The foreign exchange market is a global online network where traders buy and sell currencies. It has no physical location and operates 24 hours a day from 5 p.m. EST on Sunday until 4 p.m. EST on Friday because currencies are in high demand. It sets the exchange rates for currencies with floating rates.
The Forex market has an estimated turnover of $6.6 trillion a day. It is the largest and most liquid financial market in the world. Demand and supply determine the differences in exchange rates, which in turn, determine traders’ profits.
This global market has two tiers. The first is the interbank market. It's where the biggest banks exchange currencies with each other. Even though it only has a few members, the trades are enormous. As a result, it dictates currency values.
The second tier is the over-the-counter market. That's where companies and individuals trade. OTC has become very popular since there are now many companies that offer online trading platforms. New traders, starting with limited capital, need to know more about forex trading. It’s risky because the forex industry is not highly regulated and provides substantial leverage.
The biggest geographic OTC trading center is in the United Kingdom. London dominates the market. A currency’s quoted price is usually London’s market price. As of April 2019, U.K.’s forex trading amounted to 43.1% of total global trading, making London the most important forex trading center in the world.
Foreign exchange trading is a contract between two parties. There are three types of trades. The spot market is for the currency price at the time of the trade. The forward market is an agreement to exchange currencies at an agreed-upon price on a future date.
A swap trade involves both. Dealers buy a currency at today's price on the spot market and sell the same amount in the forward market. That way, they have just limited their risk in the future. No matter how much the currency falls, they will not lose more than the forward price. Meanwhile, they can invest the currency they bought on the spot market.
The interbank market is a network of banks that trade currencies with each other. Each has a currency trading desk called a dealing desk. They are in contact with each other continuously. That process makes sure exchange rates are uniform around the world.
The minimum trade is one million of the currency being traded. Most trades are much larger, between 10 million and 100 million in value. As a result, exchange rates are dictated by the interbank market.
The interbank market includes the three trades mentioned above. Banks also engage in the SWIFT market. It allows them to transfer foreign exchange to each other. SWIFT stands for Society for World-Wide Interbank Financial Telecommunications.
Banks trade to create profit for themselves and their clients. When they trade for themselves, it's called proprietary trading. Their customers include governments, sovereign wealth funds, large corporations, hedge funds, and wealthy individuals.
Here are the 10 biggest players in the foreign exchange market, according to Euromoney's 2018 FX Survey:
|JP Morgan Chase||12.13%|
|Bank of America Merrill Lynch||6.20%|
The Chicago Mercantile Exchange was the first to offer currency trading. It launched the International Monetary Market in 1971. Other trading platforms include OANDA, Forex Capital Markets LLC, and Forex.com.
The retail market has more traders than the Interbank Market, but the total dollar amount traded is less. The retail market doesn't influence exchange rates as much.
Role of Central Banks
Central banks don't regularly trade currencies in foreign exchange markets, but they have a significant influence. Central banks hold billions in foreign exchange reserves. Japan holds around $1.2 trillion, mostly in U.S. dollars. Japanese companies receive dollars in payment for exports. They exchange them for yen to pay their workers.
Japan, like other central banks, could trade yen for dollars in the forex market when it wants the value to fall. That makes Japanese exports cheaper. Japan prefers to use methods that are more indirect though, such as raising or lowering interest rates to affect the yen's value.
In 2014, Citigroup, Barclays, JPMorgan Chase, and The Royal Bank of Scotland pled guilty to illegal manipulation of currency prices. Here's how they did it.
Traders at the banks would collaborate in online chat rooms. One trader would agree to build a huge position in a currency, then unload it at 4 p.m. London Time each day. That's when the WM/Reuters fix price is set. That price is based on all the trades taking place in one minute. By selling a currency during that minute, the trader could lower the fix price. That's the price used to calculate benchmarks in mutual funds. Traders at the other banks would also profit, because they knew what the fix price would be.
These traders also lied to their clients about currency prices. One Barclays trader explained it as the “worst price I can put on this where the customer’s decision to trade with me or give me future business doesn’t change.”
For the past 300 years, there has been some form of a foreign exchange market. For most of U.S. history, the only currency traders were multinational corporations that did business in many countries. They used forex markets to hedge their exposure to overseas currencies. They could do so because the U.S. dollar was fixed to the price of gold. According to the gold price history, gold was the only metal the United States used to back up the value of the nation’s paper currency.
The foreign exchange market didn't take off until 1973. That's when President Nixon completely untied the value of the dollar to the price of an ounce of gold. The so-called gold standard kept the dollar at a stable value of 1/35 of an ounce of gold. The history of the gold standard explains why gold was chosen to back up the dollar.
Once Nixon abolished the gold standard, the dollar's value quickly plummeted. The dollar index was established to give companies the ability to hedge this risk. Someone created the U.S. Dollar Index to give them a tradeable platform. Soon, banks, hedge funds, and some speculative traders entered the market. They were more interested in chasing profit than in hedging risks.
The Bottom Line
The Forex market buys and sells currencies. By doing so, it determines one currency’s value against another, on a daily basis. It operates on two levels: interbank and over-the-counter. The interbank market trades in enormous volumes. So, they dictate foreign exchange rates.
The largest OTC center is in London. Since U.K. trading forms almost half of the global forex trading bulk, the United Kingdom holds the most dominant and influential forex trading center in the world.
Although central banks don’t regularly trade currencies, they can significantly influence forex rates. These banks hold several billion in foreign exchange reserves.
In 2014, a group of banks colluded to illegally manipulate currencies. As the forex market is largely unregulated, it made this scandal possible. At least six banks, including Citigroup, JP Morgan, and Barclays, were fined almost $6 billion in total after the crackdown.
Frequently Asked Questions (FAQs)
What happens when a foreign exchange market is in equilibrium?
According to the "equilibrium approach" to foreign exchange markets, currency exchange rates are constantly seeking out an equilibrium, giving exchange rates volatility. If markets were to reach perfect equilibrium, there would be no reason to adjust exchange rates, which would become fixed as traders stop finding trade opportunities.
Who governs the foreign exchange market?
The foreign exchange market is not centralized. Individual traders can choose which market they want to use for their trading. They can generally choose from a market regulated by the Commodity Futures Trading Commission (CFTC), a market governed by the Securities and Exchange Commission (SEC), or an "off-exchange market" that's regulated directly by a market maker (such as a broker or dealer).
Bureau of International Settlements. “Foreign Exchange Turnover in April 2019,”
Dummies. “What Is The Interbank Market?”
SWIFT. “About Us,”
Euromoney. “FX Survey 2018: Overall Results,”
Learning Center. “Unit A|Absolute Essentials,”
The New York Times. “Rigging Of Foreign Exchange Market Makes Felons of Top Banks,”
Federal Reserve Bank of Richmond. "The Equilibrium Approach To Exchange Rates," Page 12.
Securities and Exchange Commission. "Forex - Foreign Currency Transactions."