How are exchange rates determined?

So basically if there are more money waiting to be sold than there are people who wants to buy them there will be more demand than supply and so the price will go down and vice versa. I get that. But this is so old of a definition. I don’t get how does that translate into our new post-modern financial trading where prices are updated almost in real time (matters of milliseconds). I know banks are connected to a interbank system, and they talk to each other all the time. In a sense that network is alive, but what I don’t get is how the whole system is updated. Does it work like this? How is dollar prices go up and down? Who/ which organization decides on the price of dollar? where does brokers get the information form?

let’s assume that the banks know that there are $1.2 trillion dollars in the circulation and about 100 billion dollar CAD money. Now, is the system updating itself, as like if a bank says it want to sell a million US dollar and buy CAD, then the whole system will calculate if how much does this change the price?

Who is responsible for all the statistics? Black boxes? Stock exchanges? Does it move like stock prices?

If bank A does a trade with bank B, let’s say in 100 million dollars, how would bank C know? if bank B buys bank the 100 million dollars just so bank C would go bankrupt, how could bank C know if this was intentional?

How much of the trade is in the hands of retailer FX traders? How does that make sense if interbank only works in lots, then how can we spot trade (even if the pool all the money together) it is not guaranteed to reach the lot value of the trade, so I don’t get how a broker can connect to interbank or be involved in the game at all? is there any book explaining all of this?

Dis, since everyone is ignoring your very relevant questions, maybe check out this simple answer.

Divide your thinking in two, the banks (traders) whose job is to act as speculators and assume risk, and the bank (traders) whose job is to facilitate their corporate/government clients.

Both these set of bank traders’ actions have an affect on price.

Have a look at Eur/Gbp, check price from the date of this article, then think about the latter with this in mind.

UK’s trade deficit in goods with EU hits record high - Telegraph

Banks facilitate this deficit.

You may have seen ‘month end flows’ being quoted, just means Euro bills have to be paid using Gbp.

The retail brokers are bookmakers whose business model revolves around the action of price, their job is to encourage as many new participants as is possible, their customers’ (punters) actions have no consequence on price.

It is worth remembering that the main international banks all function as market-makers which means they constantly have a bid and an offer in the market. They don’t just invent a price when someone asks them. They have a commitment as market-makers to always have a visible bid-offer.

Let’s say that their price is, for the sake of example, 20-25, naturally, if their bid of 20 keeps getting hit then they change their price to 19-24 and if it keeps getting hit then to 18-23 and so on. Similarly, if the offer gets hit most then the price spread will rise. As market-markers, they are not interested in building exposure and aim to stay neutral (although in practice they may well have a bias). Their profit is from the spread not the market movement.

It will also happen that a bank will gain an exposure in a currency from a commercial customer which it then wants offset into the market, this can be done by biasing their market-making spread to favour the sell side. Because different market-makers are offering slightly different prices between the bids and offers then your broker is able to pass on the best from both sides with a small margin added for himself.

When the bank is dealing in actual real cash transactions where the actual funds of both currencies are transferred between actual bank accounts then the banks will have a pre-set exposure limit against each customer whether it is another bank or a commercial customer.

These pricing decisions are not manual as they used to be but are based on computer models that also adjust the spread according to volatility, volume, exposure and so on.

This is a very, very basic description of only some of the factors influencing the overall market price, but I guess it is a start, hopefully some others will expand on this…

Thanks Manxx,

Eur/Gbp good to check the current commercial rate vs the interbank quote (mt4).

e.g. tonight 0.7946 interbank, vs 79.00 best quote commercial - that means expected higher Eur, 78.50 would have been neutral, 78.00 would be expected lower Eur.

The worldwide foreign exchange market is estimated to be $5.3 trillion per day in transaction volume. This estimate comes from the Bank for International Settlements (BIS), which refers to transaction volume as [I]turnover.[/I]

That enormous volume consists of several types of transactions, of which spot trading is just one type. All of the spot trading (institutional and retail combined) amounts to about 38% of total worldwide foreign exchange volume (again, BIS figures).

But, the BIS does not normally break total spot trading down into its institutional and retail components. So, in 2011, I contacted Michael King at the BIS in Basel, Switzerland, and asked him to review some estimates I had made of these components. Michael helped me to refine my estimates. The result was that [I]retail[/I] spot forex turnover is between 8% and 10% of [I]total[/I] spot turnover.

I decided to use the 9% mean. So, crunching the numbers, we get: spot turnover = 38% of total world turnover, and retail spot turnover = 9% of that. For convenience, let’s set $5.3 trillion = $5,300 billion. We now have:

Retail spot turnover (our market) = 0.9 x 0.38 x $5,300 billion/day
= approximately $180 billion/day
= less than 3.5% of total worldwide foreign exchange turnover.

To add to the excellent insights from Manxx and peterma —

As retail forex traders, we do not actually trade in the real market. We place [I]side bets[/I] on the real market. Our bets are made with our retail forex brokers — not with other traders, and not with the market-makers who comprise the interbank network.

Retail forex brokers have various ways of offsetting their exposure to our bets, most of which involve placing trades of their own with one of the banks providing their liquidity. Example: you go LONG a certain pair, automatically placing your broker in a SHORT position. Your broker can offset (hedge) his exposure to your bet by taking a LONG position [I]of the same size in the same pair[/I] with his liquidity provider (bank).

If your broker is an ECN or STP broker, he is able to offset any size position, even one micro-lot. This is made possible by the line of credit arrangement your broker has with his bank. In other words, your broker does not have to aggregate customer positions totaling a full standard lot on his own books, before being able to transact business with the bank.

One other point worth noting: You trade (place bets) with your broker using [I]leverage.[/I] Your broker, on the other hand, trades with his liquidity providers [I]at full notional value[/I] (again, through that line of credit). So, if you enter a position for one standard lot of USD/CAD, for example, you are required to have available in your account margin equal to 2% of the $100,000 notional value of your position. That’s $2,000 of your money earmarked for margin. But, in order to offset his exposure to your $100,000 position, your broker must use $100,000 of his line of credit.

If you’re interested in reading the 2013 Triennial Central Bank Survey, published by the BIS, here is a link to it —

You might also want to read my summary of the Survey posted HERE.

The 2013 Survey is now 3 years out of date, but it’s the most recent Survey available. The BIS is currently (this month) surveying more than 50 central banks around the world, to gather the data for the 2016 Triennial Survey, which will be released in September.


Thanks Clint for such a clear and detailed explanation. :slight_smile: :slight_smile:

It is useful for traders to understand that much of the market volume is actually dealing in [I]exposures [/I]and not real [I]cash [/I]at all. If there [I]was [/I]an actual settlement then we would all need to open accounts in banks in each of the countries in whose currencies we trade and arrange actual transfers of funds for every trade that we implement.

One big benefit is that the two counterparties to each trade do not need to identify to each other and that total trades can be aggregated to derive net exposures. Opening and closing trades do not need to be with the same counterparties…But since much exposure is based on leverage, it is sometimes quite disturbing to ponder how much activity is actually based on non-existent “thin air” rather than actual bank balances!

Actually, I am not sure how brokers using ECN/STP settle their overall exposures to these systems or how credit lines are managed - have to read some more about these points!

Clint, you are a monster…

…of information…

Amazing stuff…

Thank you

[B]Manxx[/B] and [B]Francesco,[/B] thanks for the kind words, guys.

[B]Manxx,[/B] regarding transactions between retail brokers and banks — and whether they are leveraged or not — I’m trying to remember where I got the information that those transactions are all un-leveraged, and the only source I can remember is an article by Kathy Lien on the interbank market, which I read several years ago.

In that article (here’s a LINK), she mentioned (without elaborating) that transactions between Tier 1 banks on the EBS and Reuters platforms are un-leveraged. Based on that, I assumed that transactions between the Tier 1 banks and their major clients (including brokers) must also be un-leveraged. Maybe that was a false assumption on my part.

I have to admit that I haven’t spent time researching this subject. If you come up with information to the contrary, I will look forward to being corrected.


I will certainly do that and thanks for the additional info, Clint.

Whether leveraged or not, the brokers surely do not actually settle the deals in cash, I guess they just have a similar margin requirement as we do but with different terms, maybe even 1:1.

I trade through an ECN broker and I am still the broker’s risk, and I guess the broker is the ECN’s risk. In the same way that my trade is closed via my broker, regardless of who the opening and closing counterparties were at the time, I guess the broker does the same and the ECN manages an overall exposure to the broker. I have never really thought through the whole process from the broker’s point of view before…have to invite Jason Rogers here! :).

But the thought that the whole retail trading thing is really totally “phantom” money only backed up by margin deposits is really quite daunting! Naturally, the futures/options markets are the same thing in principle.

Seems the more I try and understand the other side of the brokers’ world, i.e. the broker/interbank interface the more intriguing and interesting it becomes!

I am not yet totally sure of this but it appears that it goes something like this (excluding where brokers keep positions in their own book):

  1. A broker has to have liquidity i.e. one or more counterparties with whom he (a) gets a price feed and (b) can pass on his retail clients risk. This he must do electronically via e.g. STP or ECN. So he needs to negotiate an agreement with one or more liquidity providers in the interbank market.

  2. I am assuming here (I haven’t confirmed it anywhere yet) that the broker negotiates a credit line exposure with a number of interbank participants who grant him both access to price feed and a limit on how much (net) exposure the broker can have outstanding with each counterparty. I would imagine that the counterparty would set both an intraday and an “overnight” credit limit for the broker. The broker’s exposure would be for the full nominal amount and not a leveraged sum.

  3. Whereas the retail trader has to place a sum with the broker to cover their margin requirements, I doubt that brokers have to do the same with their interbank parties. Their credit limits are simply based on an analysis of the creditworthiness of the broker.

  4. Whereas the retail trader places “exposure” on a leveraged basis, I think that the broker’s exposure is for the total sum. I.e. if I buy 10 standard lots of USD base currency pair I only have to give my broker the required margin dependent on the leverage applied, but the broker actually has to cover my position with a purchase of 1 mill USD from the liquidity provider against his credit line limit.

  5. However, I don’t think the broker actually completes any kind of cash trade requiring any account transfers and settlement, rather it is like a “loan” against his credit line of 1mill USD. This “loan” is a bit like a bank current account that continually fluctuates as retail customers buy and sell and their trades are fed through to the counterparties.

  6. Since the broker can only pass trades through to the counterparty making the price offered then I guess the broker must end up with a mixture of plus/minus exposures to all their various counterparties. Therefore I suppose there must be some kind of aggregating of positions like with the clearing services of domestic banks whereby the broker’s various exposures are netted out within the electronic system.

  7. Even though the broker passes all its trades through to its counterparties this does not mean it operates risk [U]free[/U], rather it is risk [U]neutral[/U]. By this I mean that the net gain/loss on the broker’s exposure to the interbank counterparties is matched by the net credits/debits on their customer margin accounts. So provided the retail customers’ always have sufficient margin in their accounts the broker is always able to meet its liabilities to its counterparties. This is not risk-free this is mirrored risk: interbank=>broker=>retail.

  8. A problem occurs (I assume) when markets suffer unexpected huge moves resulting in retail traders being mainly buyers or sellers and therefore accumulating exposures that approach the limits that the broker has with its counterparties. If limits are not raised then the broker’s price feeds will surely cease in one direction and the broker will only be able to take trades that reduce his counterparty exposure. What does a broker then do?

  9. Another problem occurs when markets jump by extreme amounts such as the CHF de-linking and customer account balances do not cover the losses and there is no market for the broker to close client positions immediately margin is exhausted.

  10. I still do not understand how the broker’s exposure is controlled. There is clearly no cash settlements as with spot forex deals and the exposure is like an ever-changing “loan” account with a maximum “overdraft”. But are these exposures marked-to-market daily on the net outstanding position and require a credit/debit of the net gain/loss, or are they settled “real-time” in parallel with the retail traders’ total positions?

Any thoughts or knowledge on these issues? This does not directly affect our dealings with our brokers but it is useful to understand the business from their side as well, I think?

This site seems to have some interesting information:

liquidity management - a game changer in fx brokerage - FX Brokers Handbook

they go broke, like in the CHF movement due to unbounding it from the euro. a lot of small broker got broke on that move. thats why its so important to have a broker with reputaton which is based in a country with strong regulatory meassures and avoid offshore brokers.

to the rest: great post Manxx

one thing i might can add from experience is that the brokers which are dealing with retailtraders in 99,9% cases have no direct contact with the interbank market,there is still another “middle-broker” involved.

heres a nice forbes article about insolvent brokers in the SNB problem:
Forbes Welcome

and if your broker is in a unregulated country without minimum protection your money is gone. if it is in lets say europe then at least €20000 is beeing covered by law and government (sux if you had 2 million you still only get 20.000 :wink: )

That’s an interesting read! These points were especially relevant to this topic:
"The general assumption was and has been for some time that these individual investors are going to, over time, lose their money. This, added to one other factor, ramps up the dangers. That other factor being that the brokers are (at 100:1 leverage) charging only a 1% deposit. But if they want to aggregate some of their exposure and lay it off out into the general market then they’re likely to have to pay a 3% deposit themselves…On the normal day to day basis that’s just fine. Prices move a few basis points, some win, some lose, the broker keeps his fees and gradually makes money as the investors lose theirs in aggregate.

But watch what happens when prices move 30% almost instantaneously. Those 1% stop losses can’t in fact be brought into play because there’s no market at all at those intermediate prices. We’ve had a leap from one price to another, not a move through the intermediate ones. And all of those on the wrong side of the CHF/EUR are 3,000 basis points out of the money while they only had 100 basis points on deposit. But the winners will be expecting their nice fat 3,000 basis points payouts and who has to come up with that? The currency broking platform in the middle."[/I]

There is a lot of criticism about brokers, and in many cases rightly so, but their business is not easy and a reputable broker is doing an amazing job in creating market access for retail investors/speculators. It is very much our own responsibility to reciprocate and learn the professionalism required to “behave” in these markets and try to prove this quote as unjustified:

[I]“a part of the market where individual investors really have very little business trying to play”[/I]

Unfortunately, though, I feel a very strong tendency to agree with it…

I suppose this is the crux.

In the CHF debacle it was possible to get an insight, I know of one large ‘broker’, fully regulated, who remained unscathed - but at what price?

They were a success because what they did was simple, they went after all negative retail balances, then they re-visited all plus balances.

Didn’t happen to me because I was just lucky to exit a chf trade before it happened, but I got the email nonetheless telling me that my account was going to be visited and be aware that the balance thereon may be subject to adjustment.

Likely they too were lucky in that their computer had hedged, or that human input had seen the risk.

Win win for this broker, all completely legal and according to their t&c’s.

Btw, [B]NOT[/B] fxcm.

now lets take a side for a moment that the author of this quote is just a journalist who has no clue about economics and no clue about stocks/forex/trading i still must agree to his sentence.

I made half a dozen posts telling newbies that forex is a zero sum game with no underlaying value and that in fact noone can sustainily and consistently make profits out of a zero sum game except the people who are selling the “dust and air” (brokers, market makers).

theres no need for me to repeat myself over and over again as i truly understand that im talking against a whole industry that is living from the “hopes” of people, just like casinos, and who am I to destroy peoples hopes?

i must agree to the sentence of the journalist simply because: people tend to overcomplicate things and people who are not too much in touch with the subjec/object always see something that people who are too close dont see.

put very easily this is how people act:

forex is a zero-sum-game it has no underlaying value, no “surplusses” generated anywhere, only money burnt and spent on spreads and commissions.

then you got a hundret people saying:

but if i do this…
but if i do this…
but if i behave like this…
but if i learn this…

a hundret reasons why its not a “zero-sum-game”…

but the truth is math doesnt lie, math is universal and always right. you cant talk 2 times 2 to be equal 5 no matter how much and how good you talk.

in the end it looks like this:

forex creates no value to any investor (besides some forms of investments that are not available to retail traders).

when you trade forex you pay commisions and fees of lets say sum it up to 2%

in the end you pay 2% to get 0% on your investment.

the only thing that can pay you off is fluctuations in the value (i know very obvious) which you aswell can categorize as gambling - the house is always in 2% advantage.

now just as a comparison take stocks, where the average commissions and fees come to less then 0,5% and on the other hand you have a stock that pays in average (dow jones stocks) 3% dividend. take away the fluctuations in worth (speculating) you are always 2,5% (first year, then every new year you hold onto it 3%) in plus. the investor is in plus, not the market, in forex the market is always in plus.

ah whatever, skip what i said, i dont make much sense i know and this isnt the topic here anyways

very good answers to my questions, tnx guys