Foreign Exchange Market Structure

The over-the-counter structure

Currencies are traded over the counter, meaning that transactions occur directly between participants rather than through a central exchange with a single order book. The participants are commercial and investment banks, central banks, corporations, fund managers and brokers. Because there is no central order book, there is no official closing price and no single authoritative quote; the price displayed by any provider is that provider's view of the market at that moment, and small differences between providers are normal.

A further consequence is that true traded volume is not observable. The volume figure displayed on a MetaTrader 5 currency chart is tick volume, which counts the number of price changes in a period rather than the quantity of currency exchanged. Tick volume is a useful proxy for activity, since periods of heavy trading generate frequent price changes, but it should not be interpreted as an exact measure of participation.

The four trading sessions

Trading activity follows the business hours of the major financial centres, producing four sessions that overlap in sequence. The Sydney session opens the trading week and is characterised by thin liquidity. The Tokyo session brings the yen and Asian crosses into greater activity. The London session is the deepest single session, with the widest participation and the largest share of daily turnover. The New York session overlaps London for several hours and introduces the principal United States economic releases.

The overlap between the London and New York sessions is the period in which the majority of daily volume is transacted. It is also the period in which spreads are typically tightest and in which the largest directional moves of the day most frequently occur. Outside this window, and particularly in the interval between the New York close and the Tokyo open, liquidity is thin and spreads are wider.

• Sydney: opens the week; thin liquidity.
• Tokyo: yen and Asian crosses most active.
• London: deepest liquidity and widest participation.
• New York: United States data; overlaps London for several hours.

Classification of currency pairs

Currency pairs are conventionally grouped into three categories. The majors, which include EUR/USD, GBP/USD, USD/JPY, USD/CHF, AUD/USD, USD/CAD and NZD/USD, each involve the United States dollar and are the most liquid instruments in the market, with the tightest spreads and comparatively orderly price behaviour. The minors, or crosses, are pairs of major currencies that exclude the dollar, such as EUR/GBP and EUR/JPY; they are liquid but less so than the majors.

Exotic pairs combine a major currency with the currency of a smaller or emerging economy. Their spreads can be many multiples of those on the majors, and a modest order can move the price by an amount that would be exceptional in a major pair. A trader in the early stages of development should confine activity to the majors until execution and risk management are routine, since the lower transaction cost alone makes the learning process considerably less expensive.

Timing of trading activity

A strategy behaves differently at different hours because the liquidity, spread and participation that produced its test results are properties of a particular session. A strategy tested on the London session and applied during the thin hours of the early Asian session is operating in a different market. The results should not be expected to correspond, and a trader who observes a deterioration in performance should first confirm that the strategy is being applied during the hours for which it was validated.

Where the trader's available hours do not coincide with the active period of the chosen market, two remedies exist: to adjust the schedule so that the active period is observed, or to select a market that is active during the available hours. The trading hours page on the Onys Kapital website lists the sessions and the trading hours of each instrument, and the economic calendar identifies the scheduled releases that affect liquidity within a session.

Implications for spread and cost

The variation in liquidity across the day has a direct effect on the cost of trading. The spread on a major pair during the London and New York overlap is typically at or near the minimum quoted for the account type, whereas the same pair during the late New York or early Sydney session may carry a spread several times wider. A strategy that is marginally profitable at the minimum spread may be unprofitable at the wider one, so the timing of a trade is a component of its cost.

Overnight financing is a further timing consideration. A position held past the daily rollover incurs a financing charge or credit, and a three-day adjustment is applied once a week to account for the weekend. A trader whose positions are opened late in the New York session and held into the next day should include this cost in the assessment of the trade.