When looking at FX / Forex, size matters!

When looking at FX / Forex, size matters!

Forex / FX / Foreign Exchange is an “over-the-counter” (OTC) global marketplace. Over the counter means that there isn’t one single centralised system or one single price. Participants agree deals and exchange rates between themselves.

It is comprised of a global network of financial centres that transact 24 hours a day, closing only for about 48 hours over the weekend. As one major forex hub closes, another hub in a different part of the world opens for business.

The main function of the FX market is to establish the relationships (prices) between the global trading countries. The price (exchange rate) between two currencies determines how competitive each country’s goods are against the other. For SME’s looking to export goods or services, this is critical.

The market is conducted as a sort of pyramid structure, with the largest and most important participants at the top and the smallest and weakest making up the base.

Right at the tip of the structure are the banks and “market makers”. These institutions trade hundreds of millions of pounds (or dollars, euros, etc) at a time. They do this by setting prices which they use to trade between themselves and also to offer currency to other large institutions such as hedge funds or second-tier banks.

These market makers are the absolute colossus of the market. (Industry Joke: How many market makers does it take to change a light bulb? One. The rest of the world revolves around them). They can move exchange rates and influence a country’s buying power with another country almost singlehanded.

A trade can be executed between two participants in the FX market without others being aware of the exchange rate at which the transaction was conducted

Because of this, the FX market is less transparent than centralised exchanges and is subject to fewer regulations. Large players can make fortunes by manipulating prices. In 2017 the global FX rigging scandal came to light. When three institutional FX traders were found guilty of manipulating the interbank rate in a price-fixing conspiracy. The banks were fined billions of dollars. Investigations into others are continuing.

The interbank “spread” (difference between the bid and offer prices) is very small, usually just 1 or 2 “pips”, but the huge volumes traded means the profits on each trade are enormous. Most of this interbank liquidity flows through approximately ten to fifteen financial institutions. The largest participants in the interbank market include Citibank, Deutsche Bank, Union Bank of Switzerland, and Hong Kong Shanghai Bank.

Next down the pecking order are other banks and hedge funds. These entities don’t make the prices in the interbank market but can access them directly via the market makers. They provide liquidity for the market makers, enabling them to amalgamate trades and buy and sell in huge volumes.

Banks then distribute their FX liquidity either directly to their large corporate and Blue Chip clients via API access. As these institutions are typically buying and selling very large volumes at a time, their “spread”, whilst not as tight as the interbank market, will be very close to that price, usually single-digit spreads or a fraction of a percent.

Moving even further down the chain is you, or SME bank clients, sometimes called retail clients, which access FX rates through their business banking. The UK SME market is worth about £700 billion per year in exports. However, because SME’s typically exchange much smaller amounts of currency at a time, they are not given anything like the same prices that the large corporates and Blue Chips enjoy.

Instead, an SME is charged on average 2.6% for a £75,000 currency exchange. That’s hundreds of pips on top of the interbank rate, costing smaller companies a whopping £2,000+ more for every £100k they exchange and adding billions a year to the banks’ balance sheets. Santander recently admitted that 10% of its global profits come from retail FX.

Bad enough, but as we know there’s always someone worse off. Yes, pity the poor holidaymaker, with some bureau de change spreads pushing 20% or 2,000 pips! That’s a 1,000 times mark-up from the chap sitting at the top of the pyramid. Whoever said size doesn’t matter clearly never checked the FX market.

Forex Jargon buster

Over the counter (OTC)
– a decentralised marketplace for financial instruments where trades are executed electronically in multiple locations with no transparent pricing structure

Interbank rate
– the exchange rate that the global FX market makers trade at between themselves

Liquidity
– supply of that currency pair in the market

Spread
– the difference between the bid and offer price which represents the dealer (or market maker’s) profit. The wider the spread, the larger the profit.

Bid
– the price that a dealer is prepared to buy a particular currency at

Offer (or Ask)
– the price that a dealer is prepared to sell a particular currency at

Pip (or basis point)
– the fourth digit after the decimal point in an exchange rate. E.g. 1.1234 and 1.1236 is a difference of 2 pips. Spreads can also be measured in pips

If your business imports or exports then you need to understand foreign exchange and how to ensure you get the right Forex deal for your business – find yourself a solution that focuses on fairness and transparency of trades to give yourself the best chances.

Yorkshire Powerhouse – giving an FX about YOUR business!

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