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21 market makers on forex 4The person who first came to Forex and started trading does not think much about who buys the currency and sells to whom. For a trader, the quality of the trading platform, the speed of execution of orders, the size of the spread, the availability of currency pairs and other financial instruments are more important. But when losses start because of unexpected trend reversals and lightning-fast exchange rates, it seems to the trader that the market is against him.

And behind the scenes, the mysterious gray cardinals of the market - Market Maker - pull at the strings. Who are they? How is it traded? Do they really follow your every stop? Let's try to understand.

The search for a specific culprit begins. Guilty, of course, is easy to find. They are brokers and market makers. Most traders do not understand these terms or understand wrongly. Moreover, on the Internet you can find many stories of "authoritative traders" about how market makers and brokers manipulate prices and try their best to rob their customers.

The reason for such sentiments is ignorance of the functioning mechanism of the currency market, the role and goals of each of its participants. The beginning trader should understand his role in this market, and what happens after he pressed the "Buy" or "Sell" button. To whom an order is sent to buy or sell a currency, at what price the order will be executed, who determines this price, as well as from whom the currency is bought or to whom it is sold.

WHO IS THE MARKET MAKER?

In the classical definition, a market maker is a financial institution that undertakes to provide liquidity for certain securities on the stock exchange. The stock marketmakers include large commercial banks and brokerage companies. They are required to comply with the rules of the exchange and financial legislation. The market maker literally means "the creator of the market" - this is the most important participant in the market process, ensuring its viability.

Although the Forex market is decentralized, all its participants are interconnected. Ordinary traders trade through intermediaries - brokerage companies and market makers. If the broker does not have enough of a currency to make an exchange transaction, he refers to liquidity providers, or more precisely - orders the customers for the interbank market. Brokers also issue orders for liquidity  providers when they do not want to risk their own money.

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There are many market makers on stock exchanges and everyone has their own tasks. The market maker enters into an agreement with the stock exchange, under which he undertakes to provide liquidity for certain securities or currencies. Under the contract, he must sell or buy financial instruments in cases where there are no other buyers or sellers. And the main activity of MM - mediation in transactions between sellers and buyers. By collecting bids for sale and purchase, they form the prices.

Market makers have been known since the foundation of stock exchanges. But after the organization of the market for international exchange of currencies, their influence increased significantly. The turnover of the Forex market is about 5 trillion dollars a day and most of the operations are conducted by market makers.

More than 50 percent of all currency turnover is provided by four banks. The first in terms of volume is the American Citybank, followed by German Deutsche Bank, slightly smaller than the British RBS (Royal Bank of Scotland Group plc) and Barclays, as well as the Swiss UBS. A fairly significant share is held by the US Bank of America, Morgan Stanley, JP Morgan. Asian markets are dominated by Standard Chartered Bank and Mizuho Bank, on Russian exchanges - by Rosbank and UniCredit.

The standard contract on the interbank market is $ 5,000,000. Few banks can operate with such capital. Therefore, market makers collect smaller orders in a larger, called "pool." Applications for "pools" are submitted by large intermediary companies (prime brokers).

A prime broker is a bank directly connected to trade channels. He is also a part-time market maker, who has obligations to the broker who has concluded an agreement with him on the supply of liquidity. Prime brokers accept applications worth $ 10,000 (and in some cases even less). Such applications are submitted to them by retail brokers, which provide services to ordinary traders-speculators.

Working as an intermediary, the broker earns a markup (surcharge to the spread) and commissions. In turn, Forex clients get access to interbank quotes with relatively small deposits. It turns out that this scheme is extremely beneficial to both the broker and his clients: the first does not risk his capital, and the second gets access to liquidity.

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Thus, in the current forex market, the role of market makers has changed somehow. Market makers have the right to enter into contracts for the exchange of currencies for their own funds. So there were rumors about the manipulation of prices. In fact, market-maker banks buy or sell currency in cases where the volume of purchases or sales is greatly reduced in the market. So they stabilize prices, preventing chaos. Market makers fulfill their task of providing liquidity, and do not move prices.

OVERLAPPING ORDERS (MATCHING)

Forex - a large multi-level system of requests for currency exchange. Most independent traders work at the lowest level through intermediaries. These intermediaries are distinguished by schemes for obtaining quotes and processing orders. There are brokers who only receive quotes from information systems, but do not issue orders of traders to the interbank market. They are also called dealing centers for the English name of this scheme Dealing Desk. Domestic traders call these brokers "kitchen", because everything is brewed in one place.

Many brokers summarize the positions for buying and selling for each financial instrument, and the difference is taken to the interbank market. This is called "matching" and occurs in the automatic mode.

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The figure above shows an example of a prime-broker that collects applications from retail brokers. In this picture you can see how 112 lots of orders for sale overlap within the company, and 122 of 234 lots for purchase are redirected to the interbank market.

Thus, the warrant for selling the dollar of trader Vasya from Russia may be overlapped with a warrant for the purchase of the dollar of Mr. Chen Li, who trades with a Chinese broker.

There are also brokers in the schemes of A-Book and B-Book. The scheme of the broker's work, when all customer transactions are output to the interbank market, is called A-Book. Earnings of the broker consists of commissions or from margins to the spread of the market maker. Under this scheme, it is advantageous for a broker to have profitable traders with large deposits. At such brokers the minimum deposit can make $ 5000- $ 10,000.

If the broker operates according to the B-Book scheme, then the transactions do not reach the interbank market, and the broker's profit is the loss of the client. The reason for this work can be low maintenance costs, which gives advantages in competition. There are also hybrid models, when both schemes are used simultaneously. In this case, the trades of successful traders are taken to the interbank market, and the rest are traded within the brokerage company.

INSURANCE OF RISKS BY MARKET MAKERS

According to the rules of the exchange, a market maker is obliged to buy when no one wants to buy and sell when no one wants to sell. This is a significant risk, and to compensate and generate income, banks and brokers offer a purchase price higher than the selling price. This difference is called the spread. Buying currency is cheaper, and selling more expensive, a market maker gets an income. The size of the spread may vary depending on the situation on the market. Reducing the difference between the prices of buying and selling is called a spread reduction, and an increase is the spread expansion.

The spread can be fixed in the case of highly liquid currencies or floating depending on supply and demand. Spreads expand during periods of volatile market, as well as before important economic or political events. A wide spread helps reduce market activity and compensates for losses of banks and brokers. For insurance of risks, in addition to expanding the spread, market makers apply hedging, that is, making a compensating transaction. If, for example, a bank sells a contract on its exchange, it buys the same contract for another.

PROHIBITED STRATEGIES

The undesirable flow of orders in the trader's jargon is called a "toxic stream" or "toxic". Toxic, as a rule, generates traders who earn on the imperfection of MM-algorithms, or the underlying trading infrastructure.

Almost 100% of the toxicity comes from the algorithmic traders, I mean from their high-frequency trade (HFT). Roughly speaking, this is a very large number of transactions in a very short period of time.

The prohibited strategies include:

  • Arbitrage on the difference of quotations of suppliers;
  • News trade;
  • One-sided trading of large volume.

Despite the large overall volumes, the positions do not stay long in the market, which is why ordinary traders do not have time to take advantage of additional liquidity. Such a trade leads to an imbalance in the positions of the market maker and, ultimately, losses.

Market makers can fight such trading strategies by changing or stopping pricing for customers creating a toxic stream. It does not matter whether you are trading through a broker or directly with a bank. Some advantages in this regard are given by ECN, since your bids are mixed with the rest, which makes it more difficult for a market maker to identify a specific trader.

Manual trading is almost impossible to classify as toxic, provided that you do not trade through the kitchen. Therefore, trading in a measured way, you will never become a problem for a market maker.

CONCLUSION

Do not blame market makers for all failures. They provide the Forex with liquidity so that you can buy or sell currency at a reasonable price at any time. In the case of ordinary trading for a market maker, it does not matter whether you won or lost. Problems can arise in the case of high-frequency algorithmic trading or during the news release. But, if you do not use risky strategy for the market maker, then the problems of major players will not affect you in any way.