Understanding Price Behaviour in the Forex Market – 1
This article is written to give retail traders who are new to the market an understanding of some of the issues involved in the pricing of currencies in the forex market. At the end of this article, you should be able to answer the following questions:
a) How are price quotes on a forex trading platform derived?
b) Who sets the prices?
c) Do price anomalies occur, and if they do, how can they be overcome?
d) Is the broker truly a neutral party in a forex trade?
e) How can you ensure you get the best pricing for your trade?
How Prices of Currencies Are Derived
Whenever a trader decides to trade a currency pair in the forex market, they are usually given two prices in a quote:
a) The bid price, which is the price at which a dealer will sell a currency asset to the trader,
b) An ask price (offer price) which is the price at which a trader will buy a currency asset from a dealer.
Currencies are warehoused in banks and financial institutions. When an individual wants to buy currencies for his business, or the Bureau de Change operators wants to load up their accounts, or a company wants to purchase a foreign currency to finance strategic purchases in another country or pay for a merger, the bank will aggregate these orders and approach either the central bank or some other larger institution to place orders for these currencies. Central banks hold currency auctions to provide these banks with all the money that is used to satisfy Forex orders globally. These banks in turn, serve as liquidity providers in the global currency markets, setting prices according to the demand and supply of each currency in their possession. The prices are therefore set according to market forces, and these currency quotes are fed electronically either to traders directly through their brokers (ECN/non-dealing desk brokers) or to market makers who mop up these currencies in large volumes (acting as a liquidity bridge ). The market makers then resell the currencies at slightly marked up prices to retail traders through their dealing desks).
The global online currency trading system can only thrive seamlessly where there is liquidity. So there must be sufficient liquidity to be able to absorb the flow of orders emanating from the banks acting as liquidity providers, and to keep the cost of such transactions as low as possible. In an Electronic Communication Network (ECN) or non-dealing desk environment, this liquidity is matched by the high net-worth value of the clients’ accounts in the system. That is why a strict ECN broker will require a minimum of $20,000 to $50,000 for a trader to operate an ECN account. It may even require as high as $100,000 to open an account with some high-end ECN brokers. In addition, traders using ECN are not permitted to trade mini lots or micro lots; they must trade in Standard Lots. All this is in an effort to ensure that there is enough liquidity to keep the system going. Traders with ECN accounts can thus get price quotations straight from the banks, place their orders and get their trade orders fulfilled with direct market access.
In a dealing desk environment, it is the brokers themselves who fill in the liquidity gap. They mop up large volumes of the asset, and resell to their clients with a slight mark-up. This way, the brokers can afford to pick up clients with small accounts in hundreds or few thousands of dollars. The trades therefore, do not come from the liquidity providers directly, and the orders/executions are routed via the broker’s dealing desk. In this capacity, the brokers are functioning as market makers.
This is how price quotes are setup in the online currency market, and this has implications for the trader. We discuss this in the second part of this article.