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Foreign Exchange
Market
The
foreign exchange market involves the trading of one currency for another.
Also called the forex, or FX, it is the largest market in the world when
you consider the volume of cash value traded. Forex includes the trading
between large banks, central banks, currency speculators, multinational
corporations, governments and other financial markets. The volume of the
forex around the world exceeds $1.9 trillion every day. Individuals make
up a very small part of the foreign exchange market, only participating
through banks and brokers. Individuals must be wary of forex scams.
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The History of Forex
The forex market is a cash inter-bank market, established in 1971 upon the appearance of floating exchange rates around the world. When you compare forex to other markets, it is an enormous market. For example, the US stock market has an average daily trading volume of less than $10 billion. With $1.9 trillion in average daily trades, forex is a market that continues to grow each year.
Speculation in currency markets was prevented by the Bretton Woods Agreement, which was established in 1945 in an effort to stabilize international currencies. The Bretton Woods aimed to stop money from fleeing across nations. It fixed all national currencies against the dollar. The dollar was set at a rate of $35 per ounce of gold.
Before the agreement, the gold exchange standard was in place, which used gold to back each currency. This prevented governments from debasing money and triggering inflation. However, there were problems with the gold system. An economy in growth would import goods from overseas until the gold reserves were low. Then the country's supply of money would shrink. Interest rates would increase and the economy would slow to a recession.
With the recession in place, the price of goods would fall until they appeared attractive to other nations. The economy would experience an influx of gold that would increase the money supply. Interest rates would fall and the economy would strengthen. Then the entire cycle would start over.
The boom and busts patterns were seen around the world until World War I disrupted the free flow of trade and the movement of gold between countries.
The Bretton Woods Agreement was then established to try and maintain the value of global currencies with a narrow margin against the dollar. The dollar was then set to gold. Countries were prohibited from devaluing their currency by more than 10%. After World War II, international trade expanded rapidly, causing a massive movement in capital. The Bretton Woods Agreement foreign exchange rates became destabilized as a result.
The agreement was abandoned in 1971, with the US dollar no longer convertible to gold. Over the next two years, the currencies of the major industrialized nations became increasingly free floating, controlled by supply and demand. Prices were set with volumes. The 1970's saw speed and price volatility increasing throughout the decade. New financial instruments, market deregulation and open trade resulted, as well as a new power exhibited by speculators.
In the 1980's, the movement of money between countries was boosted by the introduction of computers. The market became a continuum, trading through the American, European and American time zones. Large banks established dealing rooms in which hundreds of millions of dollars, pounds, euros and yen exchanged in minutes. This became the forefront of today's forex, where single trades for tens of millions of dollars are priced in seconds.
The market has experienced dramatic change. Now international financial transactions are not used to buy and sell goods, but to speculate on the market. The purpose is to make money out of money.
London is currently the world's leading international financial center, home to the world's largest forex market. This is due to both location - it is operating during the Asian and American markets - and to the creation of the Eurodollar market during the 1950's.
London continues to grow and is the home of many American and European bank regional headquarters. The banks that deal with the forex are usually quite large. Small banks, commercial hedgers and private investors rarely have direct access to this market. They are either too small in transaction size or they fail to meet credit criteria. However, the large inter-bank units can be broken down and offered to small traders in smaller units.
Forex Financial Instruments
There are several financial instruments used in the forex. They include:
" Futures: Foreign currency futures are forward transactions that feature standard contract sizes and maturity dates. For example, 300,000 British pounds for next July at a certain rate. They are standardized and traded on an exchange. The average contract length is three months. They are usually inclusive of interest amounts.
" Forward transaction: Money does not actually change hands until a future date. This is looking into the future. The buyer and seller agree on an exchange rate for a certain date. The transaction occurs on that date, no matter the market rate. The duration of the trade can be a few days, months or years.
" Swap: This is the most common forward transaction in the forex. Two parties exchange currencies for a preset length of time. They then reverse the transaction at a later date. These are not contracts and not traded through exchanges.
" Spot: A spot transaction is a two-day delivery transaction. It represents a "direct exchange" between two currencies. It involves cash, not a contract. There is not interest included in the transaction.
The Differences Between Spots and Futures
The Spot and Futures markets are important in understanding the forex. Futures are based on contracts and have a typical duration of three months. Spots are a two-day cash delivery. The Futures market was created to hedge out risks and for speculation. The Spot market allows actual cash deliveries.
While there is a two-day delivery date on Forex transactions, this is no longer used on today's Spot market. Every day, at 5 pm EST, Spot positions are closed then reopened. This process guarantees an unlimited timeline for delivery. For example, a Spot transaction occurs on Monday with a delivery date of Wednesday. At 5 pm on Monday, the position is closed and re-opened. Now the Spot holds a close date of Thursday. This daily process allows an investor to hold a position on the market for as long as they wish.
Each currency in a forex transaction has an inherent interest rate. For example, the US dollar has the Federal Funds Rate. This interest is added every single day. In a Futures contract, the interest is build into the price. In a Spot, the interest is not included in the offering price because it is a cash market, not a contract. Most institutions credit a day's worth of interest every time a position is carried over to the next day.
Forex Market Participants
The forex market is divided into levels of access, including: inter-banks, smaller investment banks, large multi-national corporations, large hedge funds and even some of the retail forex market makers. The levels of access are determined by the trader's "line" size - the amount of money with which they are trading.
The inter-bank market is at the top, accounting for 53% of all transactions. It is made up of the largest investment banking firms. The spreads are razor sharp and usually unknown to those outside the inner circle of the market. The lower the level of access, the wider the spread. This is because of the difference in volume. If a trader guarantees a large number of transactions for large amounts, they can also demand a better (smaller) spread.
The inter-bank caters for both the majority of commercial turnover and the large amounts of daily speculative trading. A large bank can trade billions of dollars each day. Most of the trading is conducted for the bank's own accounts, with a small amount of trading on the behalf of customers.
Forex brokers have traditionally conducted a large amount of business by facilitating inter-bank trading and matching anonymous counterparts. Much of this business has shifted to electronic systems, such as EBS, the Chicago Mercantile Exchange and Bloomberg. The broker squawk box lets traders in most trading rooms listen to ongoing inter-bank trading, but the turnover is smaller in recent years.
Commercial companies are an important part of the forex market. They seek foreign exchange in order to pay for goods and services. Commercial companies trade at smaller amounts than do banks or speculators, giving their trades little short-term impact on market rates. Their trade flows are still important in the long-term direction of a currency's exchange rate. Some multi-national companies impact the market unpredictably when very large positions are covered due to exposures that were unknown by other market participants.
National central banks try to control the money supply, inflation and interest rates for their currency. They usually have a target rate they are working towards. They use their substantial foreign exchange reserves to try and stabilize the market. However, the effectiveness of the central bank stabilizing speculation is doubtful. Central banks simply do not go bankrupt if they have large losses, and there is no evidence that they make a profit in trading.
Actually, the mere expectation of a central bank intervention is often enough to stabilize a currency. Aggressive intervention is seen several times each year in countries with dirty float currency regimes. Central banks do not always come out on top however, as seen in the 1992-93 ERM collapse.
Investment management firms use forex to facilitate transactions in foreign securities. These firms are typically managing large accounts on behalf of customers such as pension funds and endowments. An investment manager with an international equity portfolio will buy and sell foreign currencies in the spot market so that foreign equities can be purchased. Forex transactions are secondary to the actual investment decisions.
Some investment management firms feature more speculative specialist currency overlay operations. The client's currency exposure is managed with the goal of generating profits while limiting risk. With the number of these firms quite small, many have a large value of assets under management and can generate rather large trades.
Hedge funds control billions of dollars of equity, borrowing billions more and overwhelming intervention by central banks to support most types of currency. When economic fundamentals are in the hedge funds' favor they become very forceful. Since 1990, hedge funds have maintained a reputation for aggressive currency speculation.
Retail forex brokers, also known as
market makers, only handle a minute portion of the total volume of the
market. It is estimated that the total retail volume is at $25 billion to
$50 billion daily, only 2% of the market.