Exchanges and CCPs
The operation of the exchange is similar to the operation of the interbank market platforms that we discussed earlier.
As a rule, the exchange maintains a centralized order book, and each trader can send a limit order to buy or sell. An example of such a market before our eyes is the foreign exchange market of the Exchange. Anyone can sign an agreement with a broker who will connect him to the Moscow Exchange in order to conclude transactions in the same “order book” as respectable gentlemen with millions of orders.
An important difference in the exchange market lies in what happens after the conclusion of the transaction. As we already know, the order book alone is not enough for all market participants to trade with everyone. We need a mechanism that would save everyone from the need to check the solvency of each counterparty before a transaction and would ensure the execution of transactions even in the event of bankruptcy of one of the participants. There is such a mechanism - these are transactions with a central counterparty (central clearing counterparty, CCP).
In particular, I can open a trading terminal and send an order to the exchange to buy 1,000 euros for rubles at a rate of, say, 73. When the exchange computer merges my order with a sell order from Deutsche Bank, two transactions will take place: between me and the exchange and between Deutsche and the exchange. The exchange will become the central counterparty that will monitor the execution of transactions. Deutsche will never know to whom he sold the euro, and he will not need to inquire about my trustworthiness. If I do not fulfill my obligations, Deutsche will not notice this, because he made a deal with the exchange, not with me.
In order to settle transactions even in the event of a default of one of the participants, the exchange collects a margin from everyone. Before I buy 1,000 euros at the rate of 73 with the calculation tomorrow, I have to deposit at least 10,000 rubles into my account today. If tomorrow I forget or cannot transfer the remaining 63,000 rubles to the exchange, the exchange will use my collateral. Read more on this example in this article: Forex Strategy.
Deutsche Bank will hand over 1,000 euros to the exchange tomorrow. The exchange will sell them at a new market rate, which can be either higher or lower than yesterday`s 73. Suppose that the euro falls in price to the level of 71, and then the exchange will receive 71,000 rubles. The exchange will take the missing 2,000 from my collateral and transfer the full amount to Deutsche, that is, 73,000 rubles. As you can see, if the euro rate does not fall by more than 10 rubles, then my collateral will be enough for the exchange to complete its part of the deal with Deutsche and not incur losses.
Making the market
Thus, the exchange can create a market in which all participants are equal and everyone can trade with everyone. The order book helps buyers and sellers find each other, and transactions with the central counterparty eliminate credit risk. Oddly enough, currency exchanges have not yet taken over the world, and most of the transactions are still made in the OTC market.