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How Does It Work?
The Forex market is organized into a hierarchy, which consists of participants with different ranking. The standards that determine the participants’ positions are credit access, volume of transactions, and level of sophistication; those with superiority in these measures receive priority in the Forex market. At the top of the hierarchy is the Interbank market, which generates the highest volumes in trades.
Interbank is a credit-approved system where banks trade on the sole basis of their credit relationships with one another. In the Interbank market, the largest banks are able to trade with each other directly, via interbank brokers or through electronic brokering systems such as Reuters or EBS. While all the banks can see the rate that everyone is dealing at, each bank has a specific credit relationship with the other bank and trade at the rates being offered.
Market Structure
Other institutions in the market, such as corporations, online Forex market makers, and hedge funds trade Forex through commercial banks. However, many banks (community banks and banks in emerging markets), corporations, and institutional investors do not have access to these rates because they do not have established credit relationships with large commercial banks. Subsequently, these smaller participants are obligated to trade Forex through a large bank, and often, this equates to much less competitive rates. The rates become less and less competitive as it trickles down the hierarchy of participants. Eventually, the customers of banks and foreign exchange agencies receive the least competitive rates. However, in the late 1990’s, technological advances have eliminated the barriers that existed between the Interbank and end-users of Forex (retail traders).
Since 1996, retail clientele can connect directly to market makers via online trading platforms. Investors can enjoy the competitive rates and trade alongside the world’s largest banks. The Forex market is no longer reserved for big corporations; it is now made available to all types of investors. Furthermore, the boundless opportunity to trade foreign exchange awaits all aspiring corporations and individual traders.
Decentralized Network
A decentralized market is one that doesn’t have one central exchange that controls all market activity. The decentralized market has many hubs and channels which trade orders can flow through.
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 to the right to get a visual representation of how the market is connected together.
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 as other participants flow out (or down) from there.
