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What Is FOREX?

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This chapter is from the book

Market Liquidity: Myths Versus Truths

The appeal of trading liquid markets is the ease with which contracts can be bought and sold, but traders aren’t always getting what they expect. You have probably read, or heard, that the foreign currency market is the deepest and most liquid marketplace in the world. Daily FX volume is estimated to be approximately $4 trillion, dwarfing all other speculative vehicles and essentially doubling in size over the last decade. However, the headline figures are a bit misleading. For instance, the daily volume isn’t entirely composed of spot transactions by retail speculators, hedge funds, or even banks. Most of it is occurring in forward contracts and foreign exchange swaps; a smaller percentage of the daily volume occurs in options and other peripheral products. Swaps are actions taken by FX traders to avoid delivery of the underlying asset.

Specifically, an FX swap is the simultaneous purchase and sale of identical amounts of one currency for another with two different value dates. In a nutshell, it is the process of rolling from a deliverable currency position into a nondeliverable contract; later, we will touch on the concept of rolling over again in more detail. A forward contract is an individually negotiated agreement to buy or sell a particular currency at an agreed-upon price and on an agreed-upon date. Neither swaps, nor forwards, add to the liquidity of intraday speculative currency trading. As a result, although they add to the impressiveness of liquidity stats, the stats are a bit misleading.

Even more disingenuous is the assumption that trading FOREX under any brokerage firm, or arrangement, entails enjoying deeply liquid currency markets. Depending on the brokerage firm chosen, trades might not be taking place in a liquid FX market, known as an ECN (Electronic Currency Network). Brokers that provide clients with direct access to an ECN market are known as non-dealing desk brokers. On the other side of the coin, brokers that are not routing client orders to an ECN are essentially executing orders in a synthetically created (replica) market. This type of brokerage arrangement is known as a dealing-desk broker, and in this environment the broker’s “dealing desk” is taking the other side of their client’s transactions. We will discuss the details and disadvantages of this later on, but it is important to realize that those trading through a dealing desk aren’t directly benefiting from the liquidity in the true FX markets (ECNs). Even those trading in an ECN environment should know that volume is split among several networks rather than a single market. In my view, reporting an aggregate daily FX volume figure as is commonly done can be compared to combining all the volume incurred in each stock exchange around the globe and then claiming the “stock market” is exceptionally liquid.

Each FX pair is quoted in two prices: The bid is the price traders can sell and the ask is the price traders can buy. Unfortunately, the spread between the two is always at the disadvantage of the retail trader. The more liquid the market is, the less distance between the best available bid and the best available ask, which results in better fill quality. Those trading against their brokerage firm are operating in an arrangement where the spreads between the bid (the best price at which you can sell) and the ask (the best price at which you can buy) are fixed. In the case of fixed spreads, it really doesn’t matter how liquid or illiquid the FX market is because these traders won’t reap any of the benefits!

Nonetheless, even in light of these clarifications on FX market volume, FOREX traders typically enjoy ample liquidity for normal speculation. That said, I believe knowing the big picture will enable traders to make better decisions when choosing a trading arena or environment (that is, a broker).

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