We are continuing our discussion of where retail forex traders trade over the last couple of days.
The interdealer segment of the FX market is where trades occur between FX dealers.
This is as opposed to between dealers and their end customers, such as exporters and importers, asset managers, hedge funds, and even some retail forex brokers.
In the past, only the biggest of boats were allowed on these big islands.
This is because large boats preferred to only trade with other large boats.
They deemed smaller boats as too risky to trade with.
But nowadays, it’s possible for medium-sized boats to trade there as well by “attaching” themselves to one of the large boats.
We won’t get into the details right now to keep things simple, but basically, the large boat (bank) allows the medium boat (hedge fund) to trade in its name.
This is how the medium boats can access these big islands and trade with the other large boats.
In exchange for the privilege to trade in its name, the large boat typically charges the medium boat a fee based on the volume of trades done.
We know this arrangement as a “prime brokerage” arrangement.
With the large boat in the role called a “prime broker” (or “PB”) and the medium boat in the role of the prime broker’s client.
Prime brokers make it possible for these smaller (but not too small) market participants.
Despite their limited credit history or higher risk profile, to use the prime broker’s higher credit rating, and trade almost anywhere and with anyone in the “lake”.
Basically, the clear distinction that separated the interdealer market and the rest of the market in the past has now become blurred.
The important thing to know about the interdealer market is that it is a global network (of trading venues) used by banks and large non-bank financial institutions (“NBFIs”) to trade currencies between themselves.
Trades occur electronically or via voice.
This “market” operates in a highly decentralized fashion as a loose network where banks and NBFIs negotiate bilateral deals without central supervision.
This supposed “market” is, in reality, a network.
So when you see the term “interdealer market” or “interbank market”, it simply refers to a network where currency transactions are negotiated between financial institutions and other large companies.
The rates that are traded in the interdealer market then spread (like gossip) to the other boats and smaller islands (other market participants use as “reference” rates the rest of the FX market.
These rates are what’s (hopefully) displayed to you by your retail forex broker. Usually with a markup.
Now that we’re discussing retail forex brokers, let’s see where they fit in the picture.
A retail forex broker is one of the tiny boats.
Of course, since some retail forex brokers are larger than others, their boats also come in different sizes.
There are large retail forex brokers. And there are smaller ones.
Retail forex brokers can’t trade directly with other boats.
In order to trade, a retail forex broker needs to “attach” themselves to a larger boat that will allow it to trade in its name.
We know this special type of relationship as a prime broker (“PB”) relationship.
The large boat becomes the retail forex broker’s PB.
A PB is an entity that will represent the retail forex broker in all its trading transactions that occur in the lake and settle the trades in its name.
But large boats are picky.
The larger retail forex brokers, they’re able to enter into a prime broker (“PB”) relationship with a large boat.
For the smaller brokers, they consider it too risky for the large boats. They do not meet rigid standards and are not able to secure a prime broker relationship, which prevents them from being able to trade with others in the FX market.
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