The Currency Market

Foreign exchange trading has essentially been around since lile advent of money, and although the mechanics have advanced somewhat since the time of the money-changers in the temple. it still boi ls down to the exchange of one currency for another.
Of all financial markets. the FX market can probably be considered to be among the most ';purc" in the sense that supply and demand (in the free-Hoating currencies) is strictly what determines prices, For the most pan, the market is unregulated and free of distorting red lape. and the sheer size of the trading volume means that government intervention has little long-term effect on prices. After all, in a market that trades over $2 trillion a day government intervention can only go so far, and at the end of the day it is the two hundred thousand traders around the world that act as Adam Sm ith's invisible hand in guiding prices.
Since a market this free and liquid is typically hard LO out-guess. you would be right to think: "is it even worth trading such an efficient market?" The good news for traders is that the FX market is not as efficient as it may first appear, and the root of this inefficiency can be {raced back to the panicipam's motivation. The FX market has never been a value creator. but rather a vehicle for other transactions. A US portfolio manager buying Japanese stocks or an Italian company acquiring raw materials from Brazil both inadvertently become FX participants. yet the currency part of their transactions are not usually motivated by profit. The portfolio manager simply needs the yen to buy the stocks and the company needs dollars to buy the coffee.
This type of behavior breeds inefficiencies eagerly exploited by more active market panicipants, and fonunately for FX traders small arbitrage oppOI1unities still abound. Although the market may be very efficient at giving you a price, whether that price is an accurate reflection of the currency's true "value" is another story altogether, which is why good analysis and trading techniques do payoff in the long run.
Research and analysis in FX proves valuable because the currency market is different than Wall Street. The interbank market is by no means a perfect market since information is not freely available, market access is restricted, manipulation takes place. governments intervene. and a large number of participants routinely buy and sell irrespective of profit, which all comes together to turn conventional trading wisdom (such as "let your winners fUll. cut losers short") on its head in this mostly range-bound market. The FX market is different than other markets. and if you can find a way to recognize, predict, and exploit these imperfections. then there is a great deal of money lO be made. Profitable trading strategies do exist and can be found. Off-balance sheet earnings are the declared aim of most banks, and spot dealing in FX, which presents high loss potential (as far as price is concerned) but practically no credit risk, falls directly into this category. To understand a bank's motivation for getting involved in this market, all you have to know is that by combining a large FX dealing desk with a decent prop trading group, pretty soon you will be talking about billions in profits. These types of numbers have long made FX the playground of only the biggest and baddesl global banks, and because at its core the FX market continues to be a credit market. their dom inance is unlikely to be challenged any lime soon.

Unlike other markets, an FX transaction is not the exchange of cash for another asset (stocks or oil, for example), but rather the exchange of cash today in return for the acceptance of cash at n later date. The interbank market operates on this somewhat unusual principle. where one party depends on the OIher to meet their obligation without extending credit to each other. As you may wel l imagine. when dealing in this way it is crucial to know that your counterparty is of the highest credit standing, lest you be len holding the bag on one side of the transaction. For this reason, big banks prefer to deal with big banks, and smaller fish are essentially shut out of the FX pond. As a result. a small group of commercial and central banks (you can call it a cartel if you wish) has always handled the majority of FX turnover with each other, and for each other.
Technology has managed to open up this tight-knit group somewhat. although not to the extent that you may think. Most banks now either operate their own electronic dealing platforms or provide liquidity to a matching system/prime bro¬kerage platform. Products from EBS, Currellex, FXAIl, elC., enable banks to reach a larger client base whi le still maintaining full control over their risk, yet in the end, who do you think owns 1110st of these platforms anyway? The reality is that the same small group of banks still controls the FX market.
From the very beginning. the FX market was designed to ensure that market "insid¬ers" had a considerable edge over market "outsiders", Because of the tight-knit nature of the market and its lack of regulation, the FX market is a fundamentally unfair market for the nonprofessional to operate in. For example, in some emerging countries a Citibank or UBS may be the only game in town, so anyone wanting to trade that currency is forced to "pay up" to play in their turf. A player's positioning on the FX food chain depends on his/her access to information and speed, and with no central clearing exchange, it can be difficult for nonprofessionals to gain access to this information and come up with an accurate view of the market. More often than not this leaves those with limited access to information at the mercy of their bank dealer.
This is where the FX world differs from traditional financial markets, and things deemed illegal in most other markets are simply regarded as "part of the game" in FX. Insider trading. front running, price shading. etc .. are all regularly seen in FX trading, and have absolutely no legal repercllssions,
No governmem oversight and no central deal book to compare trades means that banks are pretty much free to do whatever they want to their unsuspecting customers. Unlike exchange-traded markets (NYSE) where a market maker has a responsibility to quote the Same price to two different parties, an FX dealer may quote his clients whatever price he wishes. Spreads mysteriously widen and shrink, and the "who's who" factor dominates. Good customers receive decent prices (a salesman will sha Ul to the dealer "good price, mate!"), but for irregular or com¬plicated clients it becomes practically impossible to receive fair market prices. God forbid that the dealer "read" you correctly and guessed your intentions. An FX trader who did not want to get ripped off before had to place 5 to 10.
calls to different banks and take their average as the "fair" market price. These inefficiencies, of course, all play into the hands (and pockets) of the brokers.
Dealers are free to behave in this way because they are very often the only game in lown, and they know that there is not much customers can do about il. In the same way that you and I knowingly get ripped off by the exchange booth guys at the airport, traders know they arc gcning short-changed but often have line. If Goldman is the only one willing to take your trade at that moment, you can either take it or leave, it is as simple as that.