Foreign Exchange Market (Forex)

The foreign exchange market (forex or FX) is a global decentralised market for trading currencies. It determines foreign exchange rates and includes all currency buying, selling, and exchanging at current or established prices. By trading volume, it is the largest market in the world, ahead of the credit market.

Major participants include large international banks, which operate through financial centres that facilitate trading around the clock, except on weekends. Currencies are traded in pairs, determining their relative values rather than absolute values. For instance, one USD may equal X CAD or JPY.

The market involves financial institutions and operates on multiple levels. Banks interact with a smaller group known as “dealers,” who manage large volumes of trades, primarily among banks in what’s called the “interbank market.” These trades can involve substantial amounts, often in the hundreds of millions. Due to the complexity of dealing with different currencies, the Forex market has little regulatory oversight. The foreign exchange market enables international trade and investment by allowing currency conversion. For example, a business in the United States can import goods from the European Union and pay in Euros, even if its revenue is in U.S. dollars. The market also allows for speculation on currency values and carry trade based on interest rate differentials.

Modern foreign exchange trading began in the 1970s after moving away from the fixed exchange rates of the Bretton Woods system. This market is distinctive due to its large trading volume, high liquidity, continuous operation (24/5), geographical dispersion, diverse factors influencing exchange rates, relatively low-profit margins compared to other markets, and the use of leverage to amplify gains and losses.

As such, it has been referred to as the market closest to the ideal of perfect competition, notwithstanding currency intervention by central banks.

According to the Bank for International Settlements, preliminary global results from the 2022 Triennial Central Bank Survey show that trading in foreign exchange markets averaged $7.5 trillion per day in April 2022, up from $6.6 trillion in April 2019. Foreign exchange swaps were the most traded instruments, totalling $3.8 trillion, followed by spot trading at $2.1 trillion.

The $7.5 trillion breakdown includes:

– $2.1 trillion in spot transactions

– $1.2 trillion in outright forwards

– $3.8 trillion in foreign exchange swaps

– $124 billion in currency swaps

– $304 billion in options and other products

The foreign exchange market features different access levels, with the interbank market at the top, made up of major commercial banks. In this market, spreads reflect the difference between bid and ask prices. Relationships between banks play a crucial role in accessing liquidity, as banks may seek to borrow from those with established ties for better interest rates.

The difference between the bid and ask prices in the foreign exchange market widens as you move down the access levels, with spreads increasing from 0 to 1 pip and then to 1–2 pips for currencies like the EUR. This widening occurs due to trading volume, as large traders can negotiate better spreads.

The access levels are defined by the size of the trading “line.” The top-tier interbank market represents 51% of all transactions, followed by smaller banks, multinational corporations, hedge funds, and some retail market makers.

According to Galati and Melvin, institutional investors such as pension funds and mutual funds have become increasingly significant in FX markets since the early 2000s. Additionally, hedge funds have seen substantial growth from 2001 to 2004. Central banks also participate in the market to manage currency values according to their economic objectives.

Commercial Companies

Commercial companies play a key role in the foreign exchange market as they seek currency to pay for goods and services. While their trades are usually smaller than those of banks or speculators and have minimal short-term impact, they significantly influence the long-term direction of a currency’s exchange rate. Multinational corporations (MNCs) can also create unpredictable effects when covering large positions based on less widely known exposures.

Central banks

National central banks play a vital role in foreign exchange markets by managing money supply, controlling inflation, and influencing interest rates, often through target rates for their currencies. They can use their substantial foreign exchange reserves to stabilize the market. However, the effectiveness of their stabilization efforts through speculation is uncertain, as they do not face bankruptcy from losses like other traders, and there’s little evidence that they profit from trading.

Foreign exchange fixing

Foreign exchange fixing is the daily exchange rate set by national banks, which assess their currency’s performance. These rates reflect market value and are used by banks and traders as trend indicators.

The expectation of a central bank’s intervention can stabilize a currency, but aggressive actions may be needed in countries with a dirty float regime. Despite their efforts, central banks can be overwhelmed by market forces, as seen during the 1992-93 European Exchange Rate Mechanism collapse and more recently in Asia.

Investment management firms

Investment management firms typically manage large accounts for clients like pension funds and endowments and use the foreign exchange market to facilitate foreign securities transactions. For example, an investment manager with an international equity portfolio must buy and sell various foreign currencies for securities purchases.

Some firms also offer specialized currency overlay services to manage clients’ currency risks while aiming for profit. Although few in number, these firms often manage significant assets, allowing them to execute large trades.

Retail foreign exchange traders

Individual retail speculative traders are a growing segment of the market, participating indirectly through brokers or banks. In the U.S., retail brokers are primarily regulated by the Commodity Futures Trading Commission (CFTC) and the National Futures Association (NFA), which has addressed past issues of foreign exchange fraud. In 2010, the NFA required its members dealing in Forex to register specifically as Forex Commodity Trading Advisors (CTAs) and imposed higher minimum capital requirements for those involved in Forex trading.

Many foreign exchange brokers operate under the Financial Services Authority (FSA) in the UK, integrating forex trading with other over-the-counter derivatives like contracts for difference and financial spread betting.

There are two main types of retail FX brokers: brokers and dealers (or market makers). Brokers act as agents for customers, seeking the best market prices and charging a commission or “mark-up.” In contrast, dealers or market makers act as principals, quoting the prices at which they are willing to trade directly with retail customers.

Non-bank foreign exchange companies

Non-bank foreign exchange companies offer currency exchange and international payment services to individuals and businesses. Unlike speculative brokers, they focus on actual currency exchange, delivering funds directly to bank accounts.

In the UK, around 14% of currency transfers are done through these companies, which often advertise better exchange rates and lower fees than traditional banks. In India, daily transactions with foreign exchange companies reach about $2 billion, with 25% of currency transfers made through them.

Regulated by the Foreign Exchange Dealers Association of India (FEDAI), these companies operate under the Foreign Exchange Management Act of 1999 (FEMA).

Money transfer/remittance companies and bureaux de change

Money transfer companies, or remittance companies, primarily facilitate high-volume, low-value transfers from economic migrants to their home countries. In 2007, global remittances reached $369 billion, an 8% increase from the previous year, with major recipients being India, China, Mexico, and the Philippines, totaling $95 billion. Western Union, with 345,000 agents worldwide, is the leading provider, followed by UAE Exchange.

Bureaux de change, or currency transfer companies, offer foreign exchange services for travelers, usually found in airports and tourist spots, allowing currency exchange through banks or non-bank providers.

Currency markets operate over-the-counter (OTC), resulting in multiple interconnected marketplaces with varying exchange rates depending on the bank or market maker. The most notable trading centers are London and New York City, while Tokyo, Hong Kong, and Singapore also play significant roles. Currency trading occurs continuously across different sessions worldwide.

Exchange rates fluctuate due to actual monetary flows and expectations influenced by GDP growth, inflation, interest rates, and macroeconomic conditions. Major news releases are often synchronized, but large banks have an edge as they see their customers’ order flows.

Currencies are traded in pairs, denoted as XXXYYY or XXX/YYY, where the first currency (XXX) is the base currency and the second (YYY) is the counter currency. For instance, a EURUSD price of 1.5465 indicates that 1 euro equals 1.5465 US dollars. Most rates are quoted with the USD as the base currency, except for the British pound, Australian dollar, New Zealand dollar, and euro, where the USD is the counter currency.

The factors affecting XXX will affect both XXXYYY and XXXZZZ. This causes a positive currency correlation between XXXYYY and XXXZZZ.

The 2022 Triennial Survey indicates that the most traded bilateral currency pairs in the spot market were:

 EUR/USD: 22.7%

 USD/JPY: 13.5%

 GBP/USD (cable): 9.5%

The U.S. dollar was involved in 88.5% of transactions, followed by the euro at 30.5%, yen at 16.7%, and pound at 12.9%. Trading volume for individual currencies totals 200% since each transaction involves two currencies.

Since its introduction in January 1999, the euro’s trading volume has increased significantly, yet the future dominance of the dollar remains uncertain. Traditionally, trading the euro against a non-European currency (ZZZ) required two trades, except for EUR/JPY, which is a commonly traded pair in the interbank market.

Main Take Aways

The foreign exchange market is an over-the-counter (OTC) marketplace that determines the exchange rates for global currencies.

It is the largest financial market in the world, operating through a global network of financial centres that transact 24 hours a day, only closing on weekends.

Currencies are always traded in pairs, meaning the value of one currency in the pair is relative to the value of the other.

Sources: Investopedia & Wikipedia