In our final exploration in this three-part series, we will take a look at the Forex market from an institutional perspective. While the first two articles in this series have focused on the proprietary Forex trader, we’ll begin to examine how banks and other financial institutions handle the price swings within the currency marketplace.
Let’s review what we’ve learned thus far. We know that, because there isn’t a centralized exchange for the Forex market, traders and banks can trade, literally, 24 hours a day, six days a week. We also know what conceptually happens when a Forex trade is transacted. A trader sells one currency for another in the hopes that the currency he or she bought will increase in comparison to the currency the trader sold.
Bank Arbitrage and Institutional Trading
Now….how do banks (which are, basically, mini currency exchanges) profit in the Forex market?
Well, banks are nothing more to the Forex market than what Specialists are on the New York Stock Exchange. While the Forex market is unique in its trading dynamic, it shares many similarities with other “traditional” exchanges. Every currency pair is quoted with a bid price and an ask price.
The bid is the highest amount someone is willing to pay while the ask is the least amount someone is willing to sell at. The difference between these two numbers is what is called the spread. In a nutshell, the banks are making money on the current spread between the bid and the ask. Let’s use a real-world example to illustrate how this part of the transaction plays out:
At most international airports, various currency kiosks allow travelers to swap their base currency for the currency of the country they are traveling to. Say a traveler leaves the United States for Europe and arrives in Milan, Italy.
At the Milan airport, the traveler visits the currency kiosk, so he or she can swap US Dollars for the Eurodollar. This traveler presents $100 and receives 90 Eurodollars in return. While the traveler now has 90 Eurodollars in place of $100 US Dollars, he or she doesn't realize that the current exchange rate is 95 Eurodollars for every 100 US Dollars.
Well, the exchange kiosk underquoted the exchange rate; hence, the traveler got less than market value for his or her US Dollars, and the kiosk operator made 5 Eurodollars by providing less than market value. Basically, the currency kiosk is a type of Forex exchange. This currency swap could have been made at a variety of places, but that was the monetary exchange that both parties agreed to. This is how banks profit from every currency exchange that takes place on a global scale.
Now, let's extrapolate our airport kiosk example to the practices of various financial institutions that trade foreign currencies all throughout the world. Because each bank is conducting its own series of transaction for traders who use the platform they offer, they are quoting their market price for the currency pair. (Remember that a bank in the Forex world is nothing more than an electronic platform for traders and other institutions to interact with one another.)
Here's the big question: Why doesn't a bank just increase the spread to capture more profits for itself? Well, the answer is simple: The banks need to stay competitive. There are literally thousands of banks where traders can exchange their currencies. Each bank is faced with competition from other institutions. Banks want the business of traders; in fact, they rely on it.
To maintain their competitive edge, they will try to offer the best rate to attract traders while keeping as much profit as they can. Because the Forex market is so liquid, banks rely on trade volume to make their money. Rather than increasing the spread to capture profits, they decrease the spread in hopes of attracting more volume.
Another way in which banks make money in the Forex market is through what is called risk arbitrage. In a nutshell, arbitrage is when a bank makes a trade on a particular cross rate only to take a position of equal size in the opposite direction in the hope of making money on the spread. This not only minimizes the risk but also allows them to basically control the spread and capitalize on it.
In this series of three articles, we have covered quite a bit of ground with respect to our understanding of the currency markets. We've looked at why currencies are traded and by whom. We've also outlined some trading scenarios to help illustrate how the life of a Forex trade typically plays out. Finally, we have looked through an institutional lens to see what happens when traders come together and place trades through a broker or bank.
The world of currency trading is quickly gaining in popularity due to the amount of money that can be generated in a short amount of time. The Forex market is a driving force in the global economies that influence most societies. We hope that, although we barely scratched the surface of all the components that must be considered when trading currencies, we have enlightened you enough to explore the market further and, perhaps, trade it for yourself.
