Understanding the Over the Counter Trading or OTC in Forex Market
Most of us trading in the forex market know that transactions happen over the counter, but generally we are so engrossed in getting our individual trade right that we have very little patience to understand the mechanics of the market and how trade happens in the Over the Counter format. You might be feeling how does it matter as long as my profits are in place?
Well, I would say that overlooking the inherent structure of any market might eat into your profits too. The structure of the forex market is a crucial element that can help you design your trading day and help you strategize better. The way in which the currency pairs are traded in the forex market is the most important element that goes on to make the basics of the currency market globally. This is crucial as it has a direct bearing on the participants who get into this trade, the regulations governing them as well as the overall size of the forex market.
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What Is Over The Counter Trading?
Well, let’s begin with a simpler analogy. I am sure all of you understand what over the counter drugs are. You can simply walk to the drug store, ask for these OTC medicines without any specific prescription or medical history. The same theory applies here.
Trading in the forex market is not channelized via any centralized exchange like you have in equity trade. All the different types of forex products that traders or investors trade in is always via market medium or a market maker. This is commonly a bank or a forex brokerage firm that helps in facilitating your desired trade and help you in buying and selling specific quotes from customers and taking orders from them.
Unlike an exchange traded transaction, where the exchange is the trading counter-party, the brokerage firm or the bank that is enabling the trade becomes the counter-party. As the market place is not regulated strictly by any single governing body, prices are market determined, and there is generally heavy competition and prices keep varying as per the market forces. There is no standardized pricing, and the demand and supply dynamics keep on interfering with the live prices. Execution too varies as per demand.
So the key feature of OTC in forex market includes:
- Absence of any centralized exchange system to regulate trade
- No standardized pricing system and prices dependant on market dynamics
- State of art networking to connect traders globally and enable long and short distance transaction through the simple click of the mouse
- Presence of an inter-bank market, essentially the tie up between banks that is a key catalyst for forex trade. The inter-bank market is crucial as it brings forth the essential liquidity and efficiency in these over the counter trades.
How Is The Forex OTC Trade Different From Stock Market?
Well, this might be the first question that comes to your mind that while the stock markets function equally efficiently, they have set exchanges for conducting trade, be it the NYSE or the Nasdaq. So how is this OTC trade different and why do you need such a decentralized system for the forex market?
For that first and foremost, we must understand the dynamics of the forex market. It is a global forum providing trading platform to traders across the world in one go. Needless to mention then that the volumes and the liquidity levels in the forex market are huge compared to any equity market. The daily turnover of the forex market exceeds $3 trillion. Now compare this to the combined volume of equity markets across the world. That still is pegged around a miniscule part of this amount at $30 billion.
Thus, the essential construct of this market ensures that a more free flowing system with higher degree of efficiency is required. This is where the OTC trading concept comes to play. As trade is global, regulations of any specific country or any centralized authority does not dictate the dynamics of trade.
Unlike equity market, transaction cost is lower as this system has also alleviated the need for any fees for exchange and clearing. Trade as I mentioned is solely by the electronic medium hence the efficiencies are way higher despite a significantly lower cost. Another advantage of the forex market over stocks is the direct dealing between traders and the market makers like the banks. There is absolutely no need for any middle man.
Trade is also not time bound by any geographical or other limitation. The OTC spot forex market is a 24-hour trading profit nearing machine. Traders can access the market anytime they want and tweak their trades in accordance to developing economic and geopolitical changes globally. Not just that you can execute your trade from the comfort of your bedroom. Everything is via the electronic medium and a strong global trading network.
So unlike a stock market trader, you do not have to give up everything to trade in the forex market. One can easily maintain their day jobs/college/classes or any other unavoidable engagement and then trade during your leisure time in the evening, at night or in transit. You can even double up as a stock market as well as a forex market player. In your free time or in between breaks from the stock markets, you could easily dabble in the Over The Counter forex market.
Speed is another hallmark of the Over The Counter Trade. While order submissions and order executions could be time-consuming, the OTC trade in forex market ensures that all transactions are quick, easy to execute and instantly applicable. Depending on the market condition you can exit and enter at will.
Products Used In OTC Forex Trade
Some of the key products used for trading via Over The Counter transaction in the forex market include:
- Spot forex
- Forwards trade
- Forex Options
- Forex Swaps
There can be various other permutation and combinations of these while the actual trade is executed but essentially these constitute the primary ingredients of the OTC forex market broth.
The Main Players in OTC Forex Market
Well, after the products, it is about the players. Right at the top we have the top money dealers including,
- Leading foreign exchange dealers
- All the major global banks like Goldman Sachs, HSBC, JPMOrgan and the like. Almost 60-70% of the daily forex market trade is handled by these banks through the complex inter-bank market. These banks are instrumental in setting the currency rates, managing demand-supply dynamics and overall trading volume.
The next sub-group of the leading forex market players using the OTC channel includes both financial as well as retail participants. Even hedge funds, pension funds, MFs and other high networth investors have a significant stake in the final OTC forex market pie. The forex market brokers complete this circle and form an essential link with the retail users, the liquidity providers and also act as the intermediary buyers/sellers.
To draw to a close, the OTC forex market is expanding by leap sand bounds. Industry experts peg the growth at exponential rate encouraged by recent studies that indicated that nearly 85% of US investors preferred the OTC format of trading and transaction. The efficiency and the free flowing structure is what attract maximum traders to it. Must mention that ease of use is another big thumbs up.