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What is the Interbank Forex Market?

The Interbank foreign exchange market is the market where wholesale business in the forex market is conducted. It is an OTC (Over The Counter) market and the players are banks. This is because, traditionally, banks have etablished credit limits and payments facilities among themselves and therefore have no problem in principal trading with each other. It is also because the banks are the place where companies, institutional investors, governments and private investors have been able to obtain prices to conduct forex business and of course, facilitate the transfer of funds in the various currencies.

There have been many technological developments in recent years, but essentially the market exists so that banks can cover their forex needs in many different currencies and maturities.

Further Reading: Investopedia -The Foreign Exchange Interbank Market

Investopedia - A Primer On The Forex Market

What is the distinguishing aspect of the Interbank Forex Market?

The participants in the market have the agreement to quote a two-way (buying and selling) quote on request. Although electronic trading platforms have lessened the need for these two way quotes, there is an agreement to 'reciprocate', that is, quote a price to the bank who at some stage will quote a price back, as opposed to being a market 'user', who only asks prices. This privilege has in the past meant that banks deal on narrower spreads than a customer receives.

What is a spot market?

The spot market is where currencies are dealt for delivery two working days hence. In some markets, there is next-day delivery and even same day or offset delivery. Two working days means two days in each business centre where the currencies in a deal can be 'settled'. For example, deals done on a Thursday are normally cleared on the following Monday. If Monday was a holiday in one of the centres, then Tuesday would be the settlement day. There are also forward markets, where currencies are dealt for settlement for any business day in the future.

What is a market maker?

A market maker is a dealer in a bank who is prepared to quote a two-way tradeable price to allcomers (subject to trading limits) at any time during business hours. The aim is to create the balance in price where there will be the same amount of sellers and buyers and the spread is competitive enough to attract business. This is where the money is earned. By constantly being 'in the market', it should be possible for the market maker to get the feel for the direction of the market and adjust the price accordingly. The market maker can also judge the liquidity of the market and broaden or narrow spreads accordingly. This takes immense skill, but also a lot of fun - when it goes well. Sometimes, liquidity 'dries up', there is a particularly large order in the market or the market maker is 'first to know' or 'last to know' about an order and the market can take off, leaving the market maker 'holding the baby'. This can be very frustrating, because all the profit built up over several hours can vanish in 30 seconds.

A market maker should not really be a positional trader, and views have to be neutral. Having said that, some very good market makers hold 'inventory', taking a view on the market to profit when the move comes.

Market makers should not hold positions longer than a few minutes - seconds in fast markets! They must use their networks to get prices from other market makers to be able to reverse out of positions given to them by customers and other banks if they do not have the 'flow' to be able to lay off the trades with their customer base. Carrying a loss can be fatal to a market maker, because judgment will be compromised. Therefore, a market maker should aim to be 'square' as much of the time as possible.

What is the 'right' strategy for an Interbank Forex dealer?

There are as many strategies as there are dealers. Apart from the strategy for a market maker described above, if the dealer does not want to be a market maker, then they are at the mercy of the market. By this, it is meant that a 'good' quote may not always be available, and there is a danger that if another dealer is contacted for a price, he or she will 'read into' you action or lack of it. They may try to 'read' your position and mark the price lower or higher.

What are the limiting factors for market makers?

All traders are given risk limits, which limits the size of the position they have and the losses they can sustain. This means that a market maker cannot just take on the customers' or other dealers' positions without limit. Therefore, the market maker will have to 'turn' the position in the market and this is where life becomes interesting. Firstly, every other dealer has a good idea of each other's position limit and therefore they have to sell or buy excess positions.

Market makers also have to avoid excess losses, so a prident market maker will off load a position rather than sit and hope that the market will come back to previous levels. This position watching would be very distracting and cause the dealer to start biasing his quotes.

This is where the comparisons with poker come in, because market makers are constantly bluffing and spoofing their competitors to try and get an advantage. They are always probing the markets to see who is sitting with the risk, making a mental note to be used to advantage if and when the markets move, or it is time to square up the positions at the end of the day. For market makers rarely carry positions overnight.

Testimonials from Interbank Traders

This section of the FAQ is dedicated to testimonials from Interbank traders, who experienced the Golden Days of forex dealing.

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