Snapshot on the Workings of the Forex Market

Originally published on Khaleej Times, April 5, 2012.

The foreign exchange (Forex) market is the most liquid financial market in the world. Traders include large banks, central banks, institutional investors currency speculators, corporations, governments, other financial institutions, and of course, the retail investor. Average daily turnover in the global foreign exchange markets is estimated at over $4 trillion.

Foreign exchange trading has more than doubled since 2004. The increase in turnover is due to a number of factors; The growing importance of foreign exchange as an asset class, the increased trading activity of high-frequency traders, and the emergence of retail investors as an important market segment. The growth of electronic execution and the diverse selection of execution venues have lowered transaction costs, increased market liquidity, and attracted greater participation from many customer types. In particular, electronic trading via online portals has made it easier for retail traders to trade in the foreign exchange market.

Unlike the stock market, the foreign exchange market is divided into levels of access. At the top is the interbank market which accounts for 53 percent of all transactions, is made up of commercial banks and securities dealers. Within the interbank market spreads, which is the difference between the bid and ask prices, are very small and not known to participants outside the inner circles.

The difference between bid and ask prices widen as you go down the levels of access for example 0.1 pip to 1-3 pips for a currency such as the euro, this is due to volume. If a trader can guarantee large numbers of transactions for large amounts they can demand a smaller spread. The levels of access that make up the foreign exchange market are determined by the amount of money which they are trading also known as the size of the line. From there smaller banks, followed by large multinational corporations (which need to hedge risk and pay employees in different countries), large hedge funds and even some of the retail market makers make up the remaining levels of access. Also pension funds, insurance companies, mutual funds, and other institutional investors have played an important role in financial markets in general, and in FX markets in particular, since the early 2000's.

Individual retail speculative traders are a growing segment of this market both with size and importance. Currently they participate indirectly through brokers or banks. There are two main types of retail FX brokers offering the opportunity for currency speculative trading, brokers and dealers or market makers. Brokers serve as an agent of the customers in the broader FX market by seeking the best price in the market for a retail order and dealing on behalf of the retail customer. They charge a commission or mark-up in addition to the price obtained in the market. Dealers or market makers, by contrast, typically act as principal in the transaction versus the retail customer, and quote a price they are willing to deal at.

In a typical foreign exchange transaction, a party purchases a quantity of one currency by paying a quantity of another currency. The modern foreign exchange market began forming during the 1970's after three decades of government restrictions on foreign exchange transactions (the Bretton Woods system of monetary management established the rules for commercial and financial relations among the world's major industrial states after World War II), when countries gradually switched to floating exchange rates from the previous exchange rate regime, which remained fixed as per the Bretton Woods system.

There is no unified or centrally cleared market for the majority of trades so therefore there is hardly any regulation. Due to the over-the-counter (OTC) nature of currency markets, there are rather a number of interconnected marketplaces, where different currencies instruments are traded. This implies that there is not a single exchange rate but rather a number of different rates (prices), depending on what bank or market maker is trading, and where it is. In practice the rates are often very close.

The main trading centre is London, but New York, Tokyo, Hong Kong, and Singapore are all important centres as well. Trading in London accounts for around 36 percent of the total making it by far the most important centre for foreign exchange trading. Trading in the US accounts for around 18 percent and Japan accounts for around 6 percent. Due to London's dominance in the market, a particular currency's quoted price is usually the London market price. Banks throughout the world participate. Currency trading happens continuously throughout the day, as the Asian trading session ends, the European session begins, followed by the North American session and then back to the Asian session excluding weekends.

The foreign exchange market is unique because of:

  • Its huge trading volume representing the largest asset class in the world leading to high liquidity
  • Its geographical distribution
  • Its continuous operation 24 hours a day except weekends, i.e. trading from 20:15 GMT on Sunday until 22:00 GMT Friday
  • The variety of factors that affect exchange rates
  • The low margins of relative profit compared with other markets of fixed income, and the use of leverage to enhance profit and loss margins and with respect to account size.

Of course, extreme leverage also means that an investment in currency trading can quickly work against you. This is why an education in Forex trading, such as that offered by Online Trading Academy, is essential.

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