May 7, 2013

Kinds of Exchange Systems

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.

May 6, 2013

Spot Market

Currency spot trading is the most popular foreign currency instrument around the world, making up 37 percent of the total activity.

The fast-paced spot market is not for the faint hearted, as it features high volatility and quick profits (and losses). A spot deal consists of a bilateral contract whereby a party delivers a specified amount of a given currency against receipt of a specified amount of another currency from a counter party  based on an agreed exchange rate, within two business days of the deal date. The exception is the Canadian dollar, in which the spot delivery is executed next business day.

The name "spot" does not mean that the currency exchange occurs the same business day the deal is executed. Currency transactions that require same-day delivery are called cash transactions. The two-day spot delivery of currencies was developed long before technological breakthroughs in information processing.

This time period was necessary to check out all transaction details among counterparties. Although technologically feasible, the contemporary markets did not find it necessary to reduce the time to make payments. Human errors still occur and they need to be fixed before delivery. When currency deliveries are made to the wrong party, fines are imposed. In terms of volume, currencies around the world are traded mostly against the U.S. dollar, because the U.S. dollar is the currency of reference.

The other major currencies are the euro, followed by the Japanese yen, the British pound, and the Swiss franc. Other currencies with significant spot market shares are the Canadian dollar and the Australian dollar. In addition, a significant share of trading takes place in the currency crosses, a non-dollar instrument whereby foreign currencies are quoted against other foreign currencies, such as the euro against the Japanese yen.

There are several reasons for the popularity of currency spot trading. Profits (or losses) are realized quickly in the spot market, due to market volatility. In addition, since spot deals mature in only two business days, the time exposure to credit risk is limited. Turnover in the spot market has been increasing dramatically, thanks to the combination of inherent profitability and reduced credit risk. The spot market is characterized by high liquidity and high volatility. Volatility is the degree to which the price of currency tends to fluctuate within a certain period of time. Free-floating currencies, such as the euro or the Japanese yen, tend to be volatile against the U.S. dollar.

In an active global trading day (24 hours), the euro/dollar exchange rate may change its value 18,000 times. An exchange rate may "fly" 200 pips in a matter of seconds if the market gets wind of a significant event. On the other hand, the exchange rate may remain quite static for extended periods of time, even in excess of an hour, when one market is almost finished trading and waiting for the next market to take over. This is a common occurrence toward the end of the New York trading day. Since California failed in the late 1980s to provide the link between the New York and Tokyo markets, there is a technical trading gap between around 4:30 pm and 6 pm EDT. In the United States spot market, the majority of deals is executed between 8 am and noon, when the New York and European markets overlap. The activity drops sharply in the afternoon, over 50 percent in fact, when New York loses the international trading support. Overnight trading is limited, as very few banks have overnight desks. Most of the banks send their overnight orders to branches or other banks that operate in the active time zones.

The major traders in the spot market are the commercial banks and the investment banks, followed by hedge funds and corporate customers. In the interbank market, the majority of the deals is international, reflecting worldwide exchange rate competition and advanced telecommunication systems. However, corporate customers tend to focus their foreign exchange activity domestically, or to trade through foreign banks operating in the same time zone. Although the hedge funds' and corporate customers' business in foreign exchange has been growing, banks remain the predominant trading force.

The bottom line is important in all financial markets, but in currency spot trading the antes always seem to be higher as a result of the demand from all around the world. The profit and loss can be either realized or unrealized. The realized profit and loss is a certain amount of money netted when a position is closed. The unrealized profit and loss consists of an uncertain amount of money that an outstanding position would roughly generate if it were closed at the current rate. The unrealized profit and loss changes continuously in tandem with the exchange rate.