The roles of Commercial Banks in the Forex Market

Whatever the reason for a player's participation in the market, this diverse group affects the supply and demand within the market, and thus the exchange rates at any given moment in time, and so it is important to understand just who the key players are. Here, we look at the most important players - the commercial banks.

The commercial banks account for by far the largest proportion of all trading of both a commercial and speculative nature and operate within what is known as the interbank market. This is essentially a market composed solely of commercial and investments which buy and sell currencies from each other. Strict trading relationships exist between the member banks and lines of credit are established between these banks before they are permitted to trade.

Commercial and investment banks are a fundamental part of the foreign exchange market as they not only trade on their own behalf and for their customers, but also provide the channel through which all other participants must trade. They are in essence the principal sellers within the Forex market.

One important thing to remember is that commercial and investment banks do not only trade on behalf of their customers, but also trade on their own behalf through proprietary desks, whose sole purpose is to make a profit for the bank. It should always be remembered that commercial and investment banks have exceptional knowledge of the marketplace and the ability to monitor the activities of other participants such as the central banks, investment funds and hedge funds.

Of course the commercial banks have been at the center of the Forex market for many years now and their role has remained basically the same throughout this time. However, the arrival of the first electronic brokering systems (Reuter's 'Monitor Dealing Service' in the early 1980s and Reuter's 'Dealing 2000-1' in 1989) started to change the face of the market. It was however the arrival of Reuter's 'Dealing 2000-3' system in 1992, quickly followed by the launch of 'Electronic Brokering Services (EBS)' in 1993 with the ability to automatically match buy and sell quotes from dealers that changed the face of the Forex market and the very nature of the market.

Electronic trading systems now allow dealers to conduct a number of trades simultaneously and to trade with much tighter spreads, greater efficiency, lower costs and, most importantly, far greater transparency than was provided by the old telephone dealing system.

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They  facilitate transactions between two parties. For example, two companies  wishing  to  exchange

different currencies would seek the help of a commercial bank.

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They  speculate  by  buying  and  selling  currencies.  The  banks  take  positions  on  certain  currencies

because they believe they will be worth more if, “long”, or less if, “short”, in the future. It has been

estimated  that  international  banks  generate  up  to  70%  of  their  revenues  from  currency  speculation.

“Other” speculators include many of the worlds’ most successful traders, like George Soros.

The  Forex  also  includes  central  banks  from  various  countries,  like  the  U.S.  Federal  Reserve.  They

participate in the  Forex to serve the financial interests of  their country. When a central bank buys and

sells its own or a foreign currency, the purpose is to stabilize their own country’s currency value.

The  Forex  is  so  large  and  is  composed  of  so  many  participants,  that  no  one  player,  not  even  the

government central banks, can control the market. In comparison to the daily  trading volume averages

of the $300 billion U.S. Treasury Bond market and the approximately $100 billion exchanged in the U.S.

stock markets, the Forex is huge, and has grown in excess of $4 trillion daily.

The word “market” is a misnomer describing Forex trading. Unlike other markets, there  is  not  a

centralized location for trading activity. Currency trading takes place via the Internet or over the phone.

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A  large  portion  of  Forex  trading  is  done  by  large,  international  banks.  These  banks  will  process

transactions for large companies, governments and their own accounts. These banks continually provide

prices (“bid” to buy and “ask” to sell) for each other and the broader market. The market’s current price

of  a  particular  currency is the most recent quotation from one of these banks. The “live” price

information is reported through a variety of private data reporting serv ices and is able via the Internet.

The Interbank Market

The interbank market designates Forex transactions that occur between central banks, commercial banks and financial institutions.

Central Banks - National central banks (such as the US Fed and the ECB) play an important role in the Forex market. As principal monetary authority, their role consists in achieving price stability and economic growth. To do so, they regulate the entire money supply in the economy by setting interest rates and reserve requirements. They also manage the country's foreign exchange reserves that they can use in order to influence market conditions and exchange rates.

Commercial Banks - Commercial banks (such as Deutsche Bank and Barclays) provide liquidity to the Forex market due to the trading volume they handle every day. Some of this trading represents foreign currency conversions on behalf of customers' needs while some is carried out by the banks' proprietary trading desk for speculative purpose.

Financial Institutions - Financial institutions such as money managers, investment funds, pension funds and brokerage companies trade foreign currencies as part of their obligations to seek the best investment opportunities for their clients. For example, a manager of an international equity portfolio will have to engage in currency trading in order to buy and sell foreign stocks.

The Retail Market

The retail market designates transactions made by smaller speculators and investors. These transactions are executed through Forex brokers who act as a mediator between the retail market and the interbank market. The participants of the retail market are hedge funds, corporations and individuals.

Hedge Funds - Hedge funds are private investment funds that speculate in various assets classes using leverage. Macro Hedge Funds pursue trading opportunities in the Forex Market. They design and execute trades after conducting a macroeconomic analysis that reviews the challenges affecting a country and its currency. Due to their large amounts of liquidity and their aggressive strategies, they are a major contributor to the dynamic of Forex Market.

Corporations - They represent the companies that are engaged in import/export activities with foreign counterparts. Their primary business requires them to purchase and sell foreign currencies in exchange for goods, exposing them to currency risks. Through the Forex market, they convert currencies and hedge themselves against future fluctuations.

Individuals - Individual traders or investors trade Forex on their own capital in order to profit from speculation on future exchange rates. They mainly operate through Forex platforms that offer tight spreads, immediate execution and highly leveraged margin accounts.