Chapter 3

Who Trades Currencies? Meet the Players

In This Chapter

Understanding where currency rates come from

Stepping onto a trading floor

Hedging and investing through the forex market

Understanding that speculating is the name of the game

Managing foreign currency reserves

The forex market is regularly referred to as the largest financial market in the world based on trading volumes. But this massive market was unknown and unavailable to most individual traders and investors until the early 2000s.

That leaves a lot of people in the dark when it comes to exactly what the currency market is: how it’s organized, who’s trading it, and why. In this chapter, we take a look at how the FX market is structured and who the major players are. Along the way, we clue you in to how they go about their business and what it means for the market overall.

If you believe that information is the lifeblood of financial market trading, which we certainly do, we think you’ll appreciate this guide to the movers and shakers of the currency market. When you have a better understanding of who’s active in the FX market, you’ll be able to make better sense of what you see and hear in the market.

The Interbank Market Is “The Market”

When people talk about the “currency market,” they’re referring to the interbank market, whether they realize it or not. The interbank market is where the really big money changes hands. Minimum trade sizes are one million of the base currency, such as €1 million of EUR/USD or $1 million of USD/JPY. Much larger trades (in the hundreds of millions) are routine and can go through the market in a matter of seconds. Even larger trades and orders are a regular feature of the market.

For the individual trading FX online, the prices you see on your trading platform are based on the prices being traded in the interbank market.

The sheer size of the interbank market is what helps make it such a great trading market, because investors of every size are able to act in the market, usually without significantly affecting prices. It’s one market where we would say size really doesn’t matter. We’ve seen spot traders be right with million-dollar bets, and sophisticated hedge funds be wrong with half-billion-dollar bets.

Daily trading volumes are enormous by any measure, dwarfing global stock trading volumes many times over. The most recent Bank of International Settlement (BIS) report, released in 2013, estimated daily FX trading volumes of over $5 trillion.

Getting inside the interbank market

So what is the interbank market and where did it come from? The forex market originally evolved to facilitate trade and commerce between nations. The leading international commercial banks, which financed international trade through letters of credit and bankers’ acceptances, were the natural financial institutions to act as the currency exchange intermediary. They also had the foreign branch network on the ground in each country to facilitate the currency transfers needed to settle FX transactions.

The result over a number of years was the development of an informal interbank market for currency trading. As the prefix suggests, the interbank market is “between banks,” with each trade representing an agreement between the banks to exchange the agreed amounts of currency at the specified rate on a fixed date. The interbank market is alternately referred to as the cash market or the spot market to differentiate it from the currency futures market, which is the only other organized market for currency trading.

Currency futures markets operate alongside the interbank market, but they are definitely the tail being wagged by the dog of the spot market. As a market, currency futures are generally limited by exchange-based trading hours and lower liquidity than is available in the spot market.

The interbank market developed without any significant governmental oversight and it remains largely unregulated to this day. In most cases, there is no regulatory authority for spot currency trading apart from local or national banking regulations. Interbank trading essentially evolved based on credit lines between international banks and trading conventions that developed over time.

The big commercial banks used to rule the roost when it came to currency trading, as investment banks remained focused more on stocks and bonds. But the financial industry has undergone a tremendous consolidation over the last 20 to 25 years, as bank merger after bank merger has seen famous names subsumed into massive financial conglomerates. Just 20 years ago, there were over 200 banks with FX trading desks in New York City alone. Today that number is well below a hundred. But overall trading volumes have steadily increased, testament to the power of electronic trading.

Currency trading today is largely concentrated in the hands of about a dozen major global financial firms, such as UBS, Deutsche Bank, Citibank, JPMorgan Chase, Barclays, and Goldman Sachs, to name just a few. Hundreds of other international banks and financial institutions trade alongside the top banks, and all contribute liquidity and market interest.

Bank to bank and beyond

The interbank market is a network of international banks operating in financial centers around the world. The banks maintain trading operations to facilitate speculation for their own accounts, called proprietary trading or just prop trading for short, and to provide currency trading services for their customers. Banks’ customers can range from corporations and government agencies to hedge funds and wealthy private individuals.

Trading in the interbank market

The interbank market is an over-the-counter (OTC) market, which means that each trade is an agreement between the two counterparties to the trade. There are no exchanges or guarantors for the trades, just each bank’s balance sheet and the promise to make payment.

The bulk of spot trading in the interbank market is transacted through electronic matching services, such as EBS and Reuters Dealing. Electronic matching services allow traders to enter their bids and offers into the market, hit bids (sell at the market), and pay offers (buy at the market). Price spreads vary by currency pair and change throughout the day depending on market interest and volatility.

The matching systems have prescreened credit limits and a bank will only see prices available to it from approved counterparties. Pricing is anonymous before a deal, meaning you can’t tell which bank is offering or bidding, but the counterparties’ names are made known immediately after a deal goes through.

The rest of interbank trading is done through currency brokers, referred to as voice brokers to differentiate them from the electronic ones. Traders can place bids and offers with these brokers the same as they do with the electronic matching services. Prior to the electronic matching services, voice brokers were the primary market intermediaries between the banks.

Stepping onto a currency trading floor

Although trading rooms in the large banks have shrunk since the 2008–2009 financial crisis, interbank trading rooms can still be lively and are staffed by a variety of different market professionals and each has a different role to play. The typical currency trading room has

• Flow traders: Sometimes called execution traders, these are the market-makers, showing two-way prices at which to buy and sell, for the bank’s customers. If the customer makes a trade, the execution trader then has to cover the resulting deal in the interbank market, hopefully at a profit. These traders are also responsible for watching and executing customer orders in the market. These are the traders who are generating most of the electronic prices and price action.
• Proprietary traders: These traders are focused on speculative trading for the bank’s own account. Their strategies can run the gamut from short-term day trading to longer-term macroeconomic bets. In the wake of the 2008–2009 financial crisis and changes to regulation such as the Volcker Rule, there has been a sharp decline in banks’ trading for their own accounts, and many proprietary trading desks have closed down or moved to hedge funds.
• Forward traders: Forward traders are active in the forward currency market, which refers to trades made beyond the normal spot value date. The forward market is essentially an interest rate differential market, where the interest rates of the various currencies are traded. These traders provide the bank’s customers with pricing for non-spot deals or currency swap agreements. They also manage the bank’s interest rate exposure in the various currencies.
• Options traders: Options traders manage the bank’s portfolio, or book, of outstanding currency options. They hedge the portfolio in the spot market, speculate for the bank’s own account with option strategies, and provide pricing to the bank’s customers on requested option strategies.
• Sales staff: The sales staff acts as the intermediary between the trading desk and the bank’s customers. They advise the bank’s customers on market flow, as well as who’s buying and selling; recommend spot and option trading strategies; and execute trades between the bank and its customers.

Hedgers and Financial Investors

The forex market sits at the crossroads of global trade and international finance and investing. Whether it’s a U.S. conglomerate managing its foreign affiliates’ balance sheets or a German mutual fund launching an international stock fund, they all have to go through the forex market at some point.

Participants in the forex market generally fall into one of two categories: financial transactors and speculators. Financial transactors are active in the forex market as part of their overall business but not necessarily for currency reasons. Speculators are in it purely for the money.

The lion’s share of forex market turnover comes from speculators. Market estimates suggest that upwards of 90 percent of daily FX trading volume is based solely on speculation. We look at the types and roles of speculators in the “Speculators” section of this chapter, but here we want to introduce the players who are active in the forex markets for nonspeculative reasons.

Financial transactors are important to the forex market for several reasons:

• Their transactions can be extremely sizeable, typically hundreds of million or billions.
• Their deals are frequently one-time events.
• They are generally not price sensitive or profit maximizing.

Add up those reasons and you’re looking at potentially very large, one-off trading flows that are not really concerned with where the current market is trading or which way it’s headed. They enter the market to do their deal and then they’re gone, which can introduce an element of market inefficiency that can allow traders to take advantage of counter-trend movements.

Hedging your bets

Hedgers come in all shapes and sizes, but don’t confuse them with hedge funds. (Despite the name, a hedge fund is typically 100 percent speculative in its investments.)

Hedging is about eliminating or reducing risk. In financial markets, hedging refers to a transaction designed to insure against an adverse price move in some underlying asset. In the forex market, hedgers are looking to insure themselves against an adverse price movement in a specific currency rate.

Hedging for international trade purposes

One of the more traditional reasons for hedging in the forex market is to facilitate international trade. Let’s say you’re a widget maker in Germany and you just won a large order from a UK-based manufacturer to supply it with a large quantity of widgets. To make your bid more attractive, you agreed to be paid in British pounds (GBP).

But because your production cost base is denominated in euros (EUR), you face the exchange rate risk that GBP will weaken against the EUR. That would make the amount of GBP in the contract worth fewer EUR back home, reducing or even eliminating your profit margin on the deal. To insure, or hedge, against that possibility, you would seek to sell GBP against EUR in the forex market. If the pound weakened against the euro, the value of your market hedge would rise, compensating you for the lower value of the GBP you’ll receive. If the pound strengthens against the euro, your loss on the hedge is offset by gains in the currency conversions. (Each pound would be worth more euros.)

Trade hedgers follow a variety of hedging strategies and can utilize several different currency hedging instruments. Currency options can be used to eliminate downside currency risk and sometimes allow the hedger to participate in advantageous price movements. Currency forward transactions essentially lock in a currency price for a future date, based on the current spot rate and the interest rate differentials between the two currencies.

Trade-related hedging regularly comes into the spot market in two main forms:

• At several of the daily currency fixings: The largest is the London afternoon fixing, which takes place each day at 4 p.m. local time, which corresponds to 11 a.m. eastern time (ET). The Tokyo fixing takes place each day at 8:55 a.m. Tokyo time, which corresponds to 6:55 p.m. eastern time (ET). A fixing is a process where commercial hedgers submit orders to buy or sell currencies in advance. The orders are then filled at the prevailing spot rate (the rate is fixed) at the time of the fixing.

  The difference between the amount of buying and selling orders typically results in a net amount that needs to be bought or sold in the market prior to the fixing time. On some days, this can see large amounts (several billion dollars or more) being bought or sold in the hour or so leading up to the fixing time. After the fix, that market interest has been satisfied and disappears. Month-end and quarter-end fixings typically see the largest amounts of volume.

  Short-term traders need to closely follow live market commentaries to see when there is a substantial buying or selling interest for a fixing. (See Chapter 2 for more on potential future changes to the fixing process.)

• Mostly in USD/JPY, where Japanese exporters typically have large amounts of USD/JPY to sell: Japanese exporters receive dollars for their exports, which must then be converted into JPY (sell USD/buy JPY). The Japanese export community tends to be closely knit and their orders are likely to appear together in large amounts at similar levels. Again, real-time market commentaries are the most likely source for individual traders to hear about Japanese exporter selling interest.

Hedging for currency options

The currency option market is a massive counterpart to the spot market and can heavily influence day-to-day spot trading. Currency option traders are typically trading a portfolio of option positions. To maximize their returns, options traders regularly engage in delta hedging and gamma trading. Without getting into a major options discussion here (we cover currency options in Chapter 6), option portfolios generate a synthetic, or hypothetical, spot position based on spot price movements.

To maximize the return on their options portfolios, they regularly trade the synthetic spot position as though it were a real spot position. Trading the synthetic positions generated by options is called delta hedging or gamma trading.

Option hedgers are frequently found selling at technical resistance levels or buying on support levels. When a currency pair stays in a range, it can do quite nicely. But when range breakouts occur, options traders frequently need to rush to cover those range bets, adding to the force of the directional breakout. Keep an eye out for reports of option-related buying and selling as technical levels are tested.

Another daily feature of the spot market is the 10 a.m. ET option expiry, when options due to expire that day that finish out of the money cease to exist. Any related hedging that was done for the option then needs to be unwound, though this is likely to have been done prior to the expiry if the option is well out of the money. Traders need to follow market commentaries to see if large option interest is set to expire on any given day and generally anticipate a flurry of option-related buying/selling that may suddenly reverse course after the 10 a.m. expiry.

Global investment flows

One of the reasons forex markets remain as lightly regulated as they are is that no developed nation wants to impose restrictions on the flow of global capital. International capital is the lifeblood of the developed economies and the principal factor behind the rapid rise of the BRIC economies (Brazil, Russia, India, and China). The forex market is central to the smooth functioning of international debt and equity markets, allowing investors to easily obtain the currency of the nation they want to invest in.

Financial investors are the other main group of nonspeculative players in the forex market. As far as the forex market is concerned, financial investors are mostly just passing through on their way to another investment. More often than not, financial investors look at currencies as an afterthought, because they’re more focused on the ultimate investment target, be it Japanese equities, German government bonds, or French real estate.

Crossing borders with mergers and acquisitions

Mergers and acquisitions (M&A) activity is often international and shows no sign of abating. International firms are now involved in a global race to gain and expand market share, and cross-border acquisitions are frequently the easiest and fastest way to do that.

When a company seeks to buy a foreign business, there can be a substantial foreign exchange implication from the trade. When large M&A deals are announced, note the answers to the following two questions:

• Which countries and which currencies are involved? If a French electrical utility buys an Austrian power company, there are no currency implications because both countries use the euro (EUR). But if a Swiss pharmaceutical company announces a takeover of a Dutch chemical firm, the Swiss company may need to buy EUR and sell Swiss francs (CHF) to pay for the deal.
• How much of the transaction will be in cash? Again, if it’s an all stock deal, then there are no forex market implications. But if the cash portion is large, forex markets will take note and begin to speculate on the currency pair involved.

Speculators

Speculators are market participants who are involved in the market for one reason only: to make money. In contrast to hedgers, who have some form of existing currency market risk, speculators have no currency risk until they enter the market. Hedgers enter the market to neutralize or reduce risk. Speculators embrace risk taking as a means of profiting from long-term or short-term price movements.

Speculators (specs for short) are what really make a market efficient. They add liquidity to the market by bringing their views and, most important, their capital into the market. That liquidity is what smoothes out price movements, keeps trading spreads narrow, and allows a market to expand.

In the forex market, speculators are running the show. Conventional market estimates are that upwards of 90 percent of daily trading volume is speculative in nature. If you’re trading currencies for your own account, welcome to the club. If you’re trading currencies to hedge a financial risk, you can thank the specs for giving you a liquid market and reducing your transaction costs.

Speculators come in all types and sizes and pursue all different manner of trading strategies. In this section, we take a look at some of the main types of speculators to give you an idea of who they are and how they go about their business. Along the way, you may pick up some ideas to improve your own approach to the market. At the minimum, we hope this information will allow you to better understand market commentaries about who’s buying and who’s selling.

Hedge funds

Hedge funds are a type of leveraged fund, which refers to any number of different forms of speculative asset management funds that borrow money for speculation based on real assets under management. For instance, a hedge fund with $100 million under management can leverage those assets (through margin agreements with their trading counterparties) to give them trading limits of anywhere from $500 million to $2 billion. Hedge funds are subject to the same type of margin requirements as you or we are, just with a whole lot more zeroes involved.

The other main type of leveraged fund is known as a Commodity Trading Advisor (CTA). A CTA is principally active in the futures markets. But because the forex market operates around the clock, CTAs frequently trade spot FX as well.

The major difference between the two types of leveraged funds comes down to regulation and oversight. CTAs are regulated by the Commodity Futures Trading Commission (CFTC), the same governmental body that regulates retail FX firms. As a result, CTAs are subject to a raft of regulatory and reporting requirements. Hedge funds, on the other hand, remain largely unregulated. What’s important is that they all pursue similarly aggressive trading strategies in the forex market, treating currencies as a separate asset class, like stock or commodities.

In the forex market, leveraged funds can hold positions anywhere from a few hours to days or weeks. When you hear that leveraged names are buying or selling, it’s an indication of short-term speculative interest that can provide clues as to where prices are going in the near future.

Speculating with black boxes, models, and systems

Many leveraged funds have opted for a quantitative approach to trading financial markets. A quantitative approach is one that uses mathematical formulas and models to come up with buy and sell decisions. The black box refers to the proprietary quantitative formula used to generate the trading decisions. Data goes in, trading signals come out, and what’s inside the black box, no one knows. Black box funds are also referred to as models or system-based funds.

Some models are based on complex statistical relationships between various currencies, commodities, and fixed income securities. Others are based on macroeconomic data, such as relative growth rates, inflation rates, and geopolitical risks. Still others are based on technical indicators and price studies of the underlying currency pair. These are frequently referred to as rules-based trading systems, because the system will employ defined rules to enter and exit trades.

If you’re technically or statistically inclined, you can create your own model or rules-based trading system. Many online trading platforms offer application programming interface (API) access to their trading platforms, allowing you to draw price data from the platform, filter it through your trading system, and generate trading signals. Some even allow for automated trade execution without any further user action. Check with your online currency brokerage firm to see if it has an API and supports automated trade executions.

These days there are also ready-made automated trading systems available, called expert advisors (EAs). Most currency brokers offer these to retail clients. If you’re happy to let someone else create a trading program, this could make your life easier, but all automated programs come with their own level of risk that you should be aware of. (See Chapter 10 for more information.)

Trading with discretion

The opposite of a black box trading system is a discretionary trading fund. The discretion, in this case, refers to the fund manager’s judgment and overall market view. The fund manager may follow a technical or system-based approach but prefer to have a human make the final decision on whether a trade is initiated. A more refined version of this approach accepts the trade signals but leaves the execution up to the discretionary fund manager’s trading staff, which tries to maximize position entry/exit based on short-term market dynamics.

Still another variation of discretionary funds is those that base their trading strategies on macroeconomic and political analysis, known as global-macro funds. This type of discretionary fund manager is typically playing with a longer-time horizon in mind. The fund may be betting on a peak in the interest rate cycle or the prospect that an economy will slip into recession. Shorter-term variations on this theme may take positions based on a specific event risk, such as the outcome of the next central bank meeting or national election.

Day traders, big and small

This is where you and we fit into the big picture of the forex market. If the vast majority of currency trading volume is speculative in nature, then most of that speculation is short-term in nature. Short-term can be minute-to-minute or hour-to-hour, but rarely is it longer than a day or two. From the interbank traders who are scalping EUR/USD (high frequency in-and-out trading for few pips) to the online trader looking for the next move in USD/JPY, short-term day traders are the backbone of the market.

Intraday trading was always the primary source of interbank market liquidity, providing fluid prices and an outlet for any institutional flows that hit the market. Day traders tend to be focused on the next 20 to 30 pips in the market, which makes them the source of most short-term price fluctuations.

When you’re looking at the market, look in the mirror and imagine several thousand similar faces looking back, all trying to capture the same currency trading gains that you’re shooting for. It helps to imagine this so you know you’re not alone and also so you know whom you’re up against.

The rise of online currency trading has thrust individual retail traders into the mainstream of the forex market. Online currency brokerage firms are referred to as retail aggregators by the institutional interbank market, because brokerage firms typically aggregate the net positions of their clients for hedging purposes. The online brokerages then transact with the interbank market to manage their market exposure.

Governments and Central Banks

National governments are routinely active in the forex market, but not for purposes of attempting to realign or shift the values of the major currencies. (We discuss those currency policies in greater depth in Chapter 7.)

Instead, national governments are active in the forex market for routine funding of government operations, making transfer payments, and managing foreign currency reserves. The first two functions have generally little impact on the day-to-day forex market, so we won’t bore you with the details. But the last one has taken on increased prominence in recent years, and all indications are that it will continue to play a major role in the years ahead.

Currency reserve management

Currency reserve management refers to how national governments develop and invest their foreign currency reserves. Foreign currency reserves are accumulated through international trade. Countries with large trade surpluses will accumulate reserves of foreign currency over time. Trade surpluses arise when a nation exports more than it imports. Because it is receiving more foreign currency for its exports than it is spending to buy imports, foreign currency balances accumulate. China, one of the world’s largest exporters, has many trillions of dollars as reserves.

The USD has historically been the primary currency for international reserve holdings of most countries. International Monetary Fund (IMF) data from June 2014 showed that the USD accounted for just over 60 percent of global currency reserve holdings, with EUR (25 percent) and JPY (4 percent) the next most widely held currencies.

In recent years, however, the United States has run up massive trade and current account deficits with the rest of the world. The flip side has been the accumulation of large trade surpluses in other countries, most clearly in Asia. The U.S. deficits essentially amount to the United States borrowing money from the countries with trade surpluses, while those other countries (think China) buy IOUs in the form of U.S. Treasury debt securities.

The problem is one of perception and also of prudent portfolio management:

• The perception problem stems from the continuing growth of U.S. deficits, which equates to your continually borrowing money from a bank. At a certain point, no matter how good your credit is, the bank will stop lending you money because you’ve already borrowed so much in the first place. In the case of the United States, no one is sure exactly where that point is, but let’s just say we don’t want to find out. In recent years, the U.S. Congress has had to raise its debt ceiling to accommodate its growing need to borrow. At the time of writing, the U.S. debt ceiling stood at more than $16 trillion.
• The portfolio-management problem arises from the need to diversify assets in the name of prudence. Due to the high proportion of U.S. dollars in global forex reserves, forex reserve managers need to be cognizant of the risks they face if there is a sharp drop in the U.S. dollar’s value. This was particularly relevant after the financial crisis when the U.S. dollar started to weaken.

The result has been an effort by many national governments to begin to diversify their reserves away from the USD and into other major currencies. The euro, the Japanese yen, the British pound, and to a lesser extent the Australian dollar, have been the principal beneficiaries of this shift. But before you think the sky is falling, the USD remains the primary reserve currency globally.

In terms of daily forex market trading, national governments (or their operatives) have become regular market participants over the last few years. Generally speaking, they appear to be engaging in active currency reserve management, selling USD on rallies, and buying EUR on weakness. But they’re also not averse to then selling EUR on subsequent strength and buying USD back on weakness.

Currency reserve management has taken on a market prominence in recent years that never existed before. Market talk of central bank buying or selling for reserve management purposes has become almost a daily occurrence. The impact of this in the market varies, but it can frequently lead to multiday highs and lows being maintained in the face of an otherwise compelling trend.

Traders need to closely follow real-time market commentaries for signs of central bank involvement.

The Bank for International Settlements

The Bank for International Settlements (BIS) is the central bank for central banks. Located in Basel, Switzerland, the BIS also acts as the quasigovernment regulator of the international banking system. It was the BIS that established the capital adequacy requirements for banks that today underpin the international banking system.

As the bank to national governments and central banks, the BIS frequently acts as the market intermediary of those nations seeking to diversify their currency reserves. By going through the BIS, those countries can remain relatively anonymous and prevent speculation from driving the market against them.

Market talk of the BIS being active in the market is frequently interpreted as significant reserve interest to buy or sell. Keep an eye out for market rumors of the BIS, but also keep in mind that the BIS performs more routine and smaller trade execution on behalf of its clients.

The Group of Twenty

The Group of Twenty, or G20, is a forum for the governments and central bank governors of the world’s 20 largest economies. Members include the developed markets and the larger emerging markets, including Mexico, Brazil, China, and Korea, along with Saudi Arabia. The G20 superseded the G7 and the G8 as the global leaders’ summit to keep an eye on. G20 summits take place each year, depending on the circumstances, currency values may be on the agenda for these meetings and the communiqué, the official statement issued at the end of each gathering, may contain an explicit indication for a desired shift among the major currencies. If currencies are not a hot-button topic, the G20 will include a standard boilerplate statement that currencies should reflect economic fundamentals and that excessive currency volatility is undesirable.

Forex markets closely follow the preparations leading up to the meetings for several weeks in advance. Traders are looking first to see if currencies will even be discussed, and then to see which currency or currencies will be on the agenda. The market will generally have a sense of whether currencies are an issue, and the general feeling of what the G20 would like to see done, well in advance. Still, comments from ministers and their deputies holding the preparatory consultations set the stage for the market’s expectations and can provoke market reactions even before the G20 meets, although this can be rare.