FX WHOLESALE MARKET PARTICIPANTS - WHO ARE THEY, WHAT DO THEY DO AND HOW DO THEY DO IT?
Introduction
The foreign exchange market is the world's largest capital market, with daily transaction volumes between the various wholesale participants averaging $1.9 trillion This guide will give the reader a basic idea of who these participants are, and how they go about their business.
Who are the key participants?
? Investment Managers: Investing client money in the world's equity and fixed income markets, investment managers are required to effect foreign exchange transactions on a daily basis in order to deal with the flow of their client monies from country to country.
? Hedge Funds / CTA's: Similar to investment managers, but with greater license to use "non vanilla" instruments such as derivatives.
? Corporate Users: Any large or medium sized company transacting business in more than one country.
? Retail Brokers: Aggregating smaller retail sized trades and offsetting their risk in the wholesale markets.
? Central Banks: Managing the economic needs of their countries by action (direct or indirect) in the foreign exchange and interest rate markets.
? High-value private individuals: If an individual trader's account and deal size is large enough they can access wholesale liquidity but this is a reasonably select band of people.
Why do they trade foreign exchange?
The reasons for trading FX vary from participant to participant. Some will have varying reasons to trade, and varying styles when they do. But the reasons can be broadly broken down into 7 main categories.
? Investment. Activity designed to take advantage of longer-term trends. Timeframes of weeks and months.
? Equity / Fixed Income "flow" trades. Investment managers trading to support traditional investment activity.
? Hedging. Trading to limit or completely mitigate currency exposure (risk) acquired as a result of some other aspect of the participant's business activity.
? Cross border cashflow. Where business activity takes place across borders, fx transactions are often necessary. Typically this will apply to corporate activity.
? Official central bank operations. Action taken either by single central banks or on a concerted basis typically to restrict excessive volatility.
? Liquidity provision / market making. Banks, in addition to trading for themselves, service their customers, providing them with the ability to trade large amounts.
Participants in more detail
Banks
Market Making: The banks fulfil several roles within the FX market, but their chief and most visible activity is market making. As market makers they quote prices (either 'two way' or specifically to buy or sell a given currency) to a variety of counterparties. Typically all banks will have "internal" customers (small branches, finance departments, other product trading desks) that require access to the FX market. Some smaller banks may only have these types of counterparties, medium sized banks will, in addition have external customers (pension funds, CTA / Hedge funds, corporate customers and occasional private individuals). Larger banks will service all of these customers and will also have relationships with central banks / supranational organisations (OECD etc) as well as providing liquidity for other banks large and small).
The size of the bank in question will affect its ability to service these clients, both in terms of number of specialist market makers they employ and size / breadth of transaction they can comfortably support. In addition to supplying pricing for customers, the banks will run an order book enabling clients to leave both limit and stop-loss orders with them (often on a 24 hour basis). The larger banks are able to use the current state of their order books as a proxy for the state of the market in general, and will adjust their own trading activity accordingly, if and when they see a large imbalance between buyers and sellers emerging. This leads neatly onto the second of the activities carried out by the banks.
Speculative Trading: This activity is generally divided between the market makers on a trading desk, and the bank's specialist proprietary traders. In many cases the market makers will approach their trading with a view based on the state of their order book, while the prop traders often take a view based to a greater extent on technical factors with, on average, a slightly longer timeframe in mind. There are however no real hard and fast rules about this.
Hedging: In addition, banks occasionally act in the market for hedging purposes (hedging trading book local currency P+L, hedging wage / bonus costs etc) but this is very much a tertiary part of what they do. Market making and speculative activity form the bulk of their trading.
Investment Managers
The investment management community is one of the key drivers of the foreign exchange market. Active every day of the year, the larger investment managers are, more often than not, responsible for most of the larger ticket trades in the market from week to week (hundreds of millions of dollars per trade in some cases). Their activity falls under three categories;
While Hedge funds and CTAs are able to call upon a wider range of products and styles than more "traditional" investment managers, their trading bears at least some similarity to their "real money" counterparts. They will hedge positions where necessary (although many hedge funds with an equity component are so called long/short funds and as such have far less (if any) overall market exposure requiring a hedge to be put in place). They will of course have flow related activity when purchasing / selling foreign assets and they are able to place longer term bets on the market's direction (again either directly or by use of options). In addition they are far more likely to use their sophisticated models to take shorter term positions (often based more on a technical than fundamental view). Such short term trades are often key drivers of the market intra-day, especially in less liquid currency pairs (EUR/JPY being a good example of a favoured model fund currency play).
Corporates
Any company that desires to transact business across borders is likely to require access to the foreign exchange markets. Import / Export, raw materials flow and other similar day to day corporate activities form a large part of the modern foreign exchange market. Many larger corporations have increasingly sophisticated and market literate treasury arms, some of which have branched out into outright speculation. They will typically carry out their activities in the following ways;
Retail Brokers
The retail brokers supply liquidity to the retail trading community (as well, in some cases, as some smaller hedge funds). They will clear the positions that they acquire from this trading either by direct market access (using Interbank trading platforms such as EBS and Reuters) or by their relationship with bigger banks (either by conversational dealing or via these banks' own e-commerce trading platforms). Some will also take speculative proprietary positions while others are wholly reliant on "spread retention" and intelligent market making to earn their money.
Central Banks
Responsible, along with the relevant political bodies, for management of a country's currency, the central banks will intervene from time to time (either unilaterally or on a concerted basis) to stem excessive volatility in the market. Most active in recent years has been the Bank of Japan, which has intervened fairly regularly and aggressively whenever excessive Yen strength threatens to cause economic difficulties. Central banks will in addition trade in smaller amounts as part of their day to day currency management operations but the effects of these smaller trades are rarely felt outside the banks with whom they deal.
High-Value Private Individuals
While most private traders access the market via a retail broker, those with larger accounts (typically an average trade size of USD 1 Million or greater) have the option of dealing directly with a single bank's sales desk (either via the telephone or delivered directly in the form of a streaming e-commerce platform). Rarely a market mover in themselves, they are worthy of note mainly because the majority of traders with this size of account have a greater degree of trading acumen than the average retail trader and their activities are often watched with great interest by the banks with whom they have relationships.
Summary
The wholesale foreign exchange market is a deep, liquid and efficient one. This is largely due to the diverse nature of participants, many operating on a variety of levels at different times with differing expectations. While traditionally dominated by the interbank market makers, the exponential increase in volume of business executed by the large pension funds, combined with the increase in number and sophistication of the hedge funds has served to tip the balance away from these traditional institutions in recent times. Narrowing spreads, improved technology and even moves towards centralised settlement will ensure that this trend remains in place for the foreseeable future.
Introduction
The foreign exchange market is the world's largest capital market, with daily transaction volumes between the various wholesale participants averaging $1.9 trillion This guide will give the reader a basic idea of who these participants are, and how they go about their business.
Who are the key participants?
? Banks. Primarily in the business of the distribution of money (whilst retaining some of it for themselves), banks act in several capacities dependant on situation.
? Investment Managers: Investing client money in the world's equity and fixed income markets, investment managers are required to effect foreign exchange transactions on a daily basis in order to deal with the flow of their client monies from country to country.
? Hedge Funds / CTA's: Similar to investment managers, but with greater license to use "non vanilla" instruments such as derivatives.
? Corporate Users: Any large or medium sized company transacting business in more than one country.
? Retail Brokers: Aggregating smaller retail sized trades and offsetting their risk in the wholesale markets.
? Central Banks: Managing the economic needs of their countries by action (direct or indirect) in the foreign exchange and interest rate markets.
? High-value private individuals: If an individual trader's account and deal size is large enough they can access wholesale liquidity but this is a reasonably select band of people.
Why do they trade foreign exchange?
The reasons for trading FX vary from participant to participant. Some will have varying reasons to trade, and varying styles when they do. But the reasons can be broadly broken down into 7 main categories.
? Speculative trading. Trading in the anticipation of short / medium term gain. Timeframes typically minutes, hours and days.
? Investment. Activity designed to take advantage of longer-term trends. Timeframes of weeks and months.
? Equity / Fixed Income "flow" trades. Investment managers trading to support traditional investment activity.
? Hedging. Trading to limit or completely mitigate currency exposure (risk) acquired as a result of some other aspect of the participant's business activity.
? Cross border cashflow. Where business activity takes place across borders, fx transactions are often necessary. Typically this will apply to corporate activity.
? Official central bank operations. Action taken either by single central banks or on a concerted basis typically to restrict excessive volatility.
? Liquidity provision / market making. Banks, in addition to trading for themselves, service their customers, providing them with the ability to trade large amounts.
Participants in more detail
Banks
Market Making: The banks fulfil several roles within the FX market, but their chief and most visible activity is market making. As market makers they quote prices (either 'two way' or specifically to buy or sell a given currency) to a variety of counterparties. Typically all banks will have "internal" customers (small branches, finance departments, other product trading desks) that require access to the FX market. Some smaller banks may only have these types of counterparties, medium sized banks will, in addition have external customers (pension funds, CTA / Hedge funds, corporate customers and occasional private individuals). Larger banks will service all of these customers and will also have relationships with central banks / supranational organisations (OECD etc) as well as providing liquidity for other banks large and small).
The size of the bank in question will affect its ability to service these clients, both in terms of number of specialist market makers they employ and size / breadth of transaction they can comfortably support. In addition to supplying pricing for customers, the banks will run an order book enabling clients to leave both limit and stop-loss orders with them (often on a 24 hour basis). The larger banks are able to use the current state of their order books as a proxy for the state of the market in general, and will adjust their own trading activity accordingly, if and when they see a large imbalance between buyers and sellers emerging. This leads neatly onto the second of the activities carried out by the banks.
Speculative Trading: This activity is generally divided between the market makers on a trading desk, and the bank's specialist proprietary traders. In many cases the market makers will approach their trading with a view based on the state of their order book, while the prop traders often take a view based to a greater extent on technical factors with, on average, a slightly longer timeframe in mind. There are however no real hard and fast rules about this.
Hedging: In addition, banks occasionally act in the market for hedging purposes (hedging trading book local currency P+L, hedging wage / bonus costs etc) but this is very much a tertiary part of what they do. Market making and speculative activity form the bulk of their trading.
Investment Managers
The investment management community is one of the key drivers of the foreign exchange market. Active every day of the year, the larger investment managers are, more often than not, responsible for most of the larger ticket trades in the market from week to week (hundreds of millions of dollars per trade in some cases). Their activity falls under three categories;
Hedge Funds/CTA AccountsEquity / Fixed income "flow" transactions; The day to day activity of investment managers in the FX markets largely revolves around currency conversion to either provide foreign currency for equity / bond purchases or to repatriate sale proceeds. This take the form either of steady day to day trading activity (when for example pension funds are engaged in small scale re-balancing of their portfolios moving maybe 1% out of Japan and into Australia etc) or alternatively the activity can be larger scale, supporting program trading (typically occurring when a chunk of money is invested in / withdrawn from a fund)
Hedging transactions; As investment managers are (traditionally) primarily in the business of stock and bond picking, they will typically look to mitigate some or all of the exchange risk inherent in holding foreign investment products. So for example if a U.S. fund has a Japanese portfolio (composed of varying amounts of stocks, bonds and cash deposits) worth say 100 Million Yen, they will sell this Yen and buy Dollars (in the forward or futures market rather than for immediate spot delivery). This forward transaction might be for maturity in say 6 months. This doesn't affect when they actually sell the instruments in question. If this occurs sooner they can close out the forward transaction. If the holding period is longer than the duration of the hedge trade, they will "roll over" the trade when it approaches maturity.
As the value of the equity and fixed income holdings rises and falls, periodic smaller adjustments are required to keep the hedge size appropriate for the portfolio. Exactly how frequent and precise this is lies at the discretion of the fund manager and can be dictated by the relevant investment mandates received from the client. If the profit on these hedges increases to a point where the amount of cash they represent is too high for the investment mandate in question, the fund may choose to "abrogate" the trade, cancelling it outright and taking the discounted present value of this profit and re-investing it (as many funds have upper limits dictating how much of the fund can be held in cash).
Investment Activity; While, as has already been stated, the investment managers are primarily in the business of stock picking, taking a longer term view on the currency markets in an active fashion is (especially in the present climate of relatively low equity volatility) an increasingly frequently used weapon in their armoury. Typically, although the funds have the ability to express their currency views in the spot market, they prefer to do so by adjusting the extent to which their portfolios are hedged. So, reverting to the previously discussed JPY example, if the fund manager believed that the Yen is likely to strengthen vs the Dollar, they may choose to sell only 90% of the value of the Japanese portfolio in the forward market (thus effectively taking a 10% overweight Yen position overall). Such positions can be taken either when the original forward position is instigated, or later on by adjusting the hedge amount to reflect the desired view. Increasingly, some investment managers are also looking to use options (both vanilla and exotic) to assist in both their hedging and speculative activities.
While Hedge funds and CTAs are able to call upon a wider range of products and styles than more "traditional" investment managers, their trading bears at least some similarity to their "real money" counterparts. They will hedge positions where necessary (although many hedge funds with an equity component are so called long/short funds and as such have far less (if any) overall market exposure requiring a hedge to be put in place). They will of course have flow related activity when purchasing / selling foreign assets and they are able to place longer term bets on the market's direction (again either directly or by use of options). In addition they are far more likely to use their sophisticated models to take shorter term positions (often based more on a technical than fundamental view). Such short term trades are often key drivers of the market intra-day, especially in less liquid currency pairs (EUR/JPY being a good example of a favoured model fund currency play).
Corporates
Any company that desires to transact business across borders is likely to require access to the foreign exchange markets. Import / Export, raw materials flow and other similar day to day corporate activities form a large part of the modern foreign exchange market. Many larger corporations have increasingly sophisticated and market literate treasury arms, some of which have branched out into outright speculation. They will typically carry out their activities in the following ways;
Commercial Transactions; The primary reason for corporate fx activity. This as stated before can be pure import / export related or it could be sourcing of raw materials. It can be conducted on a one off, ad hoc basis (typically in the spot market) or it can be more systematic (where future cashflow can be accurately identified in advance). This is more often effected via the forward market.
Hedging Transactions; Where future assets / liabilities are an absolute known quantity (yearly wage bills in foreign branches, large, fixed due date product orders for big ticket items such as aircraft etc), the corporation may choose to hedge against adverse currency effects. As with investment management this can be a full or partial hedge, again at the discretion ultimately of the treasurer.
Speculative Trading; Increasingly, larger corporations are taking a greater interest in the speculative side of the market. Again, as before they have the option to express their views on future rate movements either directly in the spot market, via vanilla or exotic options, or by adjusting the hedges they put on to cover future cashflow.
Retail Brokers
The retail brokers supply liquidity to the retail trading community (as well, in some cases, as some smaller hedge funds). They will clear the positions that they acquire from this trading either by direct market access (using Interbank trading platforms such as EBS and Reuters) or by their relationship with bigger banks (either by conversational dealing or via these banks' own e-commerce trading platforms). Some will also take speculative proprietary positions while others are wholly reliant on "spread retention" and intelligent market making to earn their money.
Central Banks
Responsible, along with the relevant political bodies, for management of a country's currency, the central banks will intervene from time to time (either unilaterally or on a concerted basis) to stem excessive volatility in the market. Most active in recent years has been the Bank of Japan, which has intervened fairly regularly and aggressively whenever excessive Yen strength threatens to cause economic difficulties. Central banks will in addition trade in smaller amounts as part of their day to day currency management operations but the effects of these smaller trades are rarely felt outside the banks with whom they deal.
High-Value Private Individuals
While most private traders access the market via a retail broker, those with larger accounts (typically an average trade size of USD 1 Million or greater) have the option of dealing directly with a single bank's sales desk (either via the telephone or delivered directly in the form of a streaming e-commerce platform). Rarely a market mover in themselves, they are worthy of note mainly because the majority of traders with this size of account have a greater degree of trading acumen than the average retail trader and their activities are often watched with great interest by the banks with whom they have relationships.
Summary
The wholesale foreign exchange market is a deep, liquid and efficient one. This is largely due to the diverse nature of participants, many operating on a variety of levels at different times with differing expectations. While traditionally dominated by the interbank market makers, the exponential increase in volume of business executed by the large pension funds, combined with the increase in number and sophistication of the hedge funds has served to tip the balance away from these traditional institutions in recent times. Narrowing spreads, improved technology and even moves towards centralised settlement will ensure that this trend remains in place for the foreseeable future.
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