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 being held 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 that are responsible for over 70% of the daily volume in the forex market. They are 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. This agreement was abolished in 1971 because the economies of different countries started to grow at different rates. The new valuation system that determines the exchange rates is based on supply and demand, which is still being 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 in the interbank market are Citigroup, 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 the last instance, the banks have to quote a price for each currency even if no one else wants to buy or sell a currency.
Next, we shall explore 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 carry out their trading activities mainly outside of the interbank market.
These 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. These participants make up 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.
However, often times this is 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 the 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 be 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, as depicted by the colors in the following diagram:
If the herd is net short then the interbank market is net long:
But when does the herd get into imbalance (net short or net long)? This will become clear in the next article. :-)