Forex Trading: Shadow Banking

Forex Trading: Shadow Banking

Shadow Banking; a term that seems to insinuate that forex trading has a dark side where money is being stored without our knowledge, or that big players are intentionally trading against us to make us lose in the exchange market. However, the reality is so much more different than what is being insinuated. Shadow Banking refers to the system of financial activities conducted outside traditional banking regulations and institutions, whereby hedge funds, investment banks like Goldman Sachs and JP Morgan, as well as other non-bank financial institutions provide credit and liquidity to the market.

Naturally, the fact that is not regulated by the government is of some concern as it would mean that they pose risks to financial stability. Let us take a look at what Shadow Banking offers to us as a system, and how Shadow Banking affects us Forex Traders.

Firstly, Shadow Banking provides the forex market increased liquidity and market depth. When traders put up large trades involving minor currencies, banks may be hesitant to take up these trades. Shadow banks can be an alternative to facilitate such large trades, thereby reducing slippages and improving trade execution time. For example, during periods of heightened volatility, there will be significantly more trading activity going on. Shadow banking entities are in a position to step in to provide more liquidity so that prices are stabilized, and that slippages are reduced for traders in these currency pairs.

Secondly, Shadow Banking entities provide innovation to the forex market. As they are not as regulated as the traditional banks, shadow banking entities are in a position to leverage on innovative technologies to drive the development of new solutions that would increase their profits. While this adoption of innovative technologies has its own risk, the potential of such technologies can propel these shadow banking entities to never seen before profits. For example, with the rise of A.I., it is not surprising that traditional banks would turn to the possibility of A.I. trading, and it would not be surprising to assume that shadow banking entities have already taken a large step in this direction even before traditional banks have formed an interest in this topic.

What should traders take note with regards to Shadow Banking entities?

Firstly, It is important for us to understand that many shadow banking entities are not rife with corruption and unfairness like we imagine. Many shadow banking entities are large, prestigious companies in reality, and are still regulated to a certain extent. At the same time, these are businesses that are concerned about their profits and not your profits. You must acknowledge that they do not have your best interest at heart and must do your due diligence before employing their products or services. Self awareness is a very important life skill to have, and you must be able to weigh the risk and reward of engaging the services of a shadow banking entity like JP Morgan, before engaging them.

Secondly, the fact that these shadow banking entities exist would mean that market disruptions can occur. Events like suddenly liquidity shortages, margin calls, or defaulting can trigger volatility and sharp price movements in the forex market that would affect the open positions that we have. We as traders must protect ourselves and have safeguards in place so that we do not lose our investments when that occurs. For example, in 2019, an undisclosed major shadow banking entity that specialized in algorithmic trading experienced technical issues that led to a temporary halt in its operations. Liquidity was disrupted briefly, impacting the market participants that relied on this entity for execution. There were significant losses that was not covered, highlighting the importance of diversification and contingency plans.

Shadow Banking entities have existed for a long period of time, and will continue to exist in the forex market. Like with most things, the existence of these entities can be both a good thing and a bad thing, depending on how you see it. With enough due diligence, these can be an asset to you in your trading endeavour. Possessing the knowledge that these entities exist can help you better manage your risks, as you now have more information to assess to make a more accurate decision. Remember, while it is important that you are knowledgeable, the knowledge only becomes useful when you take actions using that knowledge.