people are buying and selling, short-term speculators are indifferent as to therationale behind the moves because they know there is money to be made on bothsides of any trade. All that traders care about is maximizing their profits by posi-tioning themselves in advance of the next move, while academics often miss theforest for the trees by being so far removed from the trading floors of the world.2The Currency Market
 
Foreign exchange trading has essentially been around since the advent of money,and although the mechanics have advanced somewhat since the time of themoney-changers in the temple, it still boils down to the exchange of one currencyfor another.
Of all financial markets, the FX market can probably be considered to be amongthe most “pure” in the sense that supply and demand (in the free-floating currencies)is strictly what determines prices. For the most part, the market is unregulated andfree of distorting red tape, and the sheer size of the trading volume means thatgovernment intervention has little long-term effect on prices. After all, in a marketthat trades over $2 trillion a day government intervention can only go so far, andat the end of the day it is the two hundred thousand traders around the world thatact as Adam Smith’s invisible hand in guiding prices.
Since a market this free and liquid is typically hard to out-guess, you would beright to think: “is it even worth trading such an efficient market?” The good newsfor traders is that the FX market is not as efficient as it may first appear, and theroot of this inefficiency can be traced back to the participant’s motivation. The FXmarket has never been a value creator, but rather a vehicle for other transactions. AUS portfolio manager buying Japanese stocks or an Italian company acquiring rawmaterials from Brazil both inadvertently become FX participants, yet the currencypart of their transactions are not usually motivated by profit. The portfolio managersimply needs the yen to buy the stocks and the company needs dollars to buy thecoffee.
This type of behavior breeds inefficiencies eagerly exploited by more activemarket participants, and fortunately for FX traders small arbitrage opportunitiesstill abound. Although the market may be very efficient at giving you a price,whether that price is an accurate reflection of the currency’s true “value” is anotherstory altogether, which is why good analysis and trading techniques do pay off inthe long run.
Research and analysis in FX proves valuable because the currency market isdifferent than Wall Street. The interbank market is by no means a perfect market10 Beat the Forex Dealer
since information is not freely available, market access is restricted, manipulationtakes place, governments intervene, and a large number of participants routinelybuy and sell irrespective of profit, which all comes together to turn conventionaltrading wisdom (such as “let your winners run, cut losers short”) on its head in thismostly range-bound market. The FX market is different than other markets, andif you can find a way to recognize, predict, and exploit these imperfections, thenthere is a great deal of money to be made. Profitable trading strategies do exist andcan be found.
A SELECT CLUB
Off-balance sheet earnings are the declared aim of most banks, and spot dealing inFX, which presents high loss potential (as far as price is concerned) but practicallyno credit risk, falls directly into this category. To understand a bank’s motivationfor getting involved in this market, all you have to know is that by combining alarge FX dealing desk with a decent prop trading group, pretty soon you will betalking about billions in profits. These types of numbers have long made FX theplayground of only the biggest and baddest global banks, and because at its corethe FX market continues to be a credit market, their dominance is unlikely to bechallenged any time soon.
The Big Boys of FX
Out of the 6,322 institutions polled(totaling over $85 trillion in turnover),ten banks were responsible for morethan three quarters of all FX turnover.Marketshare. Deutsche Bank .. 19.26%UBS ....... Citigroup .Barclay's Capital .Ss eeemeereeennarsGoldman Sachs ..
   
Bank of America .. JPMorgan Chase10. Merrill Lynch ......
Source: Euromoney FX Poll. May 2006
OONDHRON
 
Unlike other markets, an FX transaction is not the exchange of cash for anotherasset (stocks or oil, for example), but rather the exchange of cash today in returnfor the acceptance of cash at a later date. The interbank market operates on thissomewhat unusual principle, where one party depends on the other to meet theirobligation without extending credit to each other. As you may well imagine, whenThe Currency Market 11
 
dealing in this way it is crucial to know that your counterparty is of the highestcredit standing, lest you be left holding the bag on one side of the transaction. Forthis reason, big banks prefer to deal with big banks, and smaller fish are essentiallyshut out of the FX pond. As a result, a small group of commercial and centralbanks (you can call it a cartel if you wish) has always handled the majority of FXturnover with each other, and for each other.
Technology has managed to open up this tight-knit group somewhat, althoughnot to the extent that you may think. Most banks now either operate their ownelectronic dealing platforms or provide liquidity to a matching system/prime bro-kerage platform. Products from EBS, Currenex, FXAIl, etc., enable banks to reacha larger client base while still maintaining full control over their risk, yet in theend, who do you think owns most of these platforms anyway? The reality is thatthe same small group of banks still controls the FX market.
AN UNFAIR PLAYING FIELD
From the very beginning, the FX market was designed to ensure that market “insid-ers” had a considerable edge over market “outsiders”. Because of the tight-knitnature of the market and its lack of regulation, the FX market is a fundamentallyunfair market for the nonprofessional to operate in. For example, in some emergingcountries a Citibank or UBS may be the only game in town, so anyone wanting totrade that currency is forced to “pay up” to play in their turf. A player’s positioningon the FX food chain depends on his/her access to information and speed, and withno central clearing exchange, it can be difficult for nonprofessionals to gain accessto this information and come up with an accurate view of the market. More oftenthan not, this leaves those with limited access to information at the mercy of theirbank dealer.
This is where the FX world differs from traditional financial markets, and thingsdeemed illegal in most other markets are simply regarded as “part of the game” inFX. Insider trading, front running, price shading, etc., are all regularly seen in FXtrading, and have absolutely no legal repercussions.
No government oversight and no central dealbook to compare trades meansthat banks are pretty much free to do whatever they want to their unsuspectingcustomers. Unlike exchange-traded markets (NYSE) where a market maker has aresponsibility to quote the same price to two different parties, an FX dealer mayquote his clients whatever price he wishes. Spreads mysteriously widen and shrink,and the “who’s who” factor dominates. Good customers receive decent prices(a salesman will shout to the dealer “good price, mate!”), but for irregular or com-plicated clients it becomes practically impossible to receive fair market prices. Godforbid that the dealer “read” you correctly and guessed your intentions (try callingup your dealer and ask him “I wish to buy, what’s the price on euro-dollar?”).An FX trader who did not want to get ripped off before had to place 5 to 1012 Beat the Forex Dealer
calls to different banks and take their average as the “fair” market price. Theseinefficiencies, of course, all play into the hands (and pockets) of the brokers.
Dealers are free to behave in this way because they are very often the only gamein town, and they know that there is not much customers can do about it. In thesame way that you and I knowingly get ripped off by the exchange booth guysat the airport, traders know they are getting short-changed but often have littlerecourse. If Goldman is the only one willing to take your trade at that moment,you can either take it or leave it; it is as simple as that.3A Rare Breed
 
Putting aside all arguments about efficient markets, traders are around for one thingand one thing only: to make money from their views on the market. Although theorystates that investors should not be capable of beating the market in the long run,people like Paul Tudor Jones! are happy to go against conventional wisdom byconsistently beating the market year after year. Either their success is merely theresult of a statistical fluke or great traders are simply a breed apart.
The mark of a great trader is their ability to walk the walk and talk the talk.While most people actually find that on paper they make great trading decisions,when real money becomes involved they soon lose the upper hand. That is becauseas soon you enter the market, you become emotionally attached to your positionand the switch from paper profits to real dollars and cents clouds your thinking byinserting doubt into your reasoning. Think about the past investment decisions youregret the most. They usually involve sound investments that you pulled the plugon too soon (I knew I should have held on to that property in Florida!) or neverentered into (I knew I should have bought the Google IPO!). Either way, the errorin judgment is frequently caused by the emotional rush brought on when switchingfrom percentages to greenbacks. This mental toughness is the reason great tradersare often referred to as having ice-water running through their veins or havingprivate parts made out of steel.
Trading is one of the few professions that enable you to quantify exactly howgood you are, since all it takes is a quick glance at your P/L. How does a consul-tant/engineer/manager know they are good at what they do? Usually it is througha combination of peer respect, promotions, and recognition that they use for mea-surement. And how do they know if they had a good or bad day? Traffic? Problems
'Part of the University of Virginia hedgies, started Tudor Investment in 1985. Never a down year, theworst performance was in 2000, when Tudor BVI Global Portfolio fund delivered 11.6%. Of note, hemanaged to time the October 1987 market crash and turn it into a 210% gain.14 Beat the Forex Dealer
 
with suppliers? Now imagine being able to look at your screen at the end of yourshift and let it tell you how your day was. For traders, the measuring stick issimple: money. The more you make, the better you are at your job. If you mademore than the guy to your right that must mean that you are better at your job thanhe is, and if you lost money today that means you had a bad day at work. Thisturns trading floors into pure meritocracies, and those that make money have thepower, while those that don’t are soon out the door.
Unlike investing, where the focus is on creating wealth (e.g. dividends), tradersmake money by catching short-term moves for quick gains. Trading, like poker,can be described as a zero-sum game. If you are winning then someone else mustbe losing. This battlefield aspect to the markets is something that the novice traderdisregards at his/her own peril, since humans sit behind those trading screens andyou can bet that they will do everything in their power to take your money, evenif that means bending the rules in their favor.
The fact that most traders are also avid gamblers should come as no surprise,and thus you may find at any one time that bets on sporting events or the eatingcapacity of the latest intern overshadow any market activity on the desk. Anotherinteresting quality about traders is that proficiency with numbers does not automat-ically translate into positive trading results, and over the years you find great mindslike Sir Isaac Newton losing fortunes in the market while atypical participants, suchas novelist Julius Verne, become great stock pickers. The ability to look beyondthe obvious facts and figures, to think of the market not only from an objectivestandpoint but also from a subjective view, is what sets great traders apart. Averagetraders look to the left-side of the chart, great traders look to the right.
THE TRADER’S EDGE
A trader’s edge is their ability to deal with uncertainty at minimum risk, which isexactly how the Rothschild family made their fortune in the 18th century. The ideawas simple yet brilliant: in a time of slow communications, courier pigeons couldbe used to transmit gold prices across the English Channel, giving you a day’shead start on the market and opening the door to arbitrage opportunities. Whenthe price was lower in Paris, they would purchase it there and sell it in London,keeping the difference. Their advantage was information, which was thoughtfullytransformed into profits.
Dealing with uncertainty can also mean being pro-active and forcing your oppo-nent’s hand. When asked about his playing, Ed Lasker, one of the greatest chessplayers of all time, noted that in order to succeed he would ask himself, “What ismy opponent’s present state of mind, and how can I worry him the most?” Simi-larly, the very best traders have the innate ability to look at the market objectivelywhile at the same time perceiving it from the eyes of their opponents. What movedo they fear the most? What will they do if prices go down? Lasker explained thathe “sometimes achieved victory by boring my opponents to death, or by luringA Rare Breed 15
 
them into attacks when attacks weren’t in their nature”. Successful traders applythese same concepts on a day-to-day basis, and use this edge to actively shape theirfuture by playing to their opponent’s weaknesses.
Market participants (and pawn shops) know that it is much easier to rip-offsomeone in trouble than to make money through your own trading skills, so overthe years they have evolved into efficient killing machines that would make Darwinproud. If the market catches a wisp of a hedge fund in trouble, you can be sure
 
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How to lose $6 billion in two months.
1. Anticipating higher natural gas prices, hedge fund Amaranth places huge betsthrough bullish spread plays.
2. At this point, the big bets are actually deep in the black and the fund begins to cashin on some of their positions. The sudden flood of supply gets the market’s attention,and the NYMEX boys soon realize that Amaranth is sitting on a huge long position.Liquidity dries up and the market begins to turn as the fund desperately tries to getout of their trade.
3. The selling soon snowballs into a rout and natural gas prices fall 50 % in two months.Fundamentals are pushed aside as traders move in for an easy play, and word of thefund’s trouble begins to leak out to the public.
4. By late September Amaranth is wiped out. The friendly financial community gladlyoffers to “bail them out” by buying their positions at heavily discounted prices. Notsurprisingly, once the bloodbath is over the market returns to normal trading andthe sweethearts that bailed them out cash in their positions for great gains.16 Beat the Forex Dealer
 
that the sharks will move in and actively push the market against them until theyare dead in the water. This active “hunting” role is something that most modeldevelopers do not take into account, and to a large degree it can be said that their“sigma-nine”? events are often self-perpetuated. If Amaranth had not gone balls-outlong on natural gas, for example, the market would probably not have dropped likeit did.
FOREX TRADERS
Foreign exchange speculators are often regarded by developing nations as “eco-nomic war criminals” who prey on the weak and defenseless, yet ask FX tradersand they will tell you that they are simply the instruments of global macroeco-nomic forces. As George Soros famously proclaimed, “As a market participant, Idon’t need to be concerned with the consequences of my [financial] actions.” Inother words, he did not create the imbalance, so why should he be blamed whenhe corrects it?
Forex traders are a unique brand of speculator with an almost monastic devotionto their profession, working obscene hours and concerning themselves with globalmacro events. What effect will the Tokyo earthquake have on the Swiss franc?How will the US dollar react to inflationary signs coming out of Germany? Tryexplaining how you make a living to a stranger (or your spouse) and they willlook at you as if you are crazy. The ability to select, process, and take advantageof seemingly unrelated and unending data points in the blink of an eye is whatsets currency traders apart. Through the eyes of a forex trader every asset trade isessentially a bet on exchange rates, and those that learn to connect the dots fasterthan anyone else end up on top.
The world’s economies are now one giant interconnected machine, and the greasethat keeps the gears running smoothly is foreign exchange. Legendary FX tradershave made their careers by figuring out, before anyone else, what repercussionsevent X will have on country Y’s currency. This clairvoyance often instills a levelof self-confidence that would humble professional athletes, and when combinedwith the tremendous amounts of leverage available to traders it often leads to sometruly mind-boggling bets.
In 1988, for example, when Bankers Trust hotshot Andrew Krieger was askedabout his short Kiwi position he famously replied, “How large is the monetarysupply of New Zealand?” Believe it or not, through the use of derivatives Kriegermanaged at one point to actually short more than New Zealand’s entire monetarysupply! Although this gutsy bet ended up netting him a cool $300 million, whenself-confidence turns into arrogance the effects can be devastating.
?Nine standard deviations away from the mean, or basically a statistically impossible event.A Rare Breed 7
Why is it a bad idea to give your startrader the keys to the backoffice?
The trading world is filled with stories of one-man demolition crews often
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Yasui Hamanaka. The Sumitomo Corp. trader's positions were so huge,that he earned the nickname "Mr. 5%" for allegedly controlling five percentof the world's copper market. Unfortunately for Sumitomo, his 10 yearcareer was mostly filled with bogus contracts and fictitious entries meant
to hide his mounting losses. By the time he was discovered, he had rackedup $2.6 billion in losses which he paid for by doing eight years in jail.
Nick Leeson. Star trader for Barings Bank, his derivative losses hidden inhis secret 88888 account ended up costing the "Queen's Bank" $1.2 billionand managed to bring down one of the world's most venerable bankinginstitutions overnight.
John Rusnak. Allied Irish Bank's chief rogue trader. His out-of-control fxtrades ended up costing the bank a cool $691 million.
Peter Young. Morgan Grenfell's star trader is not best remembered for hisunauthorized trades (a mere $350m), but the fact that he showed up tocourt wearing women's clothes in an attempt to plead insanity. Seems likeYoung got the last laugh since the court declared him unfit for trial!4FX Dealers
 
To understand how dealers trade, you simply have to understand how dealers think(i.e. make money). If the big banks are the FX wholesalers, then dealers are thesalesmen trusted to push their inventory. Like the used car salesman who wantsto clear his lot, FX dealers are looking to move as much inventory as possible(“chopping wood” in dealer speak) and regularly adjust their profit margins hereand there in order to accomplish this. It may be worth accommodating a transactionfor a customer at a slightly lower commission (or loss) if it means locking upbusiness from that client in the future.
Because of the wheeling-and-dealing style of their work, dealers have historicallybeen more associated with the streets of Brooklyn than any Ivy League school, andthey are renowned for being quick on their feet and excelling at order-flow trading;they are the definition of the intra-day trader.
ALWAYS BE FADING
A dealer’s motto. Market moves are rarely one-way and dealers understand thatthe majority of the time intra-day markets are range-bound (around 80%), so anysharp move (gap) is likely to be faded by dealers who have the deep pockets andknowledge that the price will eventually come back to them...at least most of thetime!
Another favorite trading rule of the spot dealer is to never trust the first price.After a news release, dealers know that the first price print is the knee-jerk reactionof the market and most often wrong, so dealers routinely use news events to flushout any weak positions by moving the market against them. This is commonlyknown as the “head fake,” whereby the price moves sharply in one direction beforereversing course, catching many traders off-guard in the process.20 Beat the Forex Dealer
 
 
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Dealers always fade the first move; hence the saying “never trust the first price.”
CAN DEALERS LOSE MONEY?
Yes. A dealer’s biggest nightmare is a runaway market, where they are forcedto either stop quoting prices (and risk losing customers) or continue taking theother side of the trade and risk being stuck with a losing position. Prices canat times run away from a dealer so quickly that they are unable to offset theirexposure, and leaves the stressed-out dealer with positions deep underwater. Manyrisk-hungry dealers that continued to quote prices during the USDJPY crash of1998, for example, were wiped out. In general, any one-way market is bad fordealers, since prices do not retrace and they are forced to eventually unload theirpositions at a loss. However, from a dealer’s perspective, this is simply seen as the“cost of doing business.”
TRADERS VERSUS DEALERS
Like two heavyweights in the ring, traders and dealers regularly duke it out in themarkets, with speculators complaining about dealers committing “highway robbery”FX Dealers 21
through their quotes and fills, and dealers complaining about traders “picking themoff” in arbitrage opportunities. Both have valid points in this love-hate relationship(actually mostly hate), but in the end one cannot do without the other. As in anybusiness, good market contacts and relationships are fundamental to success in themarket, and a trader may put up with a dealer’s shoddy quotes if he knows he cancount on him to take a large CADJPY order on a Friday afternoon, for example.You can have the best ideas in the world, but if you cannot find a counterparty totake your trade then you are going to be stuck with just that: an idea.
Of course, having a good relationship does not mean you are not willing to takethe other party’s money. Every time a trader picks up the phone to deal, he knowsthat the person on the other end of the line is going to try to rip him off, but smarttraders also routinely play tricks on their brokers. A favorite FX trick was to leavesmall stops with dealers all over the city and wait for them to take the bait beforeentering the market with your real move in the form of massive orders that wouldcatch dealers wrong-footed and looking silly. Similarly, dealers often know theposition of their client directly (through the margin deposit) or indirectly (throughindustry contacts) and actively push the market against them. The street is litteredwith stories of one party pulling the wool over the eyes of the other in what seemslike an endless game of cat and mouse.
NOT ALL #4 DEALERS ARE CREATED Trle SAME
 
Forward/Swap Dealers: The most cerebral of the bunch. More concernedwith time than price, these guys have to constantly keep track of value datesand expirations. Calculations can turn complicated in a hurry when clientsapproach them with obscure set-ups for which they must either quote a priceor risk losing a client.
Spot Dealers: Fly-by-the-seat-of-your-pants crowd. Rely more on their gutthan their head. Can instantly calculate averages and are above all concernedwith their net exposure at any given time. Generally more street-smart thanbook-smart, they are very attuned to human behavior and trade according toflows. If they smell blood they pounce.
Retail Spot Dealers: Usually ex-bank dealers that were “retired” or decidedto move on to a cushier gig. They occupy an awkward place between theinterbank and the retail market, with most transactions being generallystraight-forward. Cushy job that entails little more than tracking customer flowsand offsetting risk with their market makers. Now and then they organizeambushes on their clients, something they revel in. To put it in perspective,the head dealer at one of the major retail FCMs used to show up to workwearing a cap that read "FUCK YOU."
Pretty much sums it up doesn't it?5Today’s FX Market
 
The enormous technological advances that we have seen over the last 20 yearshave had a profound impact on how the FX market operates. Everything frombackoffice systems to trading has been affected by the changes, generally makingthings faster, more accurate, and more reliable. Bank dealers are now less likelyto find “surprises” at the end of the day, having second-by-second access to theirexposure. Technology has also enabled a new breed of competition to arise for theold-school voice brokers, namely electronic platforms like Reuters, FXAIl, EBS,Currenex, etc.
Whereas before a trader was forced to make the rounds in an effort to find aprice, he can now instantly see the best tradable bid/ask with a single key stroke.With all of the liquidity providers now imputing their best price into a commonplatform, it should in theory be a much better way of going about things, andfor the most part it is. However, don’t feel too sorry for the dealer, for there willalways be a place for his trade. Although electronic platforms are great for “vanilla”transactions, if you are a fund trying to push through a large Mexican peso tradein early Sydney time, your only hope for success is contacting a good dealer thatcan make it happen. No e-platform will ever make a market out of thin air.
A QUESTION OF NUMBERS
Technological advances have helped drive the growth in FX turnover, and althoughmuch is said of the tremendous volumes traded on a daily basis, the oft-quotedstatistics should be taken with a grain of salt. The FX market is by far the largestand most liquid market in the world, with daily FX turnover estimated at around$2 trillion. If this seems like a lot to you, it is because it is. Compare FX volumesto the tiny $50 billion traded at the NYSE or the $800 billion traded in governmentdebt and you get an idea of the size of the market, yet the first thing to take intoconsideration when hearing that “FX turnover has increased 50% over the last3 years” is that turnover is measured in US dollars. A depreciating dollar will24 Beat the Forex Dealer
directly translate into ballooning turnover volume.! However, even if the figuresare somewhat skewed, the fact remains that billions and billions are being tradedevery day. So the question becomes, “Who is trading all of these thousands ofbillions of dollars?”
Today's FX MarketHow much are they trading? Who is trading?Total FX Turnover a Total FX Turnover$3,500b by Counterparty
$32 titlon
3000]
 
250020001500]1000]500" —Tuez 1005 19982007 004 ol
2 Interbank — Other Financial Non-Financial
(hedge funds) (corporates)
What products are they trading? What pairs are they trading?
FX Turnover by Transaction Type FX Turnover by Currency Pair
3000Wa
    
2500
2000
1500“ORWARDS,7 a|
500 +
°
2007 2004 2001
 
International commerce may at first seem like the obvious answer, yet withthe global economy estimated at 40 trillion dollars a year, in theory all of thecommercial transactions and corporate hedging would be taken care of in a mere20 days of trading! The next obvious candidate would have to be hedge fund money,since nowadays everything is blamed on hedge funds. However, since the hedge
‘At constant exchange rates, the turnover increase is around 35%.2BIS Triennial Survey 2007. Visit www.bis.org for the full report.Today’s FX Market 25
 
fund money allocated to FX is estimated to be around | trillion, even leveragingthis amount aggressively would still leave a gigantic gap in reporting. So who isdoing all the trading’?
Where are they trading? How are they trading?
        
Average Daily Volume by
COUNTRY Dealing Channel
UNITED KINGDOM
UNITED STATES 17%JAPAN 6%
SINGAPORE 6% ‘ fers orn igSWITZERLAND 6% Ul DiesHONG KONG 4% Sas Ea)AUSTRALIA 4% ee
GERMANY 3%
  
E-BrokingSystems 427% iy
     
The truth is that nobody really knows, but it may be the case that turnovernumbers are greatly exaggerated due to the multiplying effect of FX transactionsand the use of notional funds. For example, when multinational X approaches theirbank to trade 100 million euros for dollars, a two-way transaction takes place,so the €100 million goes on both of their books. The bank then quickly contactsone of their counterparties to offset their exposure, which may in turn offset theirexposure through the derivatives market. A single transaction can therefore set inmotion a whole set of subsequent transactions totaling well over the original €100million in cash.
Although it is hard to tell exactly where these flows are coming from, what isundeniably true is that FX volumes have been steadily increasing. Volumes are infact rising at such a tremendous pace that only a fundamental shift in people’sperception of FX can explain the current situation.
THE NEW ASSET CLASS
As little as ten years ago, most asset managers regarded FX as an annoying sidetransaction that simply had to be done, and most did not particularly care for it.If a large international mutual fund wanted to buy European stocks, they wouldsimply approach their custodian bank and tell them to take care of it. This was acase of