Understanding the Interbank Market in the Foreign Exchange Market
How the Decentralized Structure of the Interbank Market Affects Price Discovery and Trading Opportunities in the FOREX Market.
Unlike traditional financial markets like the New York Stock Exchange (NYSE) or London Stock Exchange (LSE), there is no central exchange or physical location for the FOREX market. Instead, it is spread across the globe and is accessible through a network of banks and other financial institutions known as the Interbank Market. This decentralized structure eliminates exchange and clearing fees, making it more accessible and cost-effective for a wide range of participants.
Despite its decentralized nature, the forex market is not pure chaos. Instead, it is organized into a structure, with different participants operating at different levels.
At the top of the forex market structure is the interbank market. This market is made up of the largest banks in the world, such as central banks, commercial banks, and other financial institutions. These participants trade directly with each other through voice or electronic brokers, such as EBS Market and Refinitiv. They are constantly competing for clients and market share, and each platform has its own specific currency pairs that are more liquid than others.
For example, on the EBS platform, EUR/USD, USD/JPY, EUR/JPY, EUR/CHF, and USD/CHF are more liquid, while on the Refinitiv platform, GBP/USD, EUR/GBP, USD/CAD, AUD/USD, and NZD/USD are more liquid.
It is important to note that the rates offered by the interbank market participants are largely dependent on the established credit relationship between the trading parties. The better the credit standing and reputation of a bank with other banks, the better the interest rates and the larger the loan they can get.
Below the interbank market are the hedge funds, corporations, retail market makers, and retail electronic communication networks (ECNs). These institutions do not have tight credit relationships with the participants of the interbank market, so they have to do their transactions via commercial banks. This means that their rates are slightly higher and more expensive than those who are part of the interbank market.
At the very bottom of the structure are non-professional traders, known as retail traders. It used to be difficult for retail traders to engage in the forex market, but thanks to the advent of the internet, electronic trading, and retail brokers, the barriers to entry have been significantly lowered. Retail traders can now access the forex market through online platforms and mobile apps, making it more accessible to a wider range of participants.
The Interbank Market is the primary source of price discovery for the foreign exchange market. It is where large financial institutions such as central banks, commercial banks, and financial institutions buy and sell currencies in large volumes. International banks from around the world make up a large portion of the participants in the interbank market, although the activity of hedge/pension/mutual funds has also increased due to the advancement of electronic trading technology.
Traders are concerned with the forex interbank market because it is the primary source of price discovery for the foreign exchange market. The prices that traders see on their online broker platforms are based on the prices being traded in the interbank market. By understanding the activity and trends in the interbank market, traders can make more informed decisions about when to buy and sell currencies.
A trader uses the forex interbank market to make money by identifying a currency pair that is undervalued and then buying it at a lower price. The trader might then wait for the currency pair to appreciate in value and then sell it at a higher price, thereby making a profit. For example, a trader might notice that the Euro is undervalued relative to the US dollar and decide to buy Euros. If the Euro appreciates in value against the dollar, the trader can then sell the Euros and make a profit.
The interbank market is also referred to as the cash or spot market, meaning that if a trader were to take immediate delivery, that would be the price they would pay. There is another market that trades currency pairs, known as the futures market. The term “spot market” is used to distinguish it from the futures product.
In summary, the FOREX market is a decentralized, OTC market that is organized into a structure, with different participants operating at different levels that allows individuals and institutions to buy and sell currencies. It is accessible through a network of banks – the Interbank Market – and other financial institutions and eliminates exchange and clearing fees, making it more accessible and cost-effective for a wide range of participants. The interbank market is also known as the cash or spot market and is where large financial institutions buy and sell currencies where prices on trading platforms are based on the prices in the interbank market.