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Reader Questions Answered The Basics

Is the Forex Market Too Big to Manipulate?

One of the readers at Forex Live asked the question:

“What would you say about the FX market being too big for manipulation? I’ve heard this so many times, but the recent price action of EURUSD just screams the opposite. The big banks RULE the markets and they do whatever they want. How can we small players survive in this market?”

Jamie, the head man over there with whom I’ve worked in the past (I’ve also worked with Gerry, one of the other primary posters), had this to say in response:

I’ll put it this way. The forex market can be influenced by a big player or two in the near-term but not manipulated for very long.

I totally agree with what Jamie says in terms of any one single player being able to control the forex market (except possibly in the case of the less liquid more regional currencies). If some big player comes in with a large order it’s going to have an impact on prices, just as it would in any other market, but that impact will only last so long as the supply/demand dynamic in the market supports it. Say a big hedge fund comes through with a $50bln buy order for USD/JPY. There’s no doubt that prices will be influenced by that order. If, however, there isn’t any additional buy interest in USD/JPY once that $50bln goes through, prices will invariably adjust back down.

Keep in mind the size of the forex market – about $4trl in daily volume according to the estimates. That’s makes it hard for any one player, or even a set of players, to move for a sustained period. Compare that to something like gold. On a good day about 250,000 futures contracts trade there. At a prices of $1300/oz and a contract size of 100 oz, that’s a notional value of about $32.5bln. That’s less than 1% the volume of forex market trading (and about 1/5th the notional volume of the 10yr Note futures), which is why I’ve been saying for a while now that if money really started moving into gold it would go parabolic.

I’ll also agree, however, with the questioner’s point about the big banks ruling the market. They do. The big banks are the primary price makers in forex. That doesn’t mean, however, that they can move the bid/ask strictly of their own accord. They have to react to the demands of the market. The big banks are in direct competition with each other for transactional flow business, and there’s so much pricing information available to customers these days, that banks cannot get far out of line with each other or risk losing business.

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Reader Questions Answered

What about all the toxic debt?

I am reading an outlook for the US Economy from a well known forecaster, and he claims that one of the reasons for the ongoing contraction in private sector bank lending (and therefore M2 growth) is that “there are $176 billion of commercial real estate loans of questionable value on banks’ books”. Thus, the banks fear they might not be adequately capitalized should they need to write these loans off down the road, and as a result they are reluctant to extend credit.

While I agree completely with this analysis, it comes as a surprise to me that he only cites the extent of the CRE problem. So the question is: Did this author forget to mention all the other toxic stuff that was supposedly on the banks’ books (“securities held to maturity” to avoid the write-offs) or was it all erased by one of the many bailouts we’ve had in the last couple of years (and which institution is left holding the bag in that case) ?

“All the other toxic stuff” is things like:

  • Non-performing/Delinquent Residential RE Mortgades
  • Agency RMBS
  • CDOs
  • CDS

This came in by email overnight from reader Rodrigo. I’m no specialist where banks and bank balance sheets are concerned, so I can’t address what banks are holding or not holding at this point. I can, however, address things from a couple of perspectives.

First, from the headlines and stories I’ve read, the folks at the Fed seem to be more concerned with what the commercial real estate sector could do to put pressure on the banks than much else, so the newsletter author in question isn’t the only one with that concern. That is no doubt a factor in the rapid decline in Commercial and Industrial loans.

As for the “other toxic stuff”, keep one very big thing in mind. Both the Fed and Freddie and Fannie have been very active in the mortgage market. The agencies have bought up a lot of loans, many of them troublesome, while the Fed now owns about $1.2 trillion worth of MBS paper. Those activities have done a considerable amount to stablize the market, both in terms of the underlying mortgages and the securities. Obviously, we still have a fair amount of foreclosure activity, but it seems like the banks have that at least mostly factored in to things.

Here’s a look at what money supply has been doing of late courtesy of shadowstats.com. Notice how the M3 growth rate (light blue line) went negative in the latter part of 2009. That’s an indication of contracting credit and lending in the economy.

Note, M3 is no longer published by the Fed. Shadow Stats has carried on the calculation using their own methods, which is what you see above.

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Trading News

The Dominant Players in Forex

I see the question all the time about where prices come from in the forex market and who drives them. The answer is that it comes from the market makers in the inter-bank market. Want to know who the big players are there? Here’s the current ranking as per Euromoney (hat tip to Clint at BabyPips).

Source: Euromoney FX survey FX Poll 2009
Source: Euromoney FX survey FX Poll 2009

According to that same survey, the daily volume of forex trading breaks down like this:

  • Western Europe 50.19%
  • North America 26.98%
  • Asia 14.54%
  • All others 8.39%

Here’s something most folks probably don’t realize, however. According to a Financial Times article posted today, about two thirds of the $3.2 trillion in daily forex market transaction volume done each day is derivatives (see Most Active Forex Currency Pairs). That’s heavily in swaps. The focal point of that FT article is on the potential impact of new legislation requiring derivatives to be cleared through central clearinghouses.

It’s worth noting that the only bank in the ranking list above that does retail forex trading business is Deutsche Bank, which has the dbFX platform. The way I understand it, DB is a major liquidity provider to retail forex brokers. So the answer to the question of who is making prices in the forex market is Deutsche Bank.