Shares are traded on centralized exchanges, which provides a transparent mechanism for price discovery. Stock traders from all over the world inject the buy and sell prices, after which the bid prices are arranged in a descending order and the ask prices are listed in an ascending order in the order book.
The deal is executed when the bid price matches the ask price, which ultimately leads to the discovery of a fair share price. However, a novice forex trader may wonder where the currency exchange rates come from, especially since the forex market is a decentralized exchange that operates outside the official cabin
In this guide we will try to explain the source of the flow of prices offered by forex brokers.Participants in the interbank marketThe spot, futures and SWIFT markets make up what is called the interbank market. The list of participants in this market includes investment banks, commercial banks, hedge funds, major trading companies and central banks.
There are different purposes for each of these institutions to participate in the market by buying, selling or exchanging currencies. Commercial banks, for example, may want to buy, sell or transfer billions of dollars every day. These institutions can trade with each other directly. However
considerations of transparency and obtaining the best prices push these parties to trade through forex platforms in the interbank market such as Electronic Broking Services (EBS), Bloomberg platform and Eikon (Thomson Reuters). These three platforms create channels of communication between thousands of banks. Naturally, dealers in the interbank market do not disclose whether they are interested in buying or selling a currency.
These platforms at any time display two different prices, one for buying and the other for selling, which are presented to the participants in the trading platform.Example of major currency pairsIf we assume that one of the major banks wants to buy the euro currency worth up to 3 billion dollars.
The bank displays the buying and selling prices that it is willing to deal with. Usually, there is a price difference (spread) to cover the expenses incurred by the bank (order costs, trading volume, inventory costs, competition and currency risks).
Let us now suppose that the bank agent will display the bid and ask prices of 1.14203 and 1.14208 respectively. Similarly, let us suppose that there are other dealers representing other banks who will quote the buy and sell prices for the same pair as follows.Buy Sell Volume (in USD)Bank 1 1.14203 1.14208 3 billionBank 2 1.14205 1.14210 1 billionBank 3 1.14207 1.14212 4
billionBanks 1, 2 and 3 in this case are referred to as the liquidity providers in the market. Forex brokers open clearing accounts with liquidity providers, provided that these accounts are linked through an aggregator program. This software collects data from different liquidity sources and displays it in one window. In addition
the orders sent by the brokerage firm’s client are compared with the various offers of the liquidity providers in order to reach the best possible spread. The aggregation program ensures that the customer will receive the best available buy or sell price at the moment.Based on the data mentioned in the above table, the aggregator will choose the prices 1.14207 and 1.14208 as the buying and selling prices, respectively.
After that, the program adds a small margin (spread) to the selected prices as compensation for the risks borne by the broker. The broker can at any time adjust the value of the added spread as it deems necessary. Assuming that the broker adds 1 pip as a spread premium, the final buying and selling prices that will appear to the client will be 1.14202 and 1.14213, respectively.
The above table shows that deals worth $4 billion at the sell price and deals worth $3 billion at the buy price can be executed. However, the forex broker may get a better price by segmenting the trading volumes with the aggregator and sending them to more than one liquidity provider.
Example of minor currency pairsWhen dealing on currency pairs with limited trading volumes, compared to the majors, the aggregate software segments the trading volumes on a number of liquidity providers. In addition, the average strike price rises. For example, let’s say a retail trader wants to open a $3 million position on the AUD/CAD pair.
As mentioned above, quotes from the three banks can be arranged as follows:If the broker adds a spread premium of 3 pips to the AUD/CAD pair, given that the highest selling price is 0.9894 and the lowest buying price is 0.9894, the liquidity accumulator will display quotes on the trader’s screen at 0.98925 and 0.98955. Once the trader places the buy order, the volume is divided into two parts,
then a $1 million order is directed to Bank 1 and a $2 million order is directed to Bank 2.The smart order routing tool in the aggregate software calls quotes from various liquidity providers if the order volume is too large. For example, the software can divide an order of $10 million into five orders of $2 million each and then request quotes from several banks on that basis. Once the quotes arrive,
the software selects the best prices for the trader and at the same time protects the broker from any potential risks. However, it should be noted that the liquidity provider may reject the order when it is sent to them due to the last look feature.
If the liquidity provider believes (especially since it has a general view of the order flow in the market through its highly developed platforms) that it will not be able to hedge against the risk of the order, it will reject this order and make another quote to the broker.It is clear from the previous discussion that the quotations provided by the forex brokers are based on