Forex Market Structure Explained
The forex market, also known as the foreign exchange market, is the largest and most liquid market in the world. But how is this enormous marketplace structured? Beyond what you see on your forex trading platform lies a vast and structured ecosystem which forms the foundation of the forex market. In this article, we will break down the forex market structure and explore the interbank foreign exchange market. We will also explain what a forex order is, take a look at the different types of forex orders and how they are processed within the forex network.
What does 'Market Structure' mean in Forex?
When traders talk about 'market structure' in forex, they are referring to the way in which orders move through the system, who trades with whom and where liquidity actually comes from. Unlike the stock market, which usually runs through centralised exchanges such as the NYSE, the foreign exchange (forex) market has no single hub. There is no main exchange, no trading floor and no single building where all the action takes place. Instead, forex is an over-the-counter (OTC) market. Transactions happen directly between participants via electronic communication networks, bank dealing systems and forex trading platforms. Think of it as a global web of connected counterparties rather than one central marketplace.
Forex Market Structure Breakdown
At the top of the forex market structure is the interbank foreign exchange market. This is the domain of all major commercial banks, investment banks, central banks and large financial institutions that regularly exchange very large volumes of currency with one another. The prices formed in the interbank foreign exchange market strongly influence pricing across the wider forex market, and most participants further down the chain are influenced by prices and liquidity there.
Below that is a layer made up of liquidity providers and prime brokers. These are large banks and non-bank financial institutions that continuously stream bid/ask quotes to brokers and institutional clients. By consistently showing tradable prices, as well as being willing to transact at those prices, they inject liquidity into the system, making it possible for other participants in the forex market to execute trades quickly at competitive prices.
The next level down are the forex brokers and they are the ones who provide forex trading platforms. Their role is to bridge the gap between the wholesale market and the trader. Most retail traders and many professional traders cannot access the interbank foreign exchange market directly. Instead, they place trades through a forex trading platform. The broker typically aggregates price feeds from several liquidity providers, displays these quotes to clients and then routes client orders into the broader market according to its execution model.
Major participants located across global financial centres such as London, New York, Tokyo, Singapore and Sydney are linked by electronic trading infrastructure enabling the forex market to function almost continuously from Monday to Friday. That means as one region’s trading day winds down, another’s begins. This creates overlapping trading sessions and keeps pricing and trading activity going in most major currency pairs throughout the 24-hour cycle.
Forex Order Types | Understanding Forex Orders
A forex order is an instruction to buy or sell in the market. Traders place them on forex trading platforms and can use different types of forex orders to open or close positions and manage trading risk. It’s crucial to understand the different order types especially if you are new to forex trading.
Market Orders
A market order is the easiest forex order a trader can place. By placing a market order, a trader is telling the broker that they want to buy or sell a particular currency pair right now at whatever price the market is currently offering. It's as simple as grabbing something off a shelf at the store and heading straight to checkout. However, despite it being super simple, it is important that you know when to use it because once you press send, the order fills instantly at whatever price the market offers in that moment.
Limit Orders
There are two types of Limit Orders:
Buy Limit Orders are used when you think the price will dip before it moves higher. For example, if the current price of EUR/USD is 1.2000 and you expect it to drop to 1.1950 before rebounding, then you'd place a buy limit order at 1.1950.
Sell Limit Orders are used when you think price will rise before it resumes its downward momentum. Using our EUR/USD example, if the current price is 1.2000 and you expect price to move up towards 1.2050 before it resumes its downtrend, you'd place a sell limit order at 1.2050. Let’s say you opened a EUR/USD long position at 1.2000. You would like to close the position if the price advances to 1.2100. Then, you can just simply place a limit order at 1.2100 to close your position if it reaches that price.
Stop Orders
Stop Orders can be used to open a position or manage your risk of an existing order.
A Buy Stop can be placed to enter a long position only if and when the price breaks above a certain price level. For example, if the current price of EUR/USD is 1.2000 and you think the price will accelerate upwards to break 1.2050, then you'd place a buy stop order at 1.2050.
On the other hand, a Sell Stop can be placed to enter a short position only if and when the price drops below a certain price level. Using our EUR/USD example, if you think the price might fall sharply once it breaks below 1.1950, then you'd place a sell stop order at 1.1950.
One of the most useful tools on a forex trading platform is a Stop Loss Order. It is used to automatically close a position at a predetermined price level if the market moves unfavourably. This allows traders to protect trading capital by putting a cap on potential losses. For example, if you've opened a long position of EUR/USD at 1.2000 and wish to close the position should the price fall to 1.1950, then you can set a stop loss order at 1.1950.
How Forex Orders are Processed | Forex Market Structure
Once you place an order on a forex trading platform, you may wonder how exactly your order is processed in the forex network. Let’s break it down:
- Retail traders place buy or sell orders on forex trading platforms.
- Forex brokers then take those orders, aggregate them and then pass them on to the liquidity providers.
- Liquidity providers, such as banks, are a source of liquidity that enables orders to be executed.
- Liquidity providers also handle high-volume forex orders from clients. If an order is very large, they may pass some of it over to the interbank foreign exchange market to access deeper liquidity.
A key point to understand is that forex orders are the smaller pieces that make up a huge and interconnected structure known as the forex market. Once you have an understanding of where your orders fit in when you place them, you will start to wonder why slippage happens, why spread varies and why you might sometimes experience slight delays with order execution. These are some of the deeper issues beginner traders need to learn.
What Factors Drive Forex Prices?
The forex market structure is dynamic and influenced by a number of economic and political factors. These play a significant role in how prices fluctuate and how orders move. Some key factors include:
- Central Bank Policies: Interest rate changes can rapidly shift currency demand.
- Economic Indicators: Inflation rates, GDP growth and employment figures are some key data figures that can influence trading sentiment.
- Political Factors: Trade wars, elections and geopolitical conflict can create a shift in currency strength.
- Market Sentiment: Worldwide news and even trading psychology can have a major influence on how buyers and sellers enter the market.
Forex Market Structure FAQ
What is the forex market structure?
It is how the global currency market is organised, from large banks in the interbank foreign exchange market all the way down to the individual retail trader.
How do forex orders flow through the market?
Forex orders are placed by the retail traders and passed to the brokers. From there, the brokers pass orders on to liquidity providers or to the interbank foreign exchange market. This structure is designed to ensure that forex orders reach the relevant counterparty, maintaining liquidity and price stability in the market.
Who are the key players in the forex market structure?
The key players include central banks, commercial banks, hedge funds, brokers and retail traders. The forex market structure is a hierarchy, with players in the interbank foreign exchange market sitting at the very top, followed by the institutional then the retail layers.
Is the forex market decentralised?
Yes. Unlike the stock market, there isn't a centralised exchange in the forex industry. The way foreign exchange works is by over-the-counter transactions through a wide range of banks and brokers, making the forex market structure decentralised by nature.
Conclusion | Forex Market Structure Explained
For some it may be daunting when learning about the forex market structure at first glance, but it is important for traders to understand this system and how each layer is interconnected, from the interbank foreign exchange market down to the very forex trading platform you use as a retail trader. The forex market doesn't move at random, there is an underlying logic behind how forex orders are processed and how market prices move on a daily basis.
If you found this article useful and you would like to deepen your trading knowledge, keep on reading the EC Academy as we explore more topics that will aid you in your trading journey.