This will protect the broker from any losses your trade may attract.

The market makers have access to the cheaper interbank network market prices; the market maker adds their commission onto the interbank pricing and passes that onto you. The difference in prices is called the ‘Bid-Ask spread’.

Bid Price: This is the price that the interbank network is willing to sell the currency to the market maker for.

Ask Price: This is the price which the market maker is willing to sell the currency to you for.

The spread is the means which brokers make their earnings, every time you buy a currency at the market makers ‘ask’ price. The market maker then takes your order and passes your trade onto the interbank network for a cheaper price.

This is the core business model of retail Forex brokers, it’s how they put money into their pockets.

Think about every trade that is placed every day in the Forex market. Each trade has its broker’s commission added on to it, that’s a lot of money getting banked by the broker.

ECN Brokers

An ECN broker has the same position on the Forex network as a market maker broker.

The key difference is they don’t manipulate the prices that you see by adding spreads to the ‘ask’ price (well they claim they don’t).

Instead they give you the direct interbank price quotes, which are obviously going to be much cheaper. So how does Forex trading work with ECN brokers? How are they making money if they don’t apply any spreads? Well they earn commissions off your trades instead.

Large Speculators & Commercial Companies

Coexisting on the second tier of our ‘how Forex trading works’ diagram, we have the Hedge Funds and Commercial companies.

These guys have very deep pockets and make up for a large amount of the overall trading volume on the Foreign Exchange. Large specs generally have special credit relationships with commercial banks on the interbank network.

The commercial banks facilitate the large trade orders that commercial companies place to do their everyday business and the hedge funds use for their speculative trading (to make money from money).

The Small Speculators

Retail traders are the small time players. and are composed of  Forex traders like you and I. We trade smaller amounts of money compared to the “big boys”.

Retail traders are also known as ‘small speculators’ and make up only a very small percentage of the market volume. Retail traders are able to control large volumes of money with small capital through a leveraging system offered by brokers. Leverage is how forex trading works well for us stay at home traders will small balances.

Brokers temporally borrow money from banks to give the liquidy for leverage, allowing us to trade with more money than we actually own. Small speculators have a high failure rate in the markets and are often called “dumb money”.

In fact it’s a well know fact that a high percentage of forex traders lose money, around 95%.

To avoid becoming a statistic it’s important to manage your Forex trading by doing things like keeping a Forex trading journal and creating a Forex checklist before investing your hard earned money.

Now you’re familiar with how Forex trading works, in the next chapter will be a beginners guide to select a Forex broker to trade with. There are a few things you really need to know about Forex brokers so you don’t put your money in the wrong place.