One of my list members asked me the following question today:
"You talked about the foreign exchange cash market and how it is basically a market between banks in different countries. Does this mean, for example, that the exchange rate between the euro and the dollar is decided by the Federal Reserve and the ECB? Is that how a price is set without any trading on any other listed exchange? Thanks for giving me a quick lesson on this topic." - Stan Z.
The forex spot market is mostly a market between banks. That means that most of the trading happens between banks, like between Citibank and Goldman Sachs. Most of the time, this trading is done for customers of the bank, like multinational corporations. However, banks also trade with each other to protect themselves from currency risks and to take trading positions.
This kind of market structure is the same as the one for most cash market trades of government debt, like US Treasury Bonds and other similar things. You can compare it to the over-the-counter stock market. These trades don't go through an exchange. Instead, they are done directly between brokers.
There are big players in both forex and fixed income, like hedge funds and commercial and investment banks. The world's central banks also play a big role at this level when they try to change foreign exchange (forex) rates and/or interest rates (fixed income).
The sizes of transactions on the interbank market are usually $5 million or more. Obviously, the average trader won't be doing anything even close to that big. This is where online brokers and foreign exchange dealers come in. They make it possible for small traders to deal in much smaller amounts. In fact, at least one of them will trade for as little as $1.
Here is where some people start to worry. Many of these foreign exchange dealers act as market makers for their clients. This means that they take the opposite side of the trades that their customers make. This can also happen on the stock market, especially with over-the-counter (OTC) stocks. People worry about the implied conflict of interest that this creates in terms of how prices are set. When you make a trade, will the dealer who will take the other side be looking out for your best interests?
Some shady dealers may take advantage of their customers in this way, but I'm pretty sure that most of them aren't doing anything against their customers. They just add liquidity to the market and make money from the spread. When they have too much of one currency, they use hedging on the interbank market or with another dealer to balance it out. That is pretty much the same as a trader on the floor of any exchange.
When you ask how prices are set, the answer is that the market does it, not the central banks. The truth is that each bank and dealer sets its own price. That might sound strange because it would mean that rates would be different everywhere. The truth is, though, that prices between dealers and banks are almost always going to be very, very close. There are services, like Reuters, that put together dealer prices and put them in data feeds so that everyone can see the current (and past) market rates. Dealers can't quote prices that are too different from each other because of arbitrage trading.
There is also trading on the futures market and in currency exchange traded funds, which are still pretty new (ETFs). Even though the activity there is only a small part of the global market, it still helps keep prices stable everywhere.
