Understanding Forex Trading Systems

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The forex market is the largest and oldest financial market in the world. It is the biggest and most liquid market in the world, and it is traded mainly through the 24 hour-a-day inter-bank currency market. The forex market is a cash (or 'spot') inter-bank market. By comparison, the currency futures market is only one per cent as big.

Foreign exchange simply means the buying of one currency and selling another at the same time. In other words, the currency of one country is exchanged for those of another. The currencies of the world are on a floating exchange rate, and are always traded in pairs. In excess of 85 percent of all daily transactions involve trading of the major currencies: Australian Dollar, British Pound, Canadian Dollar, Japanese Yen, Swiss Franc, and the U.S. Dollar.

Unlike the futures and stock markets, trading of currencies is not centralized on an exchange. Forex literally follows the sun around the world. Trading moves from major banking centres of the U.S. to Australia and New Zealand, to the Far East, to Europe and finally back to the U.S.

How foreign exchange trading systems work? There are 3 kind of forex trading systems:

Trading with Brokers

Foreign exchange brokers, unlike equity brokers, do not take positions for themselves; they only service banks. Their roles are to bring together buyers and sellers in the market, to optimize the price they show to their customers and quickly, accurately, and faithfully executing the traders' orders.

The majority of the foreign exchange brokers execute business via phone using an open box system - a microphone in front of the broker that continuously transmits everything he or she says on the direct phone lines to the speaker boxes in the banks. This way, all banks can hear all the deals being executed.

Because of the open box system used by brokers, a trader is able to hear all prices quoted; whether the bid was hit or the offer taken; and the following price. What the trader will not be able to hear is the amounts of particular bids and offers and the names of the banks showing the prices. Prices are anonymous. The anonymity of the banks that are trading in the market ensures the market's efficiency, as all banks have a fair chance to trade.

Direct dealing

Direct dealing is based on trading reciprocity. A market maker-the bank making or quoting a price - expects the bank that is calling to reciprocate with respect to making a price when called upon. Direct dealing provides more trading discretion, as compared to dealing in the brokers' market. Sometimes traders take advantage of this characteristic.

Direct dealing used to be conducted mostly on the phone. Phone dealing was error-prone and slow. Dealing errors were difficult to prove and even more difficult to settle. Direct dealing was forever changed in the mid-1980s, by the introduction of dealing systems. Dealing systems are on-line computers that link the contributing banks around the world on a one-on-one basis. The performance of dealing systems is characterized by speed, reliability, and safety.

Dealing systems are continuously being improved in order to offer maximum support to the dealer's main function: trading. The software is rather reliable in picking up the big figure of the exchange rates and the standard value dates. In addition, it is extremely precise and fast in contacting other parties, switching among conversations, and accessing the database. The trader is in continuous visual contact with the information exchanged on the monitor. It is easier to see than hear this information, especially when switching among conversations.

Most banks use a combination of brokers and direct dealing systems. Both approaches reach the same banks, but not the same parties, because corporations, for instance, cannot deal in the brokers' market. Traders develop personal relationships with both brokers and traders in the markets, but select their trading medium based on price quality, not on personal feelings. The market share between dealing systems and brokers fluctuates based on market conditions. Fast market conditions are beneficial to dealing systems, whereas regular market conditions are more beneficial to brokers.

Matching systems

Unlike dealing systems, on which trading is not anonymous and is conducted on a one-on-one basis, matching systems are anonymous and individual traders deal against the rest of the market, similar to dealing in the brokers' market. However, unlike the brokers' market, there are no individuals to bring the prices to the market, and liquidity may be limited at times. Matching systems are well-suited for trading smaller amounts as well.

The dealing systems' characteristics of speed, reliability, and safety are replicated in the matching systems. In addition, credit lines are automatically managed by the systems. Traders input the total credit line for each counterparty. When the credit line has been reached, the system automatically disallows dealing with the particular party by displaying credit restrictions, or shows the trader only the price made by banks that have open lines of credit.

As soon as the credit line is restored, the system allows the bank to deal again. In the inter-bank market, traders deal directly with dealing systems, matching systems, and brokers in a complementary fashion.
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