The Foreign Exchange market (FX) is the largest, most liquid financial market in the world, roughly 20 times larger than the combined volume of all U.S. equity markets with a daily trading volume over 3.21 trillion dollars. In years past, the world’s largest commercial banks have dominated the FX market, offering Interbank dealing spreads to only their largest customers. With the advent of online trading, both retail and smaller institutional participants now have access to this market.

Market Liquidity

The Forex market is the most actively traded market in the world, 24 hours a day from Sunday night until Friday afternoon. This liquidity provides currency traders with the ability to enter and exit trades regardless of the size of the transaction.

Ability to profit in Bull or Bear markets

Unlike the equity market, there is no restriction on short selling in the currency market. Profit potential exists in the currency market regardless of whether a trader is long or short, or which way the market is moving. This means a trader has equal potential to profit in a rising or falling market.

Low transaction costs

The Interbank market eliminates exchange and clearing fees, which in turn lowers transaction costs. The efficiency created by a purely electronic marketplace enables clients to directly deal with the market maker, eliminating both middle men, and ticket costs. The currency market offers round the clock liquidity providing traders with tight interbank spreads during both intraday and overnight trading.

Trending market

Currencies rarely spend time in tight trading ranges and have the tendency to develop strong trends. Much of the volume is speculative in nature, and a technically trained trader can easily spot new trends and breakouts, which provide many opportunities to enter and exit the market for profit.

Leverage

Leverage is the use of various financial instruments or borrowed capital, such as margin, to increase the potential return of an investment. The leverage available in Forex trading is one of main attractions of this market for many traders. Leveraged trading, or trading on margin, simply means that you are not required to put up the full value of the position.

Forex provides more leverage than stocks or futures. In Forex trading, the amount of leverage available can be up to 100 times the value of your account. There are several reasons for the higher leverage that is offered in the Forex market. On a daily basis, the volatility of the major currencies is less than 1%. This is much lower than an active stock, which can easily have a 5-10% move in a single day. With leverage, you can capture higher returns on a smaller market movement. More importantly, leverage allows traders to increase their buying power and utilize less capital to trade. Of course, increasing leverage increases risk.

Analysis Overload

The equity and futures markets offer an incredible selection of different investments to choose from. There are literally tens of thousands of stocks and mutual funds, and hundreds of commodities to trade. The Forex market is much simpler to monitor. You really only need to keep track of 5 different currencies, the Euro, the Yen, the British Pound, the Swiss Franc, and the US dollar. The 2 other major currencies traded are the Australian and Canadian Dollars, leaving an analysts with at the most 7 currency pairs to study.

Forex Landscape

The Forex market is the fastest growing market in the world. In the United States, there are over 20 Futures Commission Merchants (FCMs) that specialize in Forex Dealing. These firms are registered with the CFTC (Commodity Futures Trading Commission) and are members of the NFA (National Futures Association.) As of December 21^st, 2007, all FCMs must maintain a

net adjusted capital of at least 5 million dollars. This increase from 1 million dollars caused a shakeup in the Forex industry, and many of the smaller FCMs were either closed, bought, or merged with larger FCMs.

The Forex market is obviously international in nature, and as such, many Forex brokers are located overseas. These brokers are either regulated by their domestic regulatory bodies such as the FSA (Financial Services Authority) in the UK or the DFSA (Dubai Financial Services authority) in the Middle East or unregulated altogether.

For more information on Futures Commission Merchants (FCM), access both the CFTC website, www.cftc.gov and the NFA, www.nfa.futures.org.

Forex Dealers and Commercial Banks

Most commercial banks in the US have customarily bought and sold foreign exchange for their customers as one of their standard financial services. Foreign exchange at many major banks has become a major business activity. They act as intermediaries and market makers, and thus provide most of the liquidity associated with the Forex market. Remember that a market maker quotes both a bid and an ask price, making a two-sided market for any given currency. These banks found it very useful to trade frequently with each other, and they developed into what is known as the Inter-Bank market for foreign exchange. In a 1998 survey conducted by the Federal Reserve Bank of New York, 88% of all reporting Forex dealers were commercial banks, though not all of the banks were considered market makers. Thus, commercial banks are one of the largest players in foreign exchange.

Over the years, foreign exchange dealing has ceased to be the exclusive domain of commercial banks. Many investment banks and other financial institutions have taken on the role of dealers in the over-the-counter market. They now serve as major dealers, executing transactions that previously would have been handled only by large banks, and providing foreign exchange services to a variety of customers in competition with the dealer banks. Although it is still called the Interbank market in foreign exchange, it really should be termed the Inter-Dealer market.

Financial Institutions and Institutional Traders

The range of institutional participants includes smaller banks and institutions that do not act as dealers. Many are buying and selling foreign exchange because they (or the customers that they represent) are in the process of buying or selling something overseas. Others include money managers, mutual funds, introducing brokers, hedge funds, pension funds, and even some high net worth individuals. For years, importers and exporters accounted for the bulk of the foreign exchange that was bought from and sold to final customers in the United States as they financed the nation's overseas trade.

Companies, mutual funds and hedge funds will often pool their customers' money together and act as a third party trader. These institutional investors have, in recent years, become major participants in the Forex market. Many have begun to take a more global approach to portfolio management. Portfolio investment has come to play a very prominent role in the Forex market and accounts for a large share of Forex market activity. This group could potentially move the market, but not nearly to the effect of the world's banks.

Individual Traders

In addition to the larger market movers, there are increasing numbers of individual traders in the Forex market. With superior liquidity and global 24-hour trading capabilities, Forex is attracting the interest of traders and investors all over the world. Although the global nature of the Forex market prevents any one individual trader from actually being able to move prices, this group of market participants is constantly expanding - though larger banks still enjoy the greater share of the market.

Role of Central Banks

All central banks participate in their nations' foreign exchange markets to some degree, and their operations can be of great importance to those markets. Central banks intervene on occasion to move or attempt to move currencies to their desired levels. A central bank is responsible for the monetary policy of a country, maintaining the stability of the national currency and money supply. Foreign exchange market intervention is not the only reason central banks buy and sell foreign currencies. Central banks might trade for public sectors, such as the post office, utility companies, and national airlines and railroads.

Due to the sheer size of the Forex market, no one entity can influence the direction of the market. One exception may be a country’s central bank either through verbal or physical intervention. A central bank can move the market by placing large orders (e.g. buying 1 billion Euros). Examples include the European Central Bank, the Reserve Bank of Australia, the Bank of England, the Bank of Canada, Bank of Japan, Swiss National Bank, Peoples Republic of China and the U.S. Federal Reserve. A central bank must hold foreign exchange reserves, usually in the form of government bonds and gold reserves. The purpose of reserves is to allow central banks an additional means to stabilize the issued currency from excessive volatility, and protect the monetary system from shock.

Large reserves of foreign currency allow a government to manipulate exchange rates, typically to stabilize the FX rates to provide a more favorable economic environment. For example, China holds vast US dollar denominated assets; $1.68 trillion as of March 08’ (Source: IMF). This is an exercise in supply and demand. When a foreign government buys US debt, it has to first exchange its currency for US dollars because you only can purchase US debt with US dollars. This exchange increases the supply of the foreign currency while at the same time increases the demand for US dollars. As the supply increases, the value of the currency decreases. As demand for the US dollar increases, it becomes more valuable.

Traders and investors alike can track the activity of central banks by monitoring Treasury International Capital (TIC) data. The US Government is very interested in keeping track of who is buying US debt and how much of it each buyer holds. The US Treasury is assigned to tracking and cataloging this information. It does so through Treasury International Capital (TIC) data. TIC data tells us how much debt the US has sold, who has purchased it and how much debt the purchasers hold in total.

By watching the trends in TIC data, you can anticipate how the US dollar is going to react in the future. TIC data is released by the Department of the Treasury on the 11^th business day of the month at 9AM EST. When the TIC data show that foreign governments and others are increasing the amount of US debt they are purchasing, you know that demand for the US dollar is increasing because you have to buy US debt in US dollars. If the TIC data is showing a decrease in purchasing, you will know that demand for the US dollar is decreasing. As demand decreases, the value of the dollar will also decrease.

For more information, visit the Department of the Treasury website: http://www.ustreas.gov/tic

Market Makers vs. STP (Straight Through Processing)

Futures Commission Merchants (FCM) are “market makers”, which simply matching buyers and sellers together. FCMs will utilize two execution methods. First, they will set up their own dealing desk. Many FCMs will take the opposite side of their client’s trade, which to some degree may be a conflict of interest. Under these circumstances, you may experience “re-quoted” market orders or “slippage” on pending orders such as stop, limit or entry buy/sell orders. Many FCMs will justify the latter on “market volatility”.

The second method of executing orders is using STP (Straight Through Processing). The FCMs electronic platform will communicate directly with an ECN using an Application Programming Interface (API). This process occurs instantaneously, theoretically in nanoseconds.

An ECN (Electronic Communication Network) is a multi-bank platform, which receives prices simultaneously from multiple banks. An ECN will use an algorithm to obtain the best price from various banks. A data feed will then send the current market price to dozens of other platforms in real time.

It is in the client’s best interest to trade with a broker who utilizes STP. The alternative is trading with brokers who have a “dealing desk”. Straight Through Processing (STP) - No Dealing Desk execution combines the benefits of direct access to the liquidity or counter party with the convenience and speed of an electronic platform. FCMs using STP will not trade against their clients. Every client, whether retail or institutional, is given equal access to the interbank market. Dealers do not have a need to know your positions, so stop and limit orders are never targeted or “hunted”. Traders rarely receive a “requoted” price with STP, maybe with the exception of extreme market volatility. Knowing that your broker only generates revenue off of the spread of the currency pair, and never takes the other side of any trades, you can be confident that your broker shares an interest in your success.

There is a conflict of interest when FCMs rely on a dealing desk to execute their clients’ trades, whereby they find a buyer for every seller, and create and match the prices they display on their platform. The currency dealer manning an exchange counter dealing desk displays a set of exchange rates for various currency pairs to complement the spreads he intends to take as profit. The Forex dealing desk broker operates in much the same manner when he trades his clients' orders against his own in-house, off-exchange account. Like the transactions between traveler and currency dealer, transactions between the dealing desk broker and his clients never make it to the interbank "trading floor" and the pricing offered is just as biased.