How Do Forex Market Makers Work?
Reading time: 10 minutes
The Forex market, It is a 24-hour market between Sunday and Friday, and is closed on Saturdays (e.g. it opens at 5pm EST on a Sunday, and closes at 4PM on a Friday EST). The Forex market also has no single central location of operation. Trading Forex (FX) itself is a reasonably straightforward affair for any single participant, but the overall interaction between the various players adds up to a complex affair.
You see, the Forex market breaks down into a large number of players of varying sizes. This article is going to look at a key type of operator in the Forex market, the role of Forex Market Makers. They play a significant part in FX prices. To better understand how market makers fit into the overall picture, we need to take a quick look at the market as a whole.
At the top of the tree sits the interbank Forex market. The interbank Forex market comprises the transactions conducted between the major banks. One way of describing it is as the wholesale level at which currencies are exchanged. It is here where we can see the core role of the FX market maker.
Each bank has dedicated market makers for each major currency pair. They provide prices at which the bank commits to buying and selling currencies from their peers in the interbank market. Though these prices are intended for the interbank market, they effectively permeate their way to the retail side of the market, as we shall discuss later. Therefore, we can say that the institutions that comprise the interbank market are the primary market makers in the FX market.
So what does a market maker do?
The name is largely self-explanatory. A market maker quotes two-way prices in a certain currency pair, thereby making a market. A Forex market maker essentially does three things:
- Sets bid and offer prices within a certain currency pair
- Commits to accepting deals at these prices within certain constraints
- Takes the resulting exposure on to their own book (at least initially)
What are the constraints mentioned in the second point above?
Basically the quote may only be good in a certain minimum or maximum size, and the price will only be good if dealt with in a timely manner. The third point establishes that a market maker is a counterparty to a Forex trade. In other words, they are not matching the trade with another party, in the way that a broker would.
In terms of taking this exposure onto their book, a market maker may subsequently choose to hedge the exposure with another bank, if they are able to gain a favourable rate. How quickly or slowly, or how much risk they lay off will be at their own discretion.
One way a market maker makes profit is by seeing two-way business. If they see enough flow at both sides of their quote, they can simply collect the bid offer spread, while netting off their exposure. Now, the large banks see huge flows of foreign currency transactions from their operations around the world.
Because of this, they can achieve significant profit simply by collecting this spread day after day. Of course, a dealer may also choose to take a position in a currency at their discretion. They can do this by either making a trade with another bank, or by pricing accordingly, in order to attract trades in a certain direction.
The Forex Market Makers Method – How Do They Set Their Prices?
Bank dealers weigh up a number of concerns when making their prices.
- The prevailing rates being quoted elsewhere
- Their own exposure – what positions they already have on their book
- Their view on the future performance of the currency pair
- Volumes available at the prevailing market rate, and the volume of the deal they are quoting for
Retail FX Pricing
The trades between the large banks form the core of the FX market by volume. There's more, though: the banks' continuous commitment to buy and sell currencies is a cornerstone of all pricing in the FX market. Despite the huge volumes that go through the interbank market, a large portion of Forex participants do not have direct access.
Why is that?
One of the foundations of the interbank market is the credit relationships that the largest banks have between each other. The banks buy and sell currencies between each other on this credit basis alone. Furthermore, deals in the interbank market are typically very large.
These aspects combine to preclude most players from directly accessing the interbank market. Indeed, there was a time when the FX market as a whole was only really the preserve of banks, institutions, and the very wealthy. That has all changed now of course.
Retail clients now readily access the Forex market. They do this via FX and CFD brokers that directly or indirectly tap into prices made by the large banks. This trend has been aided by improvements in technology. Progress in these areas has led to a variety of excellent electronic trading platforms.
One of the most popular retail FX platforms is MetaTrader 4, and perhaps the most advanced plugin available for that platform is MetaTrader 4 Supreme Edition. MT4SE offers a host of useful features, including the professional-style 'Trade Terminal' that allows multi-currency trade management.
Source: MetaTrader 4 - Market Watch & Trading Terminal
What is the upshot of these platform advances?
The gap between the trading experience of institutional investors and that of retail clients has narrowed over the years. Retail clients now have access to very competitive Forex spreads, and trading has become extremely convenient.
So how do FX brokers offer prices to retail clients?
To answer this question, we need to be careful with our terminology. You see, some of these firms are sometimes referred to as market makers, but in fact, they do not really perform all of the core functions of a true market maker.
The way FX firms operate varies, but pricing tends to ultimately be derived from the same familiar players. Namely, the large banks who operate as prime brokers for these firms. Some firms may operate effectively as a broker, hedging off their exposure immediately with their liquidity provider.
Others may take some of the exposure onto their own book. But here's the key part: generally, they do not make their own prices as a true market maker would. For any particular currency, a retail FX firm might offer an aggregate price. This would essentially be the best bid/offer that they have access to via the market making counterparties that they hedge with.
An alternative way that firms grant their clients access to the FX market is via Electronic Communications Networks (or ECNs). An ECN aggregates bids and offers from banks, institutions, and other traders into an order book. If you place a trade, the ECN will match you against the very best price available. ECNs are typically extremely fast and offer transparent systems with very tight spreads.
Pros and Cons of Market Makers Forex Prices
Some people dislike the notion of a market maker, taking the view that they are somehow calling the market against them. Obviously, a market maker is not going to quote a price that doesn't suit their own position, but they ultimately quote a two-way price. This means that there is an extremely limited amount that the price can be skewed before an arbitrage opportunity opens.
The overarching European Markets and Financial Instruments Directive (MiFID) requires UK FX firms to be committed to offering the best execution on their clients' behalf. Before this standard came into play, some firms might have tweaked their price in order reflect their book position, but this cannot happen under best execution.
When discussing market makers, the bottom line is that they are the pillar that the FX market is built upon. Beyond this fundamental contribution of effectively enabling the FX market to function, they do offer some other benefits as well. They offer consistency and liquidity to the market, with their continuous commitment to take the opposite side of any deal.
A market maker Forex price is at its roots, made by a human: someone somewhere is literally deciding the bid/offer price. Nearly all technical indicators rely on a belief that price action is guided by human behaviour, as opposed to being a random walk.
That there is such a large human element in the prime making of prices would tend to lend credibility to the efficacy of technical indicators. The human element also means that there is less volatility in comparison to ECN prices. ECNs allow automated trading systems to plug directly in, and trade at near instantaneous speeds.
This can lead to rates fluctuating at such rapid rates that it makes it less easy to use. We should also note that ECNs are very suited to high frequency trading strategies and scalpers. Market makers provide prices in good faith, as a basic component of the effective functioning of the market.
There are market makers in the stock market, as well as the FX market, and both help to provide liquidity. So how do these different types of market makers compare? Well, a key way in which the FX market differs from the stock market is that Forex transactions are less transparent. Stocks trade on exchanges where trade information is made publicly available.
This means that the price and volume data are readily available for stock trades on a real time basis. This is not the case for the Forex market however. Flows of FX business seen by the large banks is considered proprietary information, and there is no requirement for this information to be disclosed.
Market makers at the major banks are aware of large, and therefore potentially market-moving trades, before the wider market. This, in theory, gives them an advantage over other traders. The kind of information to which a market maker may be privy, but is unavailable to the market as a whole may include:
- Institutions rebalancing portfolios
- Hedging requirements
- Changes in risk appetite.
Such flows may influence the short-term trend of FX prices. Some view this as providing an unfair advantage to market makers. A market maker would argue this aid to their trading strategy is a benefit that stems from the service they provide.
Choosing an Appropriate Forex Market Maker Strategy
Whether you prefer the consistency of pricing from a market maker, or the variable spreads of an ECN is up to you You may find that your strategy or style of trading dictates what you use. If you are a scalper or an algo-trader, you may find that ECN pricing suits you better, for example. One way to access real live market prices is with Admiral Markets' demo trading account. This offers the benefit of allowing you to trade without taking on any risk.
This material does not contain and should not be construed as containing investment advice, investment recommendations, an offer of or solicitation for any transactions in financial instruments. Please note that such trading analysis is not a reliable indicator for any current or future performance, as circumstances may change over time. Before making any investment decisions, you should seek advice from independent financial advisors to ensure you understand the risks.