Forex Market Structure — Who Trades Forex? 🗺️

Unlike stock markets with physical headquarters (NYSE on Wall Street), Forex has NO central location or clearing house. It's a pure Over-The-Counter (OTC) market.

What Does OTC Mean?

Over-The-Counter = Transactions occur directly between two parties via electronic networks, with no centralized exchange

Structure:

• No single physical location
• No central order book (like stocks)
• Decentralized global network
• Peer-to-peer transactions

OTC vs. Centralized Exchange

The Two Defining Characteristics

1. 24/5 Availability

Trading "follows the sun" across time zones:

• Sunday 5 PM EST: Sydney opens (week begins)
• Monday: Tokyo → London → New York
• Friday 5 PM EST: New York closes (week ends)

2. Extreme High Liquidity

• Thousands of banks globally providing quotes
• Multiple price feeds (competition = tight spreads)
• Instant execution (always a buyer/seller available)

The Forex market operates as a pricing pyramid—the closer to the top, the better the prices.

The Three-Tier Structure

Tier 1: The Interbank Market (Top of Pyramid)

Participants:

• Major global investment banks
• Examples: J.P. Morgan, Citibank, Deutsche Bank, UBS, Goldman Sachs

Characteristics:

• Best prices (tightest spreads: 0.1-0.3 pips on EUR/USD)
• Massive volume ($100M - $5B per trade)
• Market makers (they SET the prices)
• Peer-to-peer trading (directly with each other)

Tier 2: Dealer Market (Middle of Pyramid)

Participants:

• Smaller banks
• Hedge funds
• Large corporations
• ECNs (Electronic Communication Networks)

Characteristics:

• Slightly wider spreads than Tier 1 (0.5-1.0 pips)
• Medium volume ($10M - $500M per trade)
• Access Tier 1 prices, add small markup

Tier 3: Retail Market (Bottom of Pyramid)

Participants:

• Retail Forex brokers (OANDA, IG Group, Forex.com)
• Individual traders (you)

Characteristics:

• Widest spreads (0.8-2.0 pips on EUR/USD for retail)
• Smallest volume ($1,000 - $1M per trade typically)
• Access via brokers (no direct Interbank access)
• Price takers (accept quoted prices)

How Prices Flow Down

The Price Cascade:

Step 1: Tier 1 Banks Trade
- JPMorgan quotes EUR/USD: 1.08500 / 1.08502 (0.2-pip spread)

Step 2: Tier 2 Aggregates
- ECN aggregates Tier 1: 1.08501 / 1.08502
- Adds 0.3-pip markup: 1.08498 / 1.08505 (0.7-pip spread)

Step 3: Tier 3 Retail Broker
- Receives ECN price: 1.08498 / 1.08505
- Adds 0.3-pip markup: 1.08495 / 1.08508 (1.3-pip spread)

Step 4: You See on Platform
- EUR/USD: 1.08495 / 1.08508
- You pay 1.3-pip spread (vs. 0.2 pips at Tier 1)

The vast majority of $7.5 trillion daily volume is moved by large institutions—the "whales."

A. Central Banks and Governments 🏦

Who They Are:

• Federal Reserve (USA)
• European Central Bank (ECB)
• Bank of Japan (BoJ)
• Bank of England (BoE)

Their Goal: Economic Stability (NOT Profit)

How They Move Markets:

1. Interest Rate Policy (Primary Tool)

Mechanism:

• Raise rates → Currency strengthens (attracts foreign capital)
• Lower rates → Currency weakens (capital flows out)

Example: Fed Rate Hike (2022)

Fed raises rates from 0.25% to 5.25% over 18 months
Result:
- USD offers 5% returns (vs. 0% in JPY, 2% in EUR)
- Global investors buy USD
- EUR/USD falls from 1.22 to 0.95 (-2,700 pips)
- Sustained 18-month trend

2. Direct Currency Intervention

Example: Swiss National Bank (2015)

SNB held EUR/CHF at 1.20 floor (buying EUR)
January 2015: SNB abandons floor
Result: EUR/CHF crashes from 1.20 to 0.85 in MINUTES (-3,500 pips)
Biggest one-day move in modern Forex history

B. Commercial and Investment Banks (Tier 1)

Who They Are:

• J.P. Morgan, Citibank, Deutsche Bank, UBS, Goldman Sachs

What They Do:

1. Client Execution

• Execute trades for corporations, hedge funds, governments
• Example: Apple needs to convert €500M → USD, calls Citibank

2. Proprietary Trading

• Trade bank's own capital for profit
• Use advanced algorithms, high-frequency trading

3. Market Making

• Provide bid/ask quotes 24/5
• Stand ready to buy/sell (create liquidity)

Their Impact:

• Provide the prices you see on your platform
• $5+ trillion of daily volume
• Move markets with massive orders

C. Hedge Funds and Institutional Investors

Who They Are:

• Bridgewater Associates, Citadel, Renaissance Technologies

Their Goal: Profit from Speculation

How They Trade:

1. Macro Fundamental Bets

• Analyze global economy (interest rates, GDP, inflation)
• Place billion-dollar directional bets
• Hold for weeks/months

Their Impact:

• $3-4 trillion daily volume
• Create trends (sustained directional pressure)
• Drive volatility

D. Retail Traders (You) 🧑‍💻

Our Volume:

• $750 billion daily (10% of market)
• Individual trades: $1,000 - $100,000 typically

What We CAN Do:

• ✅ React quickly (no bureaucracy)
• ✅ Trade any size (start with $100)
• ✅ Use leverage (amplify small capital)
• ✅ Align with institutional flow

The Contrarian Indicator:

Observation: Retail traders are often WRONG at extremes

Example:

Retail sentiment: 85% long EUR/USD (bullish)
Institutional positioning: Heavy EUR shorts (bearish)
Result: EUR/USD falls 200 pips (retail stops hit)

Summary

Frequently Asked Questions

Q1: What is the main difference between a centralized exchange and the OTC forex market?

Centralized Exchange (Stocks):

• Single location (NYSE building)
• Single price (all orders through one book)
• Transparent (Level 2 shows all bids/offers)

OTC Forex:

• No central location (global network)
• Multiple prices (each bank quotes differently)
• Less transparent (can't see full order book)

The Key Difference: Stocks = one auction room, one price. Forex = thousands of private negotiations, many prices.

Q2: Why are Central Banks so important to forex trading?

Central Banks are the ULTIMATE market movers because they control:

1. Interest Rates (Primary Tool)

• Raise rates → Currency strengthens
• Lower rates → Currency weakens

2. Market Intervention

• Directly buy/sell currency to influence price

Why They're #1:

• Unlimited capital (can print money)
• Policy changes predictable (scheduled meetings)
• Long-term impact (trends last months/years)

Q3: Does retail trading volume influence the market price?

Short answer: NO.

The Numbers:

• Retail volume: $750B daily (10% of market)
• Institutional volume: $6.75T daily (90% of market)

Retail Can't Move Price:

• Individual impact: Zero
• Institutional flow determines direction

BUT: Retail as Contrarian Indicator

When 80-90% of retail is long, it often signals a top. Professionals use retail sentiment data as contrarian signal.

Quiz

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Proceed to Lesson 4: Introducing Interbank and Liquidity Providers