Each region across the globe will have a location where there is a primary dealer who will be responsible for a currency pair. These dealers would pass a book from region to region as the prior region becomes less liquid. Large financial institutions want experts for each currency pair, so instead of having 4 or 5 dealers covering 20 currency pairs, they will more likely have 1 or 2 dealers for each. For emerging market trading, dealers will generally focus on a region.
That means there could be dealers who focus on South America, making exchange rate quotes in the Chilean Peso as well as the Brazilian Real for example.
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Market makers generate revenues by purchasing a currency pair on the bid, and selling the currency pair on the offer. They are trying to capture the interbank fx spread. The bid is the price traders are willing to purchase a currency pair for, while the offer is the price where traders are willing to sell a currency pair. Market makers attempt to generate profits by purchasing on the bid and selling on the offer, while hedging their position risk. Many times, a dealer will need to hold a position for an extended period, especially if the size of the transaction is too large to unwind all at one time.
The inventory an interbank dealer holds will also determine the exchange rate. Dealers also have a view of the market and this bias will also help influence the interbank exchange rate.
Another reason that market makers provide exchange rates is to attain information. By providing clients and other market makers with liquidity they can see large transactions which can move a market. This type of information is extremely helpful since many times there is no record of the transaction that others are aware of.
When stocks are traded on an exchange, there is a record of the transaction which can be viewed by everyone. This is also true for futures trades , but over the counter currency trades do not have to be posted. An interbank dealer generally has thousands of clients across the globe. Many of these financial institutions have clients that transact and take advice in all aspects of their businesses. For example, a large commercial bank might be lending money to a client, as well as providing corporate finance and investment banking advice, along with providing foreign exchange dealing operations.
By handling a wide breadth of services, a commercial bank can attract investors to dealing desks. These institutions might also provide other dealing operations such as interest rate dealing for both interest rate swaps and credit default swaps. Cross dealing opportunities make a bank an attractive place to trade the interbank forex market.
What is key for an interbank forex broker is to have access to Market Depth.
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The depth of a market such as the foreign exchange market, shows a dealer the different levels that clients want to enter or exit trades. Many of their clients are not concerned about trying to capture every available pip, and might be more concerned about getting into a trade or hedge at a specific level.
The market depth that a trader can see not only includes the specific exchange rate that an order is expected to be executed at but also the volume of the trade.
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This information is critical as it can supply the dealer with key information about support and resistance levels. Each level shows what is on the bid and what is on the offer along with the number of trades and the size of the trade. Each order book is different and shows you the volume along with the price. By having access to market depth an interbank dealer can trade around that book, to make money.
Usually there are many trades with smaller volumes near the current price of the exchange rate, while volumes increase as you move further. When prices reach a specific level, an interbank dealer can use their order book to determine if the market will be supported at that level or slice through it generating accelerating momentum.
Many times, interbank dealers will use support and resistance lines or moving averages to assist in determining if there is technical confluence in tandem with their market depth order book. The information received from clients is also key to interbank dealing success. For example, if a dealer has a large trade with a hedge fund, the direction that the market takes following their transaction can be different compared to the direction the market follows if a multi-national client is trading mainly to hedge their portfolio. These companies may want to hedge their portfolio at the most advantageous time, but since these traders are not typically market timing professionals, nor paid based on how well their hedge performs, the trade is less likely to result in a sustained move relative to a hedge fund manager that focuses on global macro trading and is willing to support a longer-term view in the market.
So, if an interbank dealer does a large transaction with a corporate treasurer, they may assume that the transaction was not specifically geared to generate revenue from the trade. In fact, a dealer in this situation might determine that this type of transaction will not push the market in the direction of the currency trade for any sustained period of time.
If, on the other hand, the transaction is traded by a hedge fund, the interbank dealer might decide that the hedge fund knows where the market might be going and use that information in a way to generate revenue for their own desk. Most of the time an interbank dealer will attempt to lay off the risk they assume, within the course of a day.
Forex Market Players
The interbank dealer is paid to deal and provide information to others within the trading organization. Prior to the financial crisis in , interbank dealers had the liberty to trade significant volumes of currencies, taking positions over days, weeks or even months.
Today, the leeway to take prolonged positions has been greatly reduced. Once a primary dealer takes a position they will need to offset the risk. Many times, the risk cannot be laid off all at once and the dealer must use many counterparties to reduce their currency exposure.
currency notes
There are two primary platforms that interbank dealers use. The interbank market system only provides access to traders who have the credit worthiness to participate within the system. The system is based solely on credit relationships that have been established with one another. The more relationships a dealer has, the more trading partners it can transact with.
Obviously the bigger the bank, the more relationships it will likely have. Credit relationships are forged between credit departments, where the amount of outstanding exposure is expressed in one number. The financial crisis is one example of a scenario where credit defaults can spiral out of control. More info.
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The Foreign Exchange Interbank Market
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