I read a while back on this forum that we are not actually trading spot forex in the sense that there is no simultaneous buying of one currency and selling of another. We are really just trading CFDs that mirror the currency movements. Haven’t thought much about this until recently again. I would like some clarification as to how this actually works? If we are really just trading CFDs that mirror the currency movements, what about institutions and the government? aren’t they actually converting currencies?
Personally I don’t concern myself with such things, if I can make a profit and I can take it out of an account, I wouldn’t care if it was chickens I was trading.
I appreciate my comment is not much use to your question, but it does make a relevant point 
I’m with Merry Trader on this as far as profit and chickens, however I do think it’s a great question.
See if this helps you. Spot forex trading
Partially, but still some some sub questions unanswered.
Maybe you read something that I posted. I can’t count the number of times that I have tried to explain on this forum that there is no buying or selling of currencies in the retail forex market.
And there is no buying or selling of currency [I]pairs[/I] either, because that concept doesn’t even make sense. Think about it: If you “bought” a currency [I]pair,[/I] what would you own?
We aren’t trading CFD’s — those are different.
Technically, we are trading “rolling spot currency contracts, with an initial 2-day settlement date, which is rolled forward daily”. Let’s deconstruct that jargon.
A [I]spot contract[/I] in any commodity, including a currency, means a transaction concluded immediately. [I]Immediately[/I] usually means [I]today,[/I] but it can also mean [I]as soon as possible.[/I]
[I]Forex spot contracts[/I] are unique, in that they always specify settlement 2 days after entry (rather than [I]today,[/I] or [I]as soon as possible.[/I])
And this specified settlement date is unique, as well, in that it gets pushed forward (into the future) by one day, every day. That is, the settlement date is “rolled” forward each day.
So, if you enter a spot forex position on Tuesday, then initially you are scheduled to settle this position in cash on Thursday. However, on Wednesday, the settlement date for this contract gets “rolled” forward to Friday. And on Thursday, it gets rolled forward to Monday. And so forth.
The result is that your “rolling” spot forex contract never reaches its settlement date. It never expires, until you close your position voluntarily, or a margin-call forces a closure.
For a brief history of CFTC regulation of rolling spot forex contracts, see this post.
[I]All[/I] retail spot forex trades, and [I]most[/I] institutional spot forex trades, are speculations. And speculations are nothing more than bets. You, as a retail spot forex trader, are placing a bet with your broker. He holds the other side of your bet for the duration of your open position. In other words, your broker is your “counterparty”, and no matter what he may do to offset his exposure to your trade, he will remain your counterparty for the duration of your trade.
Because of this onging counterparty relationship, the CFTC refuses to refer to retail forex brokers as “brokers”, but insists instead that they are “dealers”. The CFTC has created the term “Retail Foreign Exchange Dealer” (RFED) to designate the entities we call brokers. In the discussion which follows, I will continue to call them “brokers”.
When you go LONG your broker automatically goes SHORT, because he has the other side of your trade. And, vice versa, when you go SHORT, your broker goes LONG. He may not want to be in the position you have put him in. What he does about it will depend on what type of broker he is.
Here are the possibilities:
• Your position might exactly offset the equal and opposite position of another trader on your broker’s books. In this case, you and the other trader cancel each other out; your broker’s exposure to the two of you is net zero; nothing needs to be transacted upstream by your broker; and your trade has zero impact on the worldwide currency market.
• Your broker might eliminate his exposure to your position, by taking an identical position with one of his liquidity providers (banks). If you have taken a LONG position, you have put your broker in a SHORT position. If he wants to offset that SHORT position, he can take a LONG position by trading upstream with one of his liquidity providers.
Your position with your broker is most likely a [I]margined position;[/I] but, your broker’s identical position with his bank is a [I]cash position,[/I] in which he earns (or pays) interest (depending on the currency pair, and whether he is LONG or SHORT that pair). The “roll” which he credits (or debits) to you is his interest credit or debit, passed on to you. It has nothing to do with your “borrowing” money from your broker, contrary to what many traders will tell you. In retail forex trades, traders do not borrow money, and brokers do not lend money.
When your broker trades upstream, he may be trading directly with a bank, or he may be trading through an ECN (electronic communications network). An ECN simply aggregates large numbers of positions from many brokers, offsets the positions which cancel each other out, and trades the rest upstream with a bank, or banks.
If your broker offsets [I]every[/I] customer trade placed with him, by trading upstream, he is referred to as a Straight-Through-Processing (STP) broker. A so-called “ECN broker” is simply an STP broker who trades upstream with an ECN, rather than directly with the banks.
[I]If your broker is an STP broker who trades through an ECN,[/I] then customer trades placed with him [I]may, or may not,[/I] reach the worldwide foreign exchange market (the interbank market), depending on whether the ECN passes those trades upstream to the banks, or offsets them internally.
[I]If your broker is an STP broker who trades directly with the banks,[/I] then every customer trade placed with him reaches the worldwide foreign exchange market, and can be said to have some “impact” on that overall market. However, considering that all the retail forex transactions in the world amount to less than 3½% of total worldwide foreign exchange turnover, our “impact” on the overall market is essentially nil.
In the discussion above, “banks” refers to the world’s major investment banks which trade currencies among themselves and with major clients, in what we call the interbank network. This network is basically a communications network in which the big banks are linked to one another, via one of two dedicated trading platforms: Thompson Reuters or Electronic Broking Services (EBS). On either of these competing platforms, banks can see each other’s bid and ask prices for currencies, and can trade almost instantaneously with one another.
Edit: 7/1/14 — just saw this news item from [I]Forex Magnates[/I].
Yes, that’s true for governments and [I]large[/I] institutions which trade directly with the banks in the interbank network. Every trade handled at the interbank level is a cash transaction, involving the actual exchange of currencies.
[I]Your[/I] trade might actually get to that level, as well; but, even if it does, it will be like a drop in the ocean. The worldwide foreign exchange market was last measured (by the Bank for International Settlements) to be a $5.3 TRILLION per day market.
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Thanks Clint, pretty sure it was your post that I read a while back. I think this clears everything up quite nicely, thanks for the easy to understand explanation! Really appreciate it.
Thanks Clint. That was a golden post! +1
Thanks for the kind words, guys.
I’m surprised not many websites talk about what goes on in the background.
Excellent!
This should be one of the first “things” newer traders read before even opening a demo account.
Thanks for what is an excellent and thoroughly detailed reply, in my opinion.
Kind regards,
Nick
Hi Clint,
I do have a follow up question. So a bank can choose to offset the risk and take a cash position and trade upstream. My question is how does the currency denominations work. Like say my broker is in Australia and they accept USD, GBP, and Euro, I assume they only have accounts for these denominated currencies. In this case, if I were to trade say NZDJPY, how do they take this upstream?
Clint,
Thanks for sharing your research. Like:
I looked at some of the info about these platforms to get an idea of how much algorithm trading there is and am trying to relate that to how many transactions are made because of the exchange of goods and services to determine which one has the most influence. Transactions because of the exchange of goods and services have to be made so I try to follow those (fundamentals.) I think short term algorithmic trading must be the primary driver of prices between fundamental changes. I try to trade like that is so. Do the banks try to follow price levels or drive prices or arbitrage?
Thanks for the kind words, Nick.
If your broker “accepts” USD, GBP and EUR, he has made a marketing decision to handle [I]retail[/I] business (your account, my account, etc.) in those currencies. In other words, everything [I]you[/I] transact in [I]your[/I] account is ultimately settled and accounted for in [I]your[/I] account currency; and everything [I]I[/I] transact in [I]my[/I] account is ultimately settled and accounted for in [I]my[/I] account currency.
As retail traders, we can speculate (bet) on any combination of currencies (currency pairs), and our bets will be settled in our respective account currencies.
However, [I]the relationship of a broker to a bank[/I] (one of his liquidity providers) is completely different from his relationship to his retail clients. In the broker/bank relationship, instead of “bets” being placed, actual buy/sell transactions are made [I]at full cash value,[/I] meaning at full notional value (not on margin). These “cash value” transactions between the broker and the bank are not paid for on the spot, with cash transfers back and forth between broker and bank — but instead are done through a [I]line of credit,[/I] denominated in the currency (or currencies) which the broker and the bank have negotiated as part of their line-of-credit agreement.
Through this arrangement, the broker can transact business with a bank (that is, trade upstream) in any currency, and all of his business with the bank will be settled and accounted for in the currency (or currencies) in which his line of credit is denominated.
So, to return to your NZD/JPY example, if your retail account is denominated in, say, euro — you can trade the NZD/JPY pair, and the following metrics of your trade will all be [I]calculated and accounted for in EUR:[/I] the notional value of your trade, the required margin for your trade, your remaining (unused) margin, any roll-over credit or debit which may accrue to your trade, and your profit or loss on the trade.
Thus, in your EUR-denominated retail account, you are able to go LONG or SHORT the NZD/JPY without having any New Zealand dollars or Japanese yen on deposit with your broker.
In similar fashion, if your broker has a line of credit with a bank, which is denominated in, say, Australian dollars — he can go LONG or SHORT the NZD/JPY, or any other pair, without having any New Zealand dollars or Japanese yen on deposit with that bank.
Take note of this: unlike your “bet” on the NZD/JPY, which involves no actual buying or selling of either NZD or JPY, your broker’s transaction with his bank [I]does involve buying one currency, and selling the other currency[/I] — and those transactions (together with all of his other transactions) are accounted for in the currency in which his line of credit is denominated (AUD, in our example).
Thanks for the kudos.
In general terms, the [I]overall direction of price[/I] is determined by [I]fundamentals,[/I] and is beyond the ability of banks to manipulate. So, in the case of so-called “secular” price movements, the banks “follow” price.
On the other hand, [I]short-term price movements[/I] (intra-hour, intraday, etc.) are driven more by [I]technicals,[/I] than by fundamentals, and these time-frames are the playground of the big banks. A great deal (maybe most) of the [I]short-term fluctuations[/I] in currency prices are “driven” (manipulated) by the banks.
The banks see the order-flow which moves price short-term. And they can, and do, run with — and in many cases [I]front-run[/I] — those orders, trading for their own accounts, using their own money, and making large profits for themselves. This sort of insider trading is beyond regulation, and therefore can only be thought of as “legal”.
For anyone who doubts that this manipulation of short-term price movement occurs — I have a very nice bridge in Brooklyn which I would love to sell to you.
Finally, if you just can’t get enough of this subject, check out this post. It contains links to an entertaining article about the inner workings of a big London bank’s currency trading desk.
Once again, thanks Clint for your explanation. Are there any sites or books that you recommend that focuses more on these topics? I really don’t want to trouble for your explanations, hopefully you’re not repeating yourself over and over again for newbies like me 
Absolute quality post, Clint. Thanks for your time and efforts in doing so. You’re clearly a knowledgeable chap, hopefully this reflects in your trading endeavours!!
Cheers
Lance
Ah Clint, nice explanation…and bottom line, as long as traders can make money in forex, semantics matter little. But that said, your explanation certainly explains quite a few things…from spot to interbank…
That was pretty straight forward. Looks like inside information… Are yo one of the angels betting against the opposite (naming it will looks negative…) ? I mean this positive…Thanks Clint and I do appreciate.
Thanks Clint. Your post is an eye opener.
Well done mate! Deserves a bump up for next year. Useful resource for all new traders. Dare I say much better than any explanation I could have given on this subject. Keep up the good education…