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The foreign exchange market or currency market or Forex is the market where one currency is traded for another. It is the largest market in the world, in terms of cash value traded, and includes trading between large banks, currency speculators, multinational corporations, governments, and other financial markets and institutions. Retail traders (small investors - speculators) may only participate in this market indirectly through brokers or banks.
Market participants
Banks
The interbank market caters for both the majority of commercial turnover as well as enormous amounts of speculative trading every day. It is not uncommon for a large bank to trade billions of dollars on a daily basis. Some of this trading activity is undertaken on behalf of customers, but a large amount of trading is also conducted by proprietary desks, where dealers trade to make the bank profits. The interbank market has become increasingly competitive in the last couple of years and the god-like status of top foreign exchange traders has suffered as the equity guys are back in charge again. A large part of the interbank trading takes place on electronic broking systems that have negatively affected the traditional foreign exchange brokers.
Interbank Brokers
Until recently, foreign exchange brokers were doing large amounts of business, facilitating interbank trading and matching anonymous counterparts for comparatively small fees. Today, however, a lot of this business is moving onto more efficient electronic systems which function as a closed circuit for banks only. Still, the broker box providing the opportunity to listen in on the ongoing interbank trading is seen in most trading rooms, but turnover is noticeably smaller than just a year or two ago.
Customer Brokers
For many commercial and private clients, there is a need to receive specialised foreign exchange services. There is a fair number of non-banks offering dealing services, analysis and strategic advice to such clients. Many banks do not undertake trading for private clients at all, and do not have the necessary resources or inclination to support medium sized commercial clients adequately. The services of such brokers are more similar in nature to other investment brokers and typically provide a service-oriented approach to their clients. The main source of revenue for such brokers is the spread - the difference between bid and ask prices - however, the main source of income is triggering the client's stop-loss-orders.
Central Banks
The national central banks play an important role in the foreign exchange markets. Ultimately, the central banks seek to control money supply and often have official or unofficial target rates for their currencies. As many central banks have very substantial foreign exchange reserves, the intervention power is significant. Among the most important responsibilities of a central bank is the restoration of an orderly market in times of excessive exchange rate volatility and the control of the inflationary impact of a weakening currency. Frequently, the mere expectation of central bank intervention is sufficient to stabilise a currency, but in the event of aggressive intervention the actual impact on the short term supply/demand balance can lead to the desired moves in exchange rates. Central banks do not always achieve their objectives, however. If the market participants really want to take on a central bank, the combined resources of the market can easily overwhelm any central bank. Several scenarios of this nature were seen in the 1992-93 ERM collapse, and in more recent times in South East Asia.
Hedge Funds
Hedge funds have gained a reputation for aggressive currency speculation in recent years. There is no doubt that with the increasing amount of money some of these investment vehicles have under management, the size and liquidity of foreign exchange markets is very appealing. The leverage available in these markets allow such funds to speculate with tens of billions of dollars at a time, and the herd instinct typical in hedge fund circles means that having Soros and friends on your back is less than pleasant for a weak currency and economy. It is unlikely, however, that such investments would be successful if the underlying investment strategy was not sound and therefore it is argued that hedge funds actually perform a beneficial service by exploiting and exposing unsustainable financial weaknesses, forcing realignment to more realistic levels.
Commercial Companies
Tbackbone of foreign exchange markets is currency speculation. However, a minor part of the market liquidity is derived from the financial activities of comapnies seeking foreign exchange to pay for goods or services.
Commercial companies often trade in sizes that are insignificant to short-term market moves, however, as the main currency markets can quite easily absorb hundreds of millions of dollars without any big impact. But it also clear that one of the decisive factors determining the long-term direction of a currency's exchange rate is the overall trade flow. Some multinational companies can have an unpredictable impact when very large positions are covered however due to exposures that are not commonly known to the majority of market participants.
Investors and Speculators
The boundaries of speculation are unclear, however, as many of the above-mentioned participants also have speculative interests, even some of the central banks. Some argue that as in other efficient markets, the speculator performs an important role taking over the risks that commercial participants do not wish to be exposed to. While this may hold true, speculation may also do a lot of macroeconomcal damage.
The foreign exchange markets are popular with investors due to the large amount of leverage that can be obtained and the ease with which positions can be entered and exited 24 hours a day. The reason why so high leverage is offered by brokers (sometimes with margin rates as low as ½-1% percent) is that this practice is highly lucrative. By offering high leverage, the broker makes it attractive for the client to take higher risks, and this increases trading volume. As the broker gets his compensation from the spread, larger lots leads to bigger spread revenue. One should note, that why professional currency dealers themselves never leverage much more than 4:1 leverage, retail clients are offered leverage up to 400:1 which greatly enhances risk, and makes consistant proftable trading very difficult, due to the risk of triggering margin calls.
Taking advantage of interest rate differentials is another popular strategy that can be efficiently undertaken in a market with high leverage. However many arbitrage traders forget that the overall movement in exchange rates of the currency pair traded, has much greater effect on their equity and profit/loss than any interest rate adjustment (for instance by a central bank) has.
In most countries speculative currency trading is widely considered highly suspect, due to the fact that speculative trading may have huge macroeconomical impact on a country's economy. However, as mentioned above, the markets are also to some extend used by participants in need of foreign currencies to pay for actual (foreign) goods or services.
According to the Bank for International Settlements' last triennal study (April 20y04) (Triennial Central Bank Survey of Foreign Exchange and Derivatives Market Activity 2004 - Final Results), transactions :
- were strictly interdealer (ie interbank) for 53 % ;
- for 33 % involved a dealer (ie a bank) and a fund manager or some other non-bank financial institution;
- and for only 14 % were between a dealer and a non-financial company.
Market liquidity
Foreign exchange markets are unique in the financial world in that exchange rates are highly sensitive to a great variety of factors, many different types of investors have access to the market, the market is very liquid, and currencies are traded around the clock. The main international banks continually provide the market with both bid (buy) and ask (sell) offers.
The nature of the market
Viewed as a whole, the foreign exchange market is huge, probably the most liquid market in the world. It is, however, essential to understand that there is no such thing as the foreign exchange market. Due to the over-the-counter (OTC) nature of currency markets, there are rather a number of more or less interconnected market places, where different currency instruments are traded. This implies that there is no such thing as a dollar rate - buth rather a number of different rates (prices), depending on what bank, broker or market maker is clearing the trade. However, in practice the rates are often very close or similar. Too wide differences could be exploited by traders in arbitrage type of trades.
Most spot currency trades placed by retail clients are offset against the liquidity of the trader's own broker (or market maker). Thus, most spot trades never makes it into any (coherent) marketplace, as it is often the broker taking the other side of a trade. While this make fast and efficient clearing possible, it also allows for price manipulation (e.g. spiking prices) and examples of this is seen from time to time.
| Rank | Currency | ISO 4217 Code | Symbol |
| 1 | United States Dollar | USD | $ |
| 2 | Eurozone Euro | EUR | € |
| 3 | Japanese Yen | JPY | ¥ |
| 4 | British Pound Sterling | GBP | £ |
| 5 | Swiss Franc | CHF |
While it may be true that there is little or no 'inside information' in the foreign exchange markets, the brokers have access to much more information than the retail trader has. Also, scientific studies show that brokers make a lot of money on timing the execution of the clients' trades.
Exchange rate fluctuations are usually caused by actual monetary flows as well as anticipations on global macroeconomic conditions. Significant news is released publicly so, at least in theory, everyone in the world receives the same news at the same time.
Currencies are traded against one another. Each pair of currencies thus constitutes an individual product and is traditionally noted XXX/YYY, where YYY is the ISO 4217 international three-letter code of the currency into which the price of one unit of XXX currency is expressed. For instance, EUR/USD is the price of the euro expressed in US dollars, as in 1 euro = 1.2045 dollar.
On the spot market, according to the BIS study, the most heavily traded products were :
- EUR/USD - 28 %
- USD/JPY - 17 %
- GBP/USD (also called cable) - 14 %
and the US currency was involved 89% of transactions, followed by the euro (37%), the yen (20%) and sterling (17%). Although trading in the euro has grown considerably since the currency's creation in January 1999, the foreign exchange market is thus still largely dollar-centered. For instance, trading the euro versus a non-European currency ZZZ will usually involve two trades: EUR/USD and USD/ZZZ. The only exception to this is EUR/JPY, which is an established traded currency pair in the interbank spot market.
Around-the-clock market
Unlike stocks, foreign exchange is indeed an interbank, over-the-counter (OTC) market which means there is no single universal exchange for specific currency pair. The foreign exchange market operates 24 hours, 5 days per day between individuals with forex brokers, brokers with banks, and banks with banks. If the European session is ended the Asian session or US session will start, so all world currencies can be continually in trade. To some extend, traders can react to news when it breaks, rather than waiting for the market to open (except for weekends where liquidity may be low or non existant), as is the case with some other markets.
Market Size
Average daily international foreign exchange trading volume was $1.9 trillion in April 2004 according to the above-mentioned BIS study :
- $600 billion spot
- $1,300 billion in derivatives, ie
- $200 billion in outright forwards
- $1,000 billion in forex swaps
- $100 billion in options.
For various reasons, exchange-traded derivatives never caught on the Forex market as they did on all other financial markets (although attempts to launch currency futures contracts in the early 70s actually predate interest rate or stock index futures).
Bid/Offer spread
Like any market there is a bid/offer spread (difference between buying price and selling price). On major currency crosses, the difference between the price at which a market maker will sell ("ask", or "offer") to a wholesale customer and the price at which the same market-maker will buy ("bid") from the same wholesale customer is minimal, usually only 1 or 2 pips. In the EUR/USD price of 1.2238 a pip would be the '8' at the end. So the bid/ask quote of EUR/USD might be 1.2238/1.2239.
This, of course, does not apply to retail customers. To individuals, banks will routinely mark up the difference to say 1.2140 / 1.2340 for transfers, or say 1.1940 / 1.2440 for banknotes or travellers' cheques.
Individual currency speculators
Currency speculation by small traders is fairly loosely regulated in the U.S. by the U.S. Commodity Futures Trading Commission (CFTC) and has become more prominent since the introduction of on-line trading. The CFTC has noted an increase in foreign exchange trading scams .
On-line traders may use a broker who typically quote a spread perhaps 3-20 pips wide (e.g. 1.2237/1.2240 or 1.2220/1.2240). The broker will often allow their clients to use a large amount of margin, increasing both the potential gains and losses, and increasing the brokers' profits on the bid/ask spread.
Brokers do not typically charge margin interest, but since currency trades must be settled in 2 days, they will "resettle" open positions (again collecting the bid/ask spread).
There have been several sucessful large individual currency speculators (e.g. George Soros), but since the foreign exchange market is a zero sum game, small speculators should carefully consider if they have a competitive advantage in this market, i.e. why they think they can beat this market. Most often, the "market" in which the trader places his trade, is merely a somehow closed cirquit provided by his broker. Considering the CFTC warning, retail traders should be aware of the possibility that retail forex brokers may manipulate quoted spot rates, improperly trigger their clients' stop-loss orders and charge hidden fees.
Forex Communities
- Forex Tsd Forex Trading System Development forum.
External links to educational resources
- CFTC fraud warning
- Disk Lectures MBA level audio lecture with slideshow on Foreign Exchange
- Federal Reserve educational material
- Foreign Exchange related material from the Federal Reserve
- Forex Magazine Online Forex Magazine
- Forex Trading - ACM
- London FX Ltd introduction to FX spot trading terminology and conventions
- Model Code from ACI - The Financial Markets Association, a Paris, France based industry association.
