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The role of smart money in the Forex Market
The smart money acts as a MARKET MAKER for the herd. In other words: The smart money is the counterpart of the overhang of long or short positions hold by the herd. If the herd is net short then the smart money is net long. If the herd is net long then the smart money is net short. This creates a conflict of interest between the smart money and the herd. And because of its overwhelming power the smart money will always win!
To explain how the smart money operates I will use the forex market as an example. In the forex market the smart money are the mega banks. The mega banks are the 8 biggest banks are responsible for over 70% of the daily volume in the forex market. They're the driving forces that dominate the herd.
The Interbank Market
After World War II the Bretton Woods Agreement tied the exchange rate of each currency to gold. Because the economies of different countries started to grow with different speed this agreement was abolished in 1971. The new valuation system determines the exchange rates based on supply and demand which is still used today.
In the 1990s with the growth of the internet the major banks and some smaller banks started developing the interbank market. The participants of the interbank market can trade electronically with each other. The biggest participants at the interbank market are Citgroup, Deutsche Bank, Barclays, UBS, Bank of America, HSBC, BNP Paribas and Goldman Sachs.
The participants of the interbank market are using two trading networks:
- Electronic Brokering Services (EBS)
- Reuters Dealing 3000-Spot Matching
The major purpose of the interbank market is to provide a BID and ASK price for each currency at any time at which the currency can be sold or bought.
This is a very important point:
The major banks are acting as MARKET MAKERS. In last instance the banks have to quote a price for each currency even in the case if no one else wants to buy or sell a currency.
We will now see why this is a very important point.
In addition to the members of the interbank market of course there exist other market participants too. They are small to medium sized banks, hedge funds, insurance companies, pension funds, large commercial companies, speculators, retail forex brokers, retail traders etc. They are doing their trading activitities mainly outside of the interbank market. Those market participants are using trading networks like Currenex, HotspotFXi, Integral, FXall and LavaFX. These "outer" networks are trading around the price quotes of the interbank market, usually at slightly worse prices than on the interbank market. Those participants are the so called "herd".
Absorbing the imbalance of the Herd
I mentioned above the herd trades on the outer trading networks (e.g. Currenex). As in every market there are always buyers and sellers. The outer networks try to match all buy orders of the herd with all sell orders of the herd. But this is most of the time NOT the case! Most of the time there is an imbalance between the amount of buy and the amount of sell orders on the outer networks. But as in every financial market each order needs a counterparty to get executed. To solve this problem the interbank market is used:
If there is an imbalance on the outer networks then the outer networks must buy or sell the difference (between buy and sell orders) on the interbank market to get into balance.
As mentioned above the major banks, in last instance, must provide a quote for each currency. Therefore the interbank market acts as a liquidity provider for the herd! The interbank market must take the counterpart of the imbalance of the herd. It's the job of the interbank market as a market maker. Please remember that the 8 biggest banks are responsible for over 70% of the daily volume in the forex market.
If the herd is net long then the interbank market is net short. The colors in following graphic are showing this:
If the herd is net short then the interbank market is net long, as shown in following graphic:
But when does the herd get into imbalance (net short or net long)? This will get clear in the next article :-)