Understanding the Forex Market: From Decentralized Trading to Global Currency Flows

How Does the Forex Market Work? The Decentralized World of Currency Trading

Forex (foreign exchange market) differs most from traditional stock exchanges in its openness. The New York Stock Exchange is centrally managed, providing unified quotes; but the forex market is entirely different—it is a decentralized trading network with no single source of quotes. This means that the prices you receive from different banks or brokers may vary.

Because of this decentralization, Forex may seem chaotic, but it actually has a clear hierarchical structure. Market participants are divided into three distinct tiers based on trading volume and creditworthiness, from the top-tier mega banks, to mid-tier hedge funds and institutions, down to retail investors. This layering ensures market liquidity and order.

The Three-Tier Pyramid Structure of the Forex Market

Top Tier: The “Big Players” in Interbank Markets

At the apex of the pyramid are the world’s largest banks, forming the interbank market. These banks include Citibank, JPMorgan Chase, UBS, Barclays, Deutsche Bank, Goldman Sachs, HSBC, and Bank of America.

They trade with each other via phone or electronic broker platforms. The two main electronic brokers—EBS Market and Thomson Reuters Matching—are like Coca-Cola and Pepsi in the beverage industry. EBS Market has the strongest liquidity in EUR/USD, USD/JPY, EUR/JPY, USD/CHF; Thomson Reuters Matching dominates in GBP/USD, AUD/USD, and NZD/USD.

It’s worth noting that although all banks can see each other’s quotes, not everyone can trade at those prices. Exchange rates largely depend on the credit relationships established between trading parties—similar to loan applications, banks with better credit enjoy better quotes and larger credit limits.

Mid Tier: Institutional Investors and Quasi-Professional Traders

Hedge funds, trading companies, retail market makers, and ECN platforms form the second tier. Due to weaker credit relationships with banks, these institutions must trade through commercial banks, so their quotes are usually slightly higher than interbank rates.

Bottom Tier: The Retail Investors’ Stage

In the past, individual investors could hardly access the forex market. But the advent of the internet, electronic trading, and retail brokers has drastically lowered the barriers to entry. Modern retail traders can participate in Forex trading simply through retail forex brokers.

Who Is Driving Forex Market Volatility?

The Invisible Hand of Central Banks and Governments

Central banks (like the Federal Reserve, European Central Bank, Bank of England) and governments are key players in the forex market. They influence exchange rates through international trade payments, foreign exchange reserves management, and interest rate adjustments. Interestingly, the Bank of Japan often intervenes directly or verbally in the forex market to adjust its currency’s value—this is a common policy tool.

Corporate Cross-Border Transactions

International companies like Apple need to conduct large-scale currency exchanges for cross-border procurement and mergers. For example, when Apple purchases electronic components from Japan, it needs to convert USD to JPY. Although these transactions are smaller than interbank trades, they still influence exchange rate movements.

Speculative Trading by Traders

Forex speculators buy and hold foreign currencies, hoping to sell at higher rates in the future for profit. Because currency prices are constantly fluctuating and difficult to predict precisely, this uncertainty creates opportunities for traders.

How Did the Forex Market Evolve Into Today’s Structure?

1944: The Bretton Woods System Establishes Order

After WWII, major Western economies reached a consensus to establish a currency stability mechanism through the Bretton Woods Agreement. The US dollar was pegged to gold, and other currencies were linked to the dollar, creating a fixed exchange rate system. However, as global economic growth rates diverged, this system quickly revealed its limitations.

1971: The Era of Floating Exchange Rates Begins

The Bretton Woods Agreement was abolished, and the Forex market entered the era of floating rates. Currency prices no longer fixed but fluctuated freely based on supply and demand. Early on, due to limited technology, determining fair rates was difficult, but advances in computers and communication technology made everything clearer.

From the 1990s to Today: Internet Revolution Democratizes Trading

The proliferation of computers and the internet enabled banks to establish their own trading platforms. Savvy traders then launched online trading platforms (retail forex brokers), fundamentally changing the landscape of forex participation.

The Two Main Models of Forex Brokers

Market Maker Model: Balancing Liquidity and Spreads

Market makers set their own bid and ask prices. Just like you accept a bank’s quote when exchanging currency, clients can only trade at the prices set by the market maker. For example, if a bank offers EUR/USD at a bid of 1.2000 and an ask of 1.2002, the 0.0002 spread is the market maker’s profit.

Although 0.0002 may seem tiny, the accumulation of millions of trades daily generates significant revenue for market makers. For clients, this model offers stable liquidity and fast execution.

ECN Model: Transparency and Lower Costs

Electronic Communication Networks (ECN) use the best bid and ask prices from the interbank market and automatically match client orders. Unlike market makers, ECN brokers do not take the opposite side of trades but act as intermediaries. Traders can set their own prices, and ECN brokers charge lower commissions, with narrower spreads, resulting in lower overall trading costs.

Both models have their advantages: market makers provide abundant liquidity and quick execution, suitable for traders less sensitive to spreads; ECNs are ideal for professional traders who prioritize low costs and high trading volume.

Why Is the Forex Market Worth Understanding?

From its decentralized structure to multi-tiered participants, from its historical evolution to modern trading methods, the Forex market is the largest financial market globally, with daily trading volumes reaching trillions of dollars. Whether you want to hedge risks, conduct international business, or seek investment opportunities, understanding how the forex market operates is essential.