The importance of who trades in a financial market is frequently overlooked, but is one of the single most important ways of understanding structure and price action. Retail traders are used to being the bottom of the pile – the most numerous in number, but controlling the smallest overall volumes, dwarfed by giant institutions and corporates alike. But the retail forex market has grown significantly, and now contains a wide range of different traders, not all immediately familiar. The forex day trader might not think of himself as engaged in the same business as someone buying holiday money or financing a car purchase abroad, but though they trade for very different reasons (and receive very different exchange rates), they are both engaged in retail forex trading. Despite the vast differences between forex day trading and one-off currency purchases, the two markets do have some similarities, and the most expensive currencies for retail customers are normally those which are most illiquid on the interbank market. Because retail forex customers make their transactions through financial institutions, their market activity ends up being double-counted; once as a retail forex transaction, and once when this is covered by their broker.
What is a retail trader?
Retail traders can be defined by average trade size – they are the smallest participants in the market. Typically larger trades are made by businesses, then larger corporate clients, multinationals and finally giant international institutions and national governments. The only real distinction is the size of each deal; should a retail trader be in a position to make a €1 billion trade they would no longer be considered a retail client, but instead join the ranks of financial institutions.
Another way of categorising forex traders is by who they are; in this system the €1 billion trader would still officially be a retail client because they are a private individual. In practice of course this never happens, as accounts of such a size would be represented by a private bank or family office. This system is still useful for explaining small trades by very large customers, that still benefit from the excellent rates available to institutional and large corporate clients.
Whichever way you choose to categorise them, its clear that retail traders are the smallest market participants, trade the least, and with the smallest volumes. This has significant impacts on the sort of rates they can achieve when trading with banks and forex brokers.
What types of retail client exist
Retail clients are one of the most varied categories of FX trader. The needs of an FX day trader speculating for profit have little in common with a one-off purchase of travel money or someone financing a transaction abroad. The day trader fits uncomfortably into the overall categories of FX trader because he requires competitive rates, whilst only trading small quantities in comparison with corporate or institutional clients.
For those retail clients uninitiated into the world of day trading, probably their main exposure to foreign exchange comes from trips abroad. As everyone knows, the rates achieved in such transactions are abysmal, with commissions of 5% or more, minimum transactions and an inability to change coins. For those who are making purchases of several thousand the rates are slightly better, but still far behind those available to businesses for the same transactions.
Day traders make up a specialised subset of the retail market. What distinguishes this demographic from others is that they trade in small volumes, but require competitive, close to corporate rates to do so profitably. This is because the small moves traded in many retail trading strategies simply to not allow for fixed commissions, or large spreads. If you have a trading strategy that involves profiting off 2% price moves in an asset, then paying 3% in spreads or commissions will turn that strategy into a guaranteed money-loser, whatever risk management strategies you use.
As you might expect, different sections of the retail forex industry have grown up to service these two, very different, types of client. We are all familiar with the services available for travel money, be they dedicated travel wallets or bureaus, but these facilities are obviously inappropriate for day traders, who require charting, access to dozens of currency pairs, live price info and instant execution.
How do rates differ
When a private individual executes a forex trade they do not deal at the interbank rate. Instead, each bank or broker charges a mark up on their trades to cover the costs of execution and generate a profit. Naturally, larger clients expect lower rates, even to the point of the bank sometimes making a loss. Major FX clients will often receive excellent rates on the expectation they will direct more valuable business towards their bank or broker, such as FX options or corporate finance solutions.
There are a few exceptions to this; we have already looked at day traders, whose brokers’ offer them highly competitive rates. Private retail customers who are wealthy enough to make large trades, such as private wealth management clients, will also receive much more competitive rates, for similar reasons to corporate and institutional customers. The account type is then one of the most important determiners of spread and commission levels.
What is the relevance to day traders?
You may be forgiven for wondering why this is relevant to FX traders. The most important thing about market participants is the way they impact price action; so we spend more time worrying about what central banks will do than retail traders. But retail customers do sometimes give clues about price action. For example, currencies with large volumes exchanged in single purchases for travel money likely have extensive economic relationships based on tourism – for some exotic currencies, this may be their main route to access foreign currency.
Equally, retail customers always execute their trades via a financial institution, be that a bank or broker. Increased activity in the retail market will necessarily lead to increased activity by institutional clients, as they must make the interbank purchases required to carry out their own client’s transactions. Also, rates for retail customers often do reflect liquidity on the interbank market: it will always be cheaper to make a EUR/USD transaction than USD/HUF, whether you are paying commission + spread at a retail rate, or on the interbank market using a market making broker.
It helps to think of the retail market as being a sort of sub-pool of liquidity, which is linked indirectly to the larger interbank market, where market makers quote continuous prices. Forex brokers are large financial institutions in their own right, and those marketing their services to retail clients may access the market directly, either using their own platforms, via a third party, or – especially when servicing one-off customers as opposed to regular traders – they may use existing reserves to execute the trades. So whichever way you approach the market, retail volumes end up impacting the institutional market.
How Rakuten can help
The retail forex market is large and well-developed, but different participants have different intentions, and often pay different rates to access the market. This knowledge can help you understand market structure and eventually make better trades, so why not put your understanding to the test and open a free demo account and start paper trading today?