Traders working with the Forex market need to be familiar with all of the relevant layers of financial institutions who participate in giving price quotes.
For almost 30 years, traders have been able to invest in foreign exchange price movements, also known as Forex. This type of trading involves looking at the relative performance of two regional currencies with the aim of profiting from price movements of each. Many traders don’t have a clear understanding of how the Forex market works, so we’d like to cover the layers of the industry, so you know the roles of each of the participants.
To make money in Forex, you select lots (standardized units) of a currency pair, and try to choose which of the two currencies will go up. If you choose the winning currency, you can make money from the price differential. But how does the currency get put up for sale in the first place? The current system dates back to 1978, when the international community switched to a free-floating exchange system, where supply and demand set the price for various currency pairs. Before this, each currency was backed by first Gold, and then the U.S. dollar.
There are a few tiers of financial institutions who participate in offering currencies for sale. Tier I liquidity providers are responsible for the highest volume of Forex pair transfers. Central banks exchange funds they have received, and buy foreign currencies as a hedge to minimize the risk of potential economic shifts. Because of the large amount of transfers that these central banks execute every day, they have very low transaction fees. Tier I institutions rarely work with retail investors.
Tier II banks and institutions generally work with larger banks to trade currency either as a way to earn additional income from the savings deposits that they hold, or pool funds received from individual traders and offer access to prime liquidity providers for a fee. Most online Forex brokers are in this category. Many Tier II trading partners have agreements with more than one major bank, so that they can get competitive rates on the assets they offer.
Finally Tier III is exemplified by the traders themselves, as well as by professional investment counselors and small online brokerages. At this level, you typically will have to pay the highest fees to purchase currencies, because you will have to cover administrative costs added by the Tier I and Tier II providers. However, this is generally unavoidable, since most individual investors do not have the capital available to purchase the lot sizes that qualify for discounted rates.
Traders need to keep their costs low if they wish to trade currency pairs successfully. It is important to work with a Forex broker who has connections with several top liquidity providers, and who consistently offers low rates. We recommend trading this type of asset on a respected platform such as that provided by ours. For more information on pairs trading, make sure to visit our webpage.