How is Forex arranged and is it needed?

Published on November 18, 2013

How is Forex arranged and is it needed?

    When it comes to the stock market and trading on the stock exchange, the first thing that comes to mind for many people is forex trading. Indeed, advertising of this type of investment (although operations on this market can be called a stretch) has penetrated many areas of our lives - successful traders who earn thousands of dollars in parallel with their main work or while lying on the beach look at us from posters in subway cars , and with banners on the web. Meanwhile, everything is far from simple.

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    The nature of the FOREX market


    FOREX is an abbreviation of the two words Foreign Exchange, which means Currency Exchange. The same word Exchange in English refers to a exchange or any other trading platform where one asset is exchanged for another, for example, trading in stocks or futures contracts: futures and options. From here comes the first misconception regarding the nature of this market.

    Forex offices stubbornly call the game at exchange rates either trading on the stock exchange or investing. The real lion's share of the market for the exchange of some currencies for others occurs on the OTC market between large international banks. This is a relatively "closed club", getting there is very difficult. Trade goes in very large amounts. Minimum lotis the amount of 1 million dollars or euros, the standard is 5 or 10 million dollars.

    Currency trading provides primarily export-import operations of bank customers, and second, but not least, the interests of their own trade and investment departments of international banks, conducting their investment activities around the world. It is clear that in order to become a client of an international bank and start buying and selling currency in order to extract “income” from the movement of exchange rates, it is necessary to put more than one million dollars on the account.

    Trading will be conducted, most likely, without leverage and at the quotes of the bank itself, and not the free market. And bank quotes will differ from those desired for the worse for the client. Well, this is natural: the bank must also earn! His traders will not work "for free." From here follows the second and main misconception of people involved in forex trading. They think that their transactions are really being brought to the market through a cunning system of “inter-broker relations”. However, it is not.

    Most transactions in the real interbank market are made through a limited number of private information-dealing networks (for example, such well-known companies as Thomson-Reuters or Bloomberg), where entrance from the street is simply ordered. Many networks do not have gateways that would allow connecting external dealing systems to them in order to route client orders to the market. And to drive every client order into such a system is expensive and therefore not advisable.

    Each transaction that is made by currency dealers of banks through such systems is then processed by the bank’s back office and on the third banking day, it settles the delivery or acceptance of the traded currency. It is naive to believe that orders of clients of domestic forex brokers for 3-5-10 thousand dollars (and even 100 thousand) are sent to the real market. No one will do such a small amount, neither confirm, nor process the transaction, nor make settlements on it. It is simply unprofitable.

    Thus, it can be stated, and forex brokers are well aware that no transactions that they conclude with clients are displayed on either the exchange or the interbank over-the-counter market. And where then are these deals executed? And who is the opposite side in such deals?

    Where are transactions executed?


    Many forex brokers explain to their clients how they work:

    The risk management system installed on the “company” (registered on the BVI or the Cayman Islands) very well considers the risks and sends to the real OTC market not all client orders, but only their aggregated component exceeding a certain size. And the firm reduces the remaining orders with opposite orders received from other clients. That is, if you have an order for 10 thousand dollars, then it will be executed within the Forex broker itself, if 100 thousand dollars, it will be executed by its counterparty, a large international bank that will take this order to its position. But if you have an order for 1 million dollars, then it will certainly be sent "to the exchange" and executed only there.

    This, of course, is not true. None of the forex brokers practically ever brings their clients ’deals to the open market, whether it be a mythical exchange or a counterparty partner — a large international bank or an over-the-counter market, because it knows that the conditions of the game are such that the client will lose sooner or later. Therefore, there is no need to bring deals to the market.

    And who in this case becomes the second party to transactions? Where to look for a counterparty? You don’t have to go far - the forex broker itself is the second side of the transaction.

    Thus, having concluded a contract with a forex broker, having brought him money, the client will make transactions with the forex broker himself. In this case, any loss of the client is the gain of the forex broker, and any gain of the client is the loss of the forex broker. And in the loss he is just the least interested.

    The next misconception that forex brokers are trying hard to root in the minds of ordinary people is that you can make very good money by moving currency quotes. If only correctly guess the direction of the course. But is it?

    Can I make money on Forex?


    A standard example cited by forex brokers is as follows. Consider the graph shown in the figure below, which shows the movement of the euro-dollar.

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    If a client sold 1 million euros on October 25, 2011 at a price of 1.390 EUR / USD, and on December 22 of that year bought that million at a price of 1.310 EUR / USD, as shown in the figure, his profit would have amounted to 80 thousand dollars . Good money, right? These $ 80,000 would be received for the $ 1,390,000 invested in the transaction, which would yield a yield of 36% per annum for two incomplete months. Not bad?

    Yeah not bad. The trouble is that the average Russian investor does not have that kind of money. “It does not matter,” the forex broker answers him: I will give you my shoulder !

    You do not need to have a million in the account. Only $ 10,000 is enough. Then with a leverage of 100 you can buy and sell lots in the amount of up to 1 million dollars. And with a shoulder of 150 - up to one and a half million. ” So says the forex broker. This means that if you have a leverage of 100, you should not consider the return on the invested $ 1,390,000, but on the amount 100 times less !!! This, of course, increases profitability by 100 times and gives fantastic 3,600% per annum !!! This is fantastic - any person working in the financial market will tell you. And he will be right.

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    What does shoulder really mean?


    Let's see what shoulder really means. The average daily fluctuation of prices for the euro-dollar currency pair is 0.28% based on the results of the last year's trades (from April 1, 2011 to March 29, 2012.). This means that your investment of $ 1,390,000 daily experiences average fluctuations in value of about $ 4,000, then in plus or minus. This also means that approximately two and a half days of average unfavorable movement for you in one direction is enough for absolutely nothing to remain from the account of 10 thousand dollars. Your position will be closed, despite the fact that in the future you could possibly make a profit. These are the rules.

    [Upon reaching a critical level of losses on the client’s open position, the broker has the right to close it at the current market price by force. ]

    In the case considered, when the client has an account of $ 10,000 and a leverage of 100, it is enough to change the exchange rate by only 0.01 (0.01 = 100 pips = 1 figure, 1% = 1 / leverage), ie from 1.390 to 1.400 so that your position is forcibly liquidated by a forex broker and you are left without money. At shoulder 50, the situation is slightly better. Prices should change in an unfavorable direction not by 1%, but by 2% = 1/50, which is 200 pips or two figures, expressed in the terminology of currency speculators. However, even in this case, your position would be closed after only two days. The movement of prices for a figure or two - this is not such a rare event in the forex market.

    The fact that in the forex market with a leverage of more than 20 is almost impossible to earn, even correctly predicting the direction of the exchange rate in the medium and long term, unfortunately, there is a statistical fact that follows from a simple mathematical modeling of the movement of the rate. It’s absolutely not important: do you think this movement of courses at the micro level is fractal or purely Brownian.

    The sadness of this fact stems from the randomness of the pricing process on the one hand and the limited nature of your resources when working with leverage on the other. Whichever way you take a position when trading with leverage, sooner or later you will lose all your money. And no risk management, no money management from this disaster does not save. The question can only be posed as follows: with what probability and for how long a complete loss of all funds occurs.

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    The larger the leverage, the greater the likelihood of losing and the less time needed to realize this adverse event.

    A complete analogue of trading with leverage 2 in the foreign exchange market is playing at a roulette casino. If you do not stop, then sooner or later a sequence of events will arise when you lose all the money you brought with you, as well as all the money you earned before it, regardless of which game strategy you use.

    According to materials posted on the RBC-Daily website and citing Philadelphia Financial's research, forex brokers lose their money at a rate of 60-80% per quarter.

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    Source: www.rbcdaily.ru

    This means that about 70% of the funds brought by clients within 3 months migrate into the pockets of the owners of forex brokers. This profitability is no worse than the profitability of a casino, where the probability of winning by customers is even higher, which is shown in the figure below:

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    Source: www.rbcdaily.ru

    Do you really need forex?


    Generally speaking, of course you need, no matter how casino it may seem. But you only need real forex, where there is a real exchange of some currencies for others. What for? To carry out export-import operations, for investment and trading activities on a global scale such as carry trade and others, to hedge risks, and to make investments in currencies. However, banks that provide services to their customers in carrying out conversion operations do an excellent job of these operations. They make them both on the interbank over-the-counter market and on currency exchanges.

    Moreover, the liberalization of foreign exchange legislation in Russia allowed starting January 1, 2012 to participate in foreign exchange trading not only to authorized banks with foreign exchange licenses, but also to other persons.

    Moving in this direction, the leading exchange of the country OJSC Moscow Exchange opened in February 2012 two-tier access for individuals to its foreign exchange market. Wherein:

    • indeed, transactions for the purchase or sale of foreign currency are concluded either for rubles or for US dollars,
    • known place of transactions - exchange,
    • the counterparty is known for each perfect transaction - this is the central counterparty, i.e. the exchange itself, which stands between the buyer and the seller, and to both parties guarantees the execution of the transaction,
    • the rights and obligations of each party to the transaction are known,
    • the legal consequences of each transaction are known,
    • There is a clear procedure for making and executing these transactions,
    • as well as quite specific rules for accounting for such transactions by exchange intermediaries and settlements for them.

    You can access trading on the Moscow Exchange online at this link .

    It would seem that many issues of regulation of this market and supervision of those participants who wish to conduct real business and make real (and not feigned or aleatory) transactions have been resolved.

    So maybe it's worth moving in that direction? Those forex brokers who really want to legalize should be licensed as real brokers and conduct business in a civilized manner, in compliance with current legislation. It’s time for others to ask: “And you, citizens, what are you doing here?”

    Author : Vladimir Twardovsky, Chairman of the Board of ITinvest.