Have you ever wondered who forex market players are and why they trade currencies?
You’re in the right place then.
Pro Tip: not all of them trade to make money. (I know, that sounds crazy, but bear with me).
Here we will cover the different players in
currency markets and their motives.
Your bread and butter forex trader.
Speculators are individuals and firms who trade currencies with the sole purpose of profiting from exchange rate movements.
This group includes:
Forex retail traders (you and me): individuals who open a trading account with a broker, usually an online forex broker.
Each person in this group usually trades a much lower volume (as you probably could guess) than organizations or ultra-wealthy individuals.
Speaking of ultra-wealthy individuals, some of them actually trade through different entities such as hedge funds.
Now, even though the name hedge fund sounds as though hedging is all they do, this is far from it.
Hedge Funds are in the business of obtaining absolute returns.
This means, a hedge fund raises a ton of bucks from individual (wealthy, accredited) investors and invests it in order to obtain positive returns (make money).
Wait, but doesn’t everyone desire to make money?
Yes, but many investment managers are much more preoccupied with beating the returns of the market.
That makes their performance evaluations somewhat different than those of some hedge funds.
We also have the major banks in the interbank market who have proprietary trading desks to speculate and make a buck for themselves!
Thus, we can include the major multinational banks into the speculating bucket as well.
In fact, many of the big brand banks make a good chunk of their revenue from trading operations, but as we saw in interbank forex trading they also trade to make market (perhaps, even primarily to make market for their clients).
Thus, banks fall under several types of forex market players, speculators and:
A market maker, or dealer, is an organization which trades currency in order to facilitate their client’s transactions.
Say a major corporation such as Coca-cola Global needs to exchange 3 billion euros from its European subsidiaries into USD. Who will Coca-cola go to?
The major multinational banks of course. But why?
Because these banks are the ones large enough to offer the service of liquidity: I will buy your euros in exchange for dollars.
Now, the market maker profits from the difference between bid and ask prices (buy and sell prices) which is called the spread.
In order to spread the risk from taking a forex position, the market maker hedges its risk by taking an offsetting position in the interbank market.
In our example,
(1) The bank buys the 3 billion euros while selling USD to Coca-cola. This is making market.
(2) The bank sells 3 billion euros in exchange for USD in the interbank market. This is the hedge.
The bank makes money off its clients in exchange for allowing them to trade large amounts of currency, and hedges its risk in the process (this doesn’t happen exactly this way, in practice its more complex).
You could argue that retail brokers are also market makers in that they basically perform the same function of trade facilitator with retail traders instead of major corporations.
I actually agree with this view.
However, some brokers don’t have the same access to the interbank market which causes them to sometimes remain with the opposite position of their traders.
What’s the difference between an investor and a speculator?
The investor only trades currency initially, in order to acquire a long position in a foreign asset.
As such, the investor trades with the purpose to diversify or gain a higher level of return in a long position.
Usually, the investor hedges exchange rate risk, unless he’s very convinced rates will move favorably in the long term.
On the other hand, a speculator trades much more frequently because he’s trying to make money off favorable exchange rate movements.
Pension funds: where is your pension invested? If part of it’s invested in foreign assets in a foreign denomination, then the investment manager of the fund had to trade currencies to acquire those assets.
Mutual funds & Other funds: there are many, many different types of funds out there, but if they invest in foreign assets, then they are basically doing something similar to pension fund managers, as described in the previous paragraphs.
Multinational corporations: as described in the example of Coca-cola, a multinational will need to trade currencies as part of its international operations (little way around it).
These corporations can and do hedge foreign exchange risk as well, beyond conducting normal operations.
There's still another major forex market player we haven't touched upon yet.
What does the Federal Reserve (FED), the European Central Bank, the Bank of Japan, and the Bank of England have in common?
They trade currencies in order to maintain economic stability in their respective economies (couldn’t just say country, right?).
As a forex market player, a Central Bank has a very different goal than all other players in the market.
They maintain price stability or growth (or both, as is the FED’s mandate).
How do they maintain such stability?
By managing the supply of currency.
You’re well aware of how impactful interest rate hikes (or decreases) are.
Well, you see them in the news all the time, so they must be important.
Their important because interest rates are increased (or decreased) by changing money supply.
If the FED believes the economy is overheating, and there might be higher than expected inflation (prices going up too quickly), it might want to increase interest rates.
Why higher interest rates?
Because higher rates make capital investment by firms more expensive (companies would have to get debt at higher rates, ouch!).
This makes investment fall, and thus, demand for money goes down, decreasing pressure on prices.
But how do we increase rates?
We can look at interest rates as the price of money.
If there’s a bunch of USD out there, then rates will be low (there’s a lot of the greenback, so its price is low).
Thus, to increase rates, means to decrease the amount of dollars out there.
And that’s what the FED and other Central Banks do, they buy and sell securities in large quantities to change currency supply.
Most forex market players trade currencies to make money by speculating or making market (dealing).
Other forex market players trade to hedge the risk of their currency positions.
Central Banks trade to protect the economy of their country or region.
I’m sure this gives you a better idea of who’s out there messing with your trades.
Everyone plays in the market and influence how exchange rates move.
It’s like throwing stuff into a stew.
Some ingredients have a strong flavor, while others don’t, but they all ultimately chip into the experience (for better or worse).
See you soon,
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