STRUCTURE OF THE FOREIGN EXCHANGE (FX) MARKET EXPLAINED

The foreign exchange (FX) market is the largest and most liquid financial market in the world, with daily trading volumes exceeding $7 trillion as of 2024. Despite its vast size and importance, it operates differently from traditional exchanges such as the London Stock Exchange or the New York Stock Exchange. Key to understanding the FX market is its decentralised nature, dominated by over-the-counter (OTC) trading, a range of dealer institutions, and a network of liquidity providers that ensure the continuous flow of currency transactions across the globe.

Unlike stock markets, the FX market does not have a single physical location or central exchange. Instead, it is a global electronic network facilitated by banks, financial institutions, corporations, hedge funds, and individual traders. This ecosystem relies on a combination of OTC trades and dealer-led transactions, with technology playing a critical role in bridging counterparties.

This article will delve into the main components that structure the FX market, focusing on the nuances of OTC trading, the role of dealers, and the function of liquidity providers. We will explore how these elements come together to create a dynamic and interlinked financial system.

Over-the-counter (OTC) trading is the cornerstone of the FX market's structure. Unlike organised exchanges, OTC trading in FX involves direct negotiation between counterparties without the oversight of a centralised exchange. This format enables high flexibility, customisable contracts, and continuous trading across global time zones—making it exceptionally well-suited to the global nature of currency markets.

OTC trading in FX can be conducted through various channels:

• Bilateral Agreements: Two institutions, such as banks or corporates, can agree privately on the terms of a currency trade, including size, delivery date, and price.
• Electronic Communication Networks (ECNs): These platforms connect market participants electronically, facilitating anonymous transactions with sophisticated matching algorithms.
• Broker Systems: Voice or electronic brokers help traders find counterparties, particularly for larger or less liquid trades where pre-existing relationships matter.

The OTC market accounts for more than 90% of all FX trading and encompasses a variety of instruments, including spot transactions, forwards, options, and non-deliverable forwards (NDFs). One advantage of OTC structures is that they allow for tailored contract specifications, which is important for handling specific hedging or speculative requirements.

However, the lack of central clearing does introduce counterparty risk. To mitigate this, the industry relies on mechanisms such as credit support annexes (CSAs), ISDA Master Agreements, and increasingly, central counterparties (CCPs) for certain derivative transactions. Regulatory efforts, particularly after the 2008 financial crisis, have intensified the push for transparency in OTC trading. Institutions are increasingly reporting their OTC trades to repositories to facilitate market oversight.

Despite these challenges, OTC trading remains preferred among institutional participants for its flexibility and immediate execution. Market participants benefit from differentiated pricing and more customised solutions than in standardised exchange environments.

In sum, OTC trading forms the skeleton of FX market activity, allowing for decentralised yet interconnected transactions that occur in real time across global centres—from London to New York, Tokyo to Singapore.

Dealers play a pivotal role in the structure of the FX market. These are typically large financial institutions—often commercial or investment banks—that maintain inventories of currencies and stand ready to buy or sell during trading hours. Dealers act as intermediaries between market participants, facilitating trades and enhancing liquidity.

In more technical terms, dealers operate on a principal basis, meaning they take on the risk of holding foreign exchange positions for clients and may profit from the bid-ask spread. They differ from brokers (who act on an agency basis) because dealers quote both buying and selling prices and execute trades using their own balance sheet.

The core responsibilities of FX dealers include:

• Market Making: Continuously quoting bid and ask prices for specific currency pairs, thereby enabling immediate trade execution.
• Risk Management: Actively managing exposure through hedging strategies and portfolio optimisation, given that dealers are at risk of adverse price movements.
• Client Services: Offering customised solutions, market insights, and hedging products to corporate clients, asset managers, and other institutional investors.
• Price Discovery: Helping to determine market-clearing prices through their trading activities and analysis.

Globally, a handful of major banks dominate the FX dealer space. As of the latest available data, firms like JPMorgan Chase, UBS, Deutsche Bank, Citi, and Goldman Sachs consistently rank among the top FX dealers by volume. These institutions often operate sophisticated trading desks and maintain advanced algorithms that support electronic trading and automated price distribution.

Dealers also interact directly with other counterparties, including fellow dealers, asset managers, central banks, and corporate treasurers. In interdealer markets, transactions are often conducted anonymously using platforms such as Reuters Matching or EBS (Electronic Broking Services), which facilitate efficient trade flows at institutional scale.

Although their share of trading volume has declined slightly with the rise of electronic trading and non-bank liquidity providers, dealers still remain central to the functioning of the FX market. Their ability to warehouse risk and provide liquidity during volatile periods or for complex trades remains an invaluable component of the global FX infrastructure.

Ultimately, dealers are the market’s facilitators—ensuring that demand for currency conversions is met around the globe, every hour of the business day.