FX Market Mechanics
Using Just FX Analytics
The FX market is decentralized or "over-the-counter" market, where trading occurs directly between two parties rather than via centralized exchanges. It is the largest financial market in the world, accounting for over $5 trillion in daily trading volume. In a typical corporate FX transaction, a contract is made to purchase one currency and sell another at a set rate. This contract is subsequently "settled" by physically delivering the currencies between parties. The key participants of the FX market are international banks, who act as "market makers" and trade significant volumes of currency, driving global price movements. Transactions between these major banks are referred to as the "interbank market", and represents the most efficient market (best pricing with smallest spread) for FX. The FX market operates 24 hours a day, except weekends. Trading may also be suspended in individual markets on public holidays, which can impact liquidity (for example, relatively little volume is trade on Christmas Day and New Year's Day).
The "bid" price is what the dealer is willing to pay for currency if the customer is selling, while the “ask” price is how much the dealer wants for a currency if the customer is buying. The ask price is also referred to as the "offer" price. The bid price is lower than the ask price, because you cannot sell currency at a higher price than you buy it. The difference between the bid and ask prices is referred to as the "spread".
Liquidity refers to the level of trading activity for a given currency pair at a point in time. High liquidity helps keep the market stable and avoid price volatility, and keeps spread tighter and hence pricing more favourable. It is therefore often more risky to trade at times when liquidity is reduced, such as major market holidays.
A "market maker" quotes prices at which currency can be bought and sold to the counterparties (other organizations) with which they have a relationship. Specifically, what identifies a market maker is that they always quote both bid and ask prices for a set of currencies. It is effectively the network of market makers around the world which drive foreign exchange pricing. Large international banks typically have market makers for every major currency pair. Market makers make money in two ways: firstly, through the bid/ask spread on the currencies they trade, and secondly (optionally) by taking positions themselves in the market by trading with other banks.
FX pricing is driven by market makers and due to the decentralized nature of the market, there is no single "source of truth" for pricing. In fact, pricing available to a trade is highly dependent on the counterparties with which they have a relationship. Typically market makers will consider several factors in setting pricing: 1) Rates being quoted by other market makers - it is always desirable to attract FX "flow" (transaction volume) by offering competitive pricing. 2) Positions they have taken in the market - for example, if they wish to adjust their risk profile they may offer pricing which enables them to rebalance their position. 3) Their prediction of future direction for an exchange rate.
When market makers quote bid and ask pricing, they typically accompany this with a "volume". This is the size of trade for which the price will be honoured. At any one time, there may be multiple quotes in the market with different pricing at different volumes. This means that depending on the size of a trade, different prices may be available. The best pricing in the market ("top of book") may only be available for smaller volumes, and larger trades may be executed at a price further down the order book.
Banks monetize FX operations in several ways. The capital markets departments typically make money through market making and trading operations - collecting bid/ask spread and taking positions in the market. However, banks also generate profit through the corporate FX services they provide. Typically, the FX sales desk which quotes pricing to corporate customers will apply a margin or mark-up to the prices at which the bank's traders are dealing. This margin is not disclosed, and can differ wildly from customer to customer ("price discrimination"). Just FX Analytics uses interbank top-of-book prices usually accessible only to professional traders to benchmark corporate FX rates and calculate this markup.