In the next few posts we are going to discuss in detail how the exchange rates are determined from the highest to the lowest possible transaction level. Since we are in the business of trading these exchange rates, we should have the macro as well as the micro picture about the currency market. Currency market is highly decentralized. This makes it interesting as well as challenging to understand. But with a little bit of effort we can develop a fairly accurate picture of how this market operates.
As a trader, you should know how the interbank market works. Interbank market is where the exchange rates actually get determined and then get passed on to us through our brokers. At each tier of the market, a small spread gets introduced. Since we are at the lowest level of the market, we get the least competitive rates. With a better understanding of the market, we might be able to know how to get a better deal. In this post we are going to talk about the Interdealer Brokers who are supposed to bring the big banks together in making exchange rate deals. ICAP is the biggest interdealer broker. Watch the video below in which MD ICAP North America talks about the role of interdealer brokers in the market.
Do you know what are interdealer brokers and what are market makers? Do you know what is the Automated Electronic Order Matching System? If you have been trading forex for a while you must have wondered how your orders are being executed by your broker. Obviously when you are buying, the broker is taking the opposite side and selling. But what happens on the other side with the broker is very important for you to understand as it will help you become a better more informed trader. The orders that the brokers take on their order book get accumulated upto a certain amount. Once their is sufficient volume on the order book, the broker will offset the orders in interbank market. When the broker offloads orders in interbank market, they go to these interdealer brokers who are brokers’ brokers in simple terms. The broker adds a few points to the deal that they get from interdealer broker and pass it on to you. This is how the broker is making money.
Today’s Markets Are All About Speed
In today’s market we are talking about milliseconds and nanoseconds. Today’s markets are all about speed. In less than a minute markets can shed thousands of points. Times can come when market moves very fast and very large orders get accumulated. The broker is unable to offload those orders in interbank market. This doesn’t happen often but it happened a few times so that you should be aware of it. It happened a few years back when Swiss National Bank unpegged Swiss Franc from Euro. The market moved so fast that USDCHF fell more than 2000 pips in less than a minute. The market freezed. There was no one to take the opposite side of the trade. The stop losses placed by traders on that day simply didn’t trigger as their was no counterparty. You need to understand this point. Stop loss is no guarantee that you will not suffer a big loss.
On that day EURCHF fell more than 2,200 pips in just under a minute. Many traders who were happily trading EURCHF, USDCHF, GBPCHF and other CHF pairs by placing stop losses got their accounts blown up in just a few minutes. Some traders got negative balances on their account in thousands of dollars meaning they had to pay these thousands of dollars to their broker. A number of brokers went belly up meaning some of them went bankrupt as they couldn’t offload the orders in interbank market in time. Alpari UK was one such broker. On that fateful day, FXCM suffered a loss of $225 million. So you can see how risky things can become. These type of events are known as Black Swan events. Just like Black Swans which are rare, these events are rare but they can happen. Do you know what happened on Black Monday. On October 19th, 1987, stock markets around the world suffered the biggest drop in one single day. You should read about it. These case studies are very informative.
What Are Interdealer Brokers?
So you should understand how the whole automated electronic order matching system works. Let’s start. The first thing that you need to understand is the role of interdealer brokers. Interdealer brokers as the name suggests are the middlemen between the brokers. You can call them brokers’ broker. Watch the video below that explainsin simple terms what are interdealer broker.
The point is you should know how the whole forex market is organized. You should have a big picture about the market and how the different players in the market like the central banks and the big banks and hedge funds operate. You should also have a micro view of the market on how the orders get executed in the market. This will help you lot in understanding how the different moves in the market develop. Brokers are just the market makers meaning they are supposed to execute your orders by acting as a counterparty. But as said above sometimes, things move so fast that whole system just freezes up. This happened recently in Swiss Case as explained above.
What Is ICAP?
As the above video on interdealer brokers suggests one well known interdealer broker is ICAP. Infact ICAP is the biggest interdealer broker. ICAP is the acronym for Intercapital Public Limited Company. As said above ICAP is an important interdealer broker. ICAP is a UK based company with its headquarters in London. It is listed on the London Stock Exchange and is included in FTSE 250 Index. It also have major offices at New York, Tokyo and smaller offices in around 30 financial centers in the world that includes Hong Kong, Sydney, Singapore, Madrid etc. ICAP is known for its Electronic Broking Services also known as EBS. Below is a video introduction to ICAP.
Watching the above video should give you an idea of the size of ICAP. ICAP daily deals with transaction volume in excess of $1.4 trillion. This is a huge volume. You can see in the above video the large floor where individuals are busy around the clock arranging currency exchange deals between big banks and brokers. This might get you tempted to find a job with them. Now if you want to join ICAP, you can watch their graduate recruitment video below!
As the above videos show ICAP provides specialist intermediary services in the wholesale financial markets. An interdealer broker matches buyers and sellers so that commercial banks can execute deals. Banks pay a commission to these brokers. You must be knowing now what this commission is called. Yes it is known as bid ask spread. ICAP uses a special electronic platform that helps in matching buyers and sellers.
Electronic Broking Services EBS
Electronic Broking Services EBS is an electronic trading platform that was created by the partnership of world’s leading market making banks to trade forex in 1993 in an attempt to challenge Reuters monopoly. In 2006, EBS was acquired by Intercapital Public Limited Company (ICAP). Today Reuters and EBS compete head on for the liquidity offered by the major foreign exchange banks. ICAP is the world’s largest interdealer broker. ICAP provides specialist intermediary broking services to large commercial banks and investment banks. ICAP has a daily transaction volume in excess of $1.4 trillion half of which is electronic.
EBS has emerged as a leading provider of forex and precious metals transactional trading and data solutions to a large number of organizations and professionals. Watch the video below that shows a day in the life of an ICAP broker.
As said above ICAP is not limited to forex. It also deals with interest rates, interest rate swaps, credit, credit derivatives, equity derivatives as well as intellectual property.
Now below is another video that gives you the glimpse of how these interdealer brokers operate. As said above in today’s markets speed is everything. Talk about Speed Trading.
We hope you enjoyed reading this post on interdealer brokers. Watching the above videos gives you a glimpse of how fast paced today’s financial markets have become. Today we are dealing with speeds of milliseconds and nano seconds.Is their a method to this madness? Yes there is. Even today floor traders use pivot points which are more than a 100 years old now in determining the direction of the market each day.You can read the post on how to trade with pivot points. There are few different formulas that floor traders use to calculate these pivot points. One of the formula is known as Camarilla Pivot Point Formula. Do you know how to trade with Camarilla Pivot Points? In the next post we are going to talk about Reuters and its role as an interdealer broker.
ICAP Under Investigation By Regulatory Authorities
ICAP has been investigated by the regulatory authorities on the allegations of manipulating derivatives benchmark. Regulatory authorities have also been investigating ICAP on libor rate rigging. European Competition Authorities fined ICAP $17 million in 2015 on rigging a benchmark interest rate.