What’s the deal with interbank forex trading?
You’ve probably heard of the interbank market many times, but what is it?
Is it connected to retail currency traders like you and me?
And more importantly, what should you know about it as a forex trader?
As usual, we first have to know what we’re dealing with.
Interbank forex trading is currency trading that occurs in the forex interbank market.
Emil…. Duh! But what is the forex interbank market?
Much like the name suggests,
The interbank market is just a bunch of banks trading currencies with each other.
But not every bank has access to it.
This is a special club where only the big guns play.
We’re talking major multinational banks like Deutsche Bank, Citi, JP Morgan, and you know the rest…
Beyond the few that everyone knows, there are close to a thousand of lesser known, but still big banks which have created good business relationships with others in the club.
In this fashion, we have an interconnected web of banks which have forged business relationships with each other, and mutually related banks, like a social network.
Most of the volume transacted in forex markets as a whole, is done through the interbank market.
The minimum transaction hovers around 1 million of the base currency.
Actually, transactions of 100 million are routine, and small, if anything.
Ok, but why is it important?
Interbank forex trading allows the global economy to function smoothly.
This has to do with why banks are trading currency with each other in the first place.
How does a bank make money? It services clients.
When it comes to foreign exchange, ultra-wealthy individuals, large multinational corporations, hedge funds, you name it… need to buy and sell currencies for different purposes.
But if you have 3 billion Euros you want to sell for Japanese Yens, who do you go to?
That’s right, you go to the big banks who can (and do) offer these services.
From the perspective of the banker, you care about providing liquidity to your clients (allowing them to buy and sell currencies in large quantities).
You profit with the spread (difference) between bid and offer prices you provide to your clients.
This is called making market. And is why these banks are called market makers.
They buy and sell currency to provide liquidity (otherwise you wouldn’t find someone to sell your 3 billion euros to) and profit with the spread.
But wait, doesn’t the bank lose money if the trade goes against them?
No. Banks are making market (dealing), not taking positions.
This is why they hedge risk by taking an offsetting position with another bank.
And this is why a good, established business relationship is important.
If I sell my 3 billion euros to Deutsche Bank (DB), DB will sell those 3 billion euros to another bank in the market who needs them (maybe to hedge a trade of theirs).
If the other bank is insolvent, or incapable of holding its end of the deal, DB could lose a ton of money with price movements.
In practice, it’s not as simple as this, but that’s the general idea.
Banks work in conjunction to spread risk.
They are not speculators, some of their clients are.
Note: most banks also have proprietary trading desks to speculate, but we will leave that out for now.
Market makers are also called dealers. But banks aren’t the only dealers in the space, your retail broker is also a dealer.
The difference is banks deal with big transactions, for big clients.
While retail brokers deal with individual, normal forex traders like you and me.
The difference then, lies in the scale, and as such, in the clients they service.
Retail forex brokers make money the same way as banks, through the spread of making market.
They also hedge their positions because it’s not their business to speculate on the markets by taking long or short positions.
They do this by maintaining a relationship with a larger institution (a bank) with access to the interbank forex market.
In this fashion, the retail broker hedges its risk in the same way banks do.
But unless the retail broker is part of a larger bank, this service has a price.
This is why retail brokers must have larger spreads than banks in the interbank forex trading market.
Otherwise they wouldn’t make money. They are intermediaries after all.
For this reason the interbank forex market is usually called the wholesale market. Spreads are lower, and volume is much larger.
For us retail traders, spreads are higher, since the cost of servicing us is also higher.
So you might think the interbank forex trading affects you through the spreads:
You get worse spreads than the big players.
While this is true, the influence of the interbank market does not stop there.
Currency markets are huge. So if anyone is going to influence price then it’s someone in the interbank market.
Think about it, some whale decides to dump several billion dollars in a slow day… price is much more likely to move as a result of that transaction.
But banks are interconnected through the interbank market.
What ends up happening?
Banks have very similar if not the same bid and offer prices most of the time.
If said whale dumps those dollars and causes a slight decline in the dollar at that moment in time, banks will adapt their bid and offer prices.
What happens then?
Since the bank changed it, your retail forex broker now has to pay the new spread, so in turn, the retail broker changes his spread to the end retail trader accordingly.
What this means is movements in the interbank forex trading market cascades to us, retail traders.
The prices we trade with are more a function of what’s happening in the interbank market than what’s happening in the retail fx trader market.
This is why we keep an eye on huge mergers and acquisitions, big plays by Central Banks, and any other huge market movement.
I hope this piece illuminates why forex interbank trading is usually called the top level of the forex market.
Its importance is paramount to the functioning of the global economy.
And what happens in this market directly influences your trading through both spreads and bid/offer prices.
See you soon,
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