Where Do Forex Rates Come from?

Stocks are traded on a centralized exchange which facilitates a transparent price discovery mechanism. When stock traders across the globe feed their bid and ask prices, the bid prices are listed in the descending order and the ask prices are listed in an ascending order in the order board. A trade gets executed when the bid and ask prices match each other. That leads to the discovery of the price of a stock. However, a beginner Forex trader would wonder where does the exchange rate of a currency pair come from, as the currency market is a decentralized over-the-counter market. This guide will walk you through the origin of price feed offered by a Forex broker.

Interbank Market and Participants

The spot market, forward market, and SWIFT (Society for Worldwide Interbank Telecommunication) together make up the interbank market. Investment and commercial banks, hedge funds, big trading companies, and central banks make up the market participants. The aforesaid institutions would have a variety of needs to buy, sell, or exchange their currencies. Commercial banks, in particular, may have a need to buy, sell, or convert billions of dollars worth currencies every day. These institutions can trade directly with each other. However, for the sake of convenience, transparency, and realization of best exchange rates, trades are usually done through interbank Forex trading platforms such as the Electronic Broking Services (EBS), Bloomberg Terminal, and Eikon (Thomson Reuters). These three platforms connect thousands of banks.

An interbank dealer will never reveal whether he is interested in buying or selling a currency. At any given point of time, two prices, one each to buy and sell a currency is fed into the network through the electronic trading platform.

Major Currency Pair Example

For example, a major bank would be interested in buying 3 billion US dollars worth of euro. They will feed a bid price and an ask price. The bid and ask rate will have a small spread that would cover all the likely charges (order costs, volume, inventory costs, competition, and currency risk) inherited by the bank. Now, let us consider that the bank’s dealer quotes 1.14203 and 1.14208 as bid and ask rate, respectively. Likewise, let us assume that two more dealers representing other banks send out a two-way quote for the EUR/USD pair as follows.

  Bid Ask Volume (in $)
Bank I 1.14203 1.14208 3 billion
Bank II 1.14205 1.14210 1 billion
Bank III 1.14207 1.14212 4 billion

The banks I, II, and III are referred to as liquidity providers. Forex brokers will maintain clearing accounts with liquidity providers. Multiple clearing accounts of a Forex broker are connected to the respective liquidity providers through aggregation software. The software performs liquidity aggregation and offers it in a single view. Additionally, the orders from the clients of a Forex broker and multiple liquidity providers are combined to arrive at the best spread. The aggregator ensures that a client receives the best bid or offer price available at any point in time.

Thus, from the column provided above, an aggregator would select 1.14207 and 1.14208 as the bid and ask price, respectively. Now, to negate broker’s risk, the software will also add a small margin (spread) over the bid and ask rate. The spread can be modified by the broker as necessary. If the broker’s spread markup is 1 pip, then the final bid and ask quote shown to the retail trader would be 1.14202 and 1.14213 respectively. From the above table, it can be understood that as much as $4 billion worth of transactions can be executed at the bid rate and $3 billion worth of transactions can be executed at the ask rate. However, a Forex broker would achieve a better price when the volume gets split by the aggregator and sent to different liquidity providers.

Minor Currency Pair Example

In the case of currency pairs with lower trading volumes, the aggregator will split the volume across multiple liquidity providers. Additionally, the average fill price will be higher. For example, let us consider that a retail trader is willing to open $3 million worth long position in the AUD/CAD pair. As discussed earlier, the quotes from three banks may look as follows:

  Bid Ask Volume (in $)
Bank I 0.9890 0.9895 1 million
Bank II 0.9892 0.9894 2 million
Bank III 0.9894 0.9896 1 million

If the broker’s spread markup is 3 pips for the AUD/CAD currency pair, then considering the highest bid of 0.9894 and the lowest ask of 0.9894, the aggregator would provide a quote of 0.98925 and 0.98955 to the trader. Once the trader places a buy order, the volume would be split into two parts, with $1 million worth order routed to Bank I and $2 million worth order routed to Bank II.

The smart order routing facility of the aggregator would ask for a quote from multiple liquidity providers if the order volume is too high. The aggregator can even split a $10 million order into five $2 million orders and request a quote from several banks. Once the quote arrives, it can work out the best price for the trader such that the broker would not face any risk. Even then, the order can be rejected using the last look facility on the liquidity provider's end. If the liquidity provider believes (as they will have an overall idea of the inflow of orders in the market through their highly advanced terminals) that they will not be able to hedge the risk, then the order would likely to get rejected and a requote would be given.

From the above discussion, it can be understood that the rates quoted by a Forex broker are primarily derived from the quotes provided by multiple liquidity providers. Thus, it is not uncommon to see a slight difference in quotes provided by different brokers. This is how Forex brokers receive and display rates for a client.