Trading with Brokers
Foreign
exchange brokers, unlike equity brokers, do not take positions for themselves;
they only service banks. Their roles are:
• bringing together buyers and
sellers in the market;
• optimizing the price they show to
their customers;
• quickly, accurately, and
faithfully executing the traders' orders.
The
majority of the foreign exchange brokers executes business via phone. The phone
lines between brokers and banks are dedicated, or direct, and are usually installed
free of charge by the broker. A foreign exchange brokerage firm has direct
lines to banks around the world. Most foreign exchange is executed through an
open box system—a microphone in front of the broker that continuously transmits
everything he or she says on the direct phone lines to the speaker boxes in the
banks. This way, all banks can hear all the deals being executed. Because of
the open box system used by brokers, a trader is able to hear all prices
quoted; whether the bid was hit or the offer taken; and the following price.
What the trader will not be able to hear is the amounts of particular bids and
offers and the names of the banks showing the prices. Prices are anonymous the
anonymity of the banks that are trading in the market ensures the market's
efficiency, as all banks have a fair chance to trade.
Brokers
charge a commission that is paid equally by the buyer and the seller. The fees
are negotiated on an individual basis by the bank and the brokerage firm. Brokers
show their customers the prices made by other customers either two-way (bid and
offer) prices or one way (bid or offer) prices from his or her customers.
Traders show different prices because they "read" the market differently;
they have different expectations and different interests. A broker who has more
than one price on one or both sides will automatically optimize the price. In
other words, the broker will always show the highest bid and the lowest offer.
Therefore, the market has access to the narrowest spread possible.
Fundamental
and technical analyses are used for forecasting the future direction of the
currency. A trader might test the market by hitting a bid for a small amount to
see if there is any reaction. Brokers cannot be forced into taking a principal
role if the name switch takes longer than anticipated. Another advantage of the
brokers' market is that brokers might provide a broader selection of banks to
their customers. Some European and Asian banks have overnight desks so their
orders are usually placed with brokers who can deal with the American banks,
adding to the liquidity of the market.
Direct Dealing
Direct
dealing is based on trading reciprocity. A market maker—the bank making or
quoting a price—expects the bank that is calling to reciprocate with respect to
making a price when called upon. Direct dealing provides more trading discretion,
as compared to dealing in the brokers' market. Sometimes traders take advantage
of this characteristic. Direct dealing used to be conducted mostly on the
phone. Dealing errors were difficult to prove and even more difficult to
settle. In order to increase dealing safety, most banks tapped the phone lines
on which trading was conducted. This measure was helpful in recording all the
transaction details and enabling the dealers to allocate the responsibility for
errors fairly. But tape recorders were unable to prevent trading errors. Direct
dealing was forever changed in the mid - 1980s, by the introduction of dealing
systems.
Dealing Systems
Dealing
systems are on-line computers that link the contributing banks around the world
on a one-on-one basis. The performance of dealing systems is characterized by
speed, reliability, and safety. Accessing a bank through a dealing system is
much faster than making a phone call. Dealing systems are continuously being
improved in order to offer maximum support to the dealer's main function:
trading. The software is very reliable in picking up the big figure of the
exchange rates and the standard value dates. In addition, it is extremely precise
and fast in contacting other parties, switching between conversations, and accessing
the database. The trader is in continuous visual contact with the information
exchanged on the monitor. It is easier to see than hear this information,
especially when switching between conversations.
Most
banks use a combination of brokers and direct dealing systems. Both approaches
reach the same banks, but not the same parties, because corporations, for
instance, cannot deal with the brokers' market. Traders develop personal
relationships with both brokers and traders in the markets, but select their
trading medium based on price quality, not on personal feelings. The market share
between dealing systems and brokers fluctuates based on market conditions. Fast
market conditions are beneficial to dealing systems, whereas regular market
conditions are more beneficial to brokers.
Matching Systems
Unlike
dealing systems, on which trading is not anonymous and is conducted on a
one-on-one basis, matching systems are anonymous and individual traders deal
against the rest of the market, similar to dealing in the brokers' market.
However, unlike the brokers' market, there are no individuals to bring the prices
to the market, and liquidity may be limited at times. Matching systems are
well-suited for trading smaller amounts as well.
The
dealing system characteristics of speed, reliability, and safety are replicated
in the matching systems. In addition, credit lines are automatically managed by
the systems. Traders input the total credit line for each counter party. When
the credit line has been reached, the system automatically disallows dealing
with the particular party by displaying credit restrictions, or shows the trader
only the price made by banks that have open lines of credit. As soon as the
credit line is restored, the system allows the bank to deal again. In the interbank
market, traders deal directly with dealing systems, matching systems, and
brokers in a complementary fashion.
