Forex Basics III: Bank Arbitrage and Institutional Trading

In our final exploration in this three part series, we will take a look at the Forex market with an institutional perspective. While the first two articles in this series have focused on the proprietary Forex trader, we’ll begin to examine how banks and other financial institutions handle the price swings within the currency market place. Let’s review what we’ve learned thus far. We know that because there isn’t a centralized exchange for the Forex market, it allows traders and banks to trade literally 24 hours a day, six days a week. We also know what conceptually happens when a Forex trade is transacted. A trader sells one currency for another in the hopes that the currency they bought will increase in comparison to the currency they sold.

Now….how do banks, (which are basically in essence mini-currency exchanges) profit in the Forex market?

Well, banks are nothing more to the Forex market than what Specialists are on the New York Stock Exchange. While the Forex market is unique in its trading dynamic, it shares many similarities to other “traditional” exchanges. Every currency pair is quoted with a bid price and an ask price. The bid is the highest amount that someone is willing to pay while the ask is the least amount that someone is willing to sell. The difference between these two numbers is what is called the spread. In a nutshell, the banks are making money on the current spread between the bid and the ask. Let’s use a real world example to illustrate how this part of the transaction plays out:

At most international airports, there are various currency kiosks that allow travelers to swap their base currency for the currency of the country they are traveling to. A traveler leaves the United States for Europe and arrives in Milan Italy. At the Milan airport, the traveler visits the currency kiosk so they can swap their US Dollars for the Eurodollar. They present $100 and receive 90 Eurodollars in return. While the traveler now has 90 Eurodollars in place of their $100 US Dollars, they don’t realize that the current exchange rate is 95 Eurodollars for every $100 US Dollars. Well, the exchange kiosk under quoted the exchange rate hence the traveler got less that market value for their US Dollars and the kiosk operator has made 5 Eurodollars by providing less than market value. Basically, the currency kiosk is a type of Forex exchange. This currency swap could have been made at a variety of places, but that was the monetary exchange that both parties agreed to. This is how banks profit from every currency exchange that takes place on a global scale.

Just like our example of airport kiosks, we can equate this to the various financial institutions that trade foreign currencies all throughout the world. Because each bank is conducting their own series of transaction for traders who utilize the platform that they offer, they are quoting their market price for the currency pair, (remember that a bank in the Forex world is nothing more than an electronic platform for traders and other institutions to interact with one another.) Now the big question, why doesn’t a bank just increase the spread to capture more profits for themselves? Well, the answer is simple, they need to stay competitive. There are literally thousands of banks where traders can exchange their currencies. Each bank is faced with competition from other institutions. Banks want the business of traders, in fact they rely on it. To maintain their competitive edge, they will try to offer the best rate to attract traders while keeping as much profit as they can. Because the Forex market is so liquid, banks rely on trade volume to make their money. Rather than increasing the spread to capture profits, they decrease the spread in hopes of attracting more volume.

Another way in which banks make money in the Forex market is through what is called risk arbitrage. In a nutshell, arbitrage is when a bank makes a trade on a particular cross rate only to take a position of equal size in the opposite direction in the hopes of making money on the spread. This not only minimizes the risk, but allows them to basically control the spread and capitalize on it.

Over the past few weeks, we have covered quite a bit of ground in regards to our understanding of the currency markets. We’ve looked at why currencies are traded and by whom. We’ve also outlined some trading scenarios to help illustrate how the life of a Forex trade typically plays out. Finally, we have looked through an institutional lens to see what happens when traders come together and place trades through a broker or bank. The world of currency trading is quickly gaining in popularity due to the amount of money that be generated in a short amount of time. The Forex market is a driving force in the global economies for which most societies are influenced. We have barely scratched the surface in regards to all the components that must be considered when trading currencies.

~Trade Smart

Duane Gott

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Comments

[Nyoman RAMAYANTA]

more focus in Carry Trade or Forex Arbitrage

[Michael]

Congratulations for your blog, I find it very interesting, I wonder if they know of any course that will allow me to make money with forex? Thank you for your reply.

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