Introduction to the Currency Market

Although we may not be aware of it, the currency market has a deep impact on our everyday life, from the most obvious currency exchange we have to do when visiting a foreign country, to the way our goods prices and sometimes even salaries fluctuate due to the variance of value of our currencies relative to those of foreign countries with which we do business. Even the money under your mattress is continually changing in value!

What is the currency market?

We define a market as a place where people could meet each other for buying or selling things, be they tangible like in a food market, or virtual like web sites such as eBay.

There are in the world some well established financial markets like the physically located New York Stock Exchange (NYSE) and the Chicago Mercantile Exchange (CME), or electronic based markets like NASDAQ. In these markets traders are able to exchange shares, commodities, bonds, or currencies. On the currency market, also known as forex market, buyers and sellers have a place to exchange Dollars, Euros, Pounds, Yen, etc.

But why is there a need for a foreign exchange market? The forex market is an important tool for allowing business transactions be done between different currencies. Imagine, for example, the Chinese manufacturer who has an order of ten thousand t-shirts from a European wholesaler. The Chinese manufacturer, most probably will want to be paid on US dollars from the European wholesaler, who will have to change its euros to US dollars to pay the Chinese manufacturer. At the same time the Chinese manufacturer will need to buy cotton on the cotton market, traded in US dollars. In the end, this manufacturer probably will change the US dollars of profit to Chinese yuans, to spend it on goods and salaries in China, or maybe he or she is thinking of opening a business on England, so will change some of his US dollars to British pounds. Without a currency market, none of these transactions could be made fairly. Having a free market where thousands of participants could decide on the value of an asset is the most logical and fair way to give anything a value.

The foreign exchange market provides the machinery for making international payments, for transferring purchasing power from one currency to another, and ensuring that the relative value of each currency is clear and universal.

There were even money changers in Ancient Greece, but the foreign exchange as we know it has evolved a lot since then. Since the 1970’s, deep structural changes have occurred in the world financial system and economy:

  • A change in the international monetary system, from the fixed exchange rate specified on the Bretton Woods agreements, to the floating exchange rates in the early 70s ’til our days
  • Financial deregulation through the world, resulting in higher freedom for financial transactions and increased competition among financial institutions.
  • International trade liberalization, within multilateral trade agreements. Enormous expansion of international capital transactions.
  • Huge advances in technology, allowing instantaneous transmission of market information, and fast and reliable execution of financial transactions.
  • The development of new financial instruments and advances in the understanding of the financial system.

All of these provide fertile ground for development in foreign exchange trading.

In the first decade of the 21st century, the great technological advances in internet based trading have enabled the small retail trader easy access to the forex market, traditionally the domain of global banks.

Who are the participants?

Because you will trade with (or perhaps against) them, it’s very important to know who are the players in the currency market:

On the top of the hierarchy there are a group of major banks whose trades massively affect exchange rates. They are connected for this trading through two electronic services, EBS and Reuters Dealing. These banks form a network known as the interbank market, which is the center of the Forex Market, and from where is derived the exchange rates your dealer offers you. These major banks trade for costumers, but also for the banks’ own accounts (what is known as proprietary desks, or just “prop desks”).

Governments and Central Banks are special kind of participants, as they cause changes on the exchange rates prices due to their monetary or fiscal policy, especially with interest rate changes.

Dealers and Brokers provide clients access to the forex market, charging them a part of the spread, a commission, or both. They make their profits through these charges, but very often also maintain positions against their own costumers. In the worst cases, they also profit from cheating the costumers, shading the price, spiking zones to run orders, or using requotes or slippage when there was no real slippage of the price. These practises are the reason many people prefer to trade just on regulated markets, and why you should be careful when choosing a dealer.

The difference between dealers and brokers is that brokers just give you access to the interbank market (to some of the banks they work with acting for them as liquidity providers), sending your order to the market, while dealers don’t send your order to the market, but give you counterpart. Have in mind that many so-called ECN brokers use this denomination mainly for advertising purposes, but will give you also counterpart unless your orders (or the sum of various customer orders) reach the minimum acceptable in the interbank, 10 lots or 1 million units.

The rest of the participants in the forex market generally could be classified on two categories: financial transactors and speculators. While financial transactors need to participate in the FX market as part of their overall business, speculators are in it expressly for the money.

Financial transactors mainly are hedgers and financial investors. As financial transactors, corporations participate in the FX market to hedge the risk of currency change to protect benefits, while financial investors need to exchange currencies to make international investments. So their business is on other places than the forex market, but they need to serve themselves from this market to run their business and reduce risks.

On the other side, speculators, who makes about the 90% of the forex volume, are those participants whose primary aim is to obtain profits from their views on the market. Hedge Funds, CTAs or the already cited bank’s prop desks are the big boys on this category, while the small retail traders usually find themselves at the bottom of the forex pyramid.

Spot FX

When we talk about Forex trading usually we refer to just one kind of product, the spot, which means that the trade is done with the price which is traded now, or “on the spot”. It is the trade of the current exchange price, with a settlement of a maximum of two days. Spot is the most traded product in the FX market, with a volume of 1.5$ trillion from a total of 4$ trillions traded every day, based on the figures of the 2010 survey of The Bank for International Settlements (BIS), the international supervisor for banks around the world. It opposes other forex instruments like forwards or swaps in that in these products the settlements take place on any pre-agreed date three or more business days after the deal date.

Apart from these Over The Counter (OTC) products, we could find two Forex products in organized exchanges: currency futures and currency options.

Main characteristics of the Forex market

Why would you like to trade on FX? The forex market has some characteristics that make it very attractive for traders, like huge liquidity, low trading costs, or the chance to trade at any hour.

First of all, the Forex market is an unregulated market, also known as OTC (over the counter). Being unregulated means that it has not a central market nor regulator that dictates prices and rules, but instead is formed by a number of banks and dealers that permit the trading between participants, allowing each bank or dealer to decide its own prices.

For many people this is the main disadvantage of the forex market, because of the dealers’ opportunity to manipulate prices. But, at the same time, this unregulation creates competitivity between the dealers for offering tighter spreads and better service.

Anyway, being a regulated market doesn’t mean being free of price manipulation. It just means that the manipulation can only be done by the regulator of the market, like the CME on the future markets, having the monopoly of the market rules, and being able to change them at any moment.

Because it’s a non regulated market, FX doesn’t have a strict predefined schedule, but it is possible to trade it every day at every hour, avoiding in great part the opening gap risk so important in other markets. In practice, because of a big liquidity drop due to the closing of banks, weekends used to be non tradeable because there are often no big moves and the spread is very wide due to very low liquidity. Also, because their liquidity providers (the banks) are closed, most of the forex brokers use this time for server maintenance, and close between the close of the Friday NY session, and the open of the Wellington and Sydney Monday session. So it’s better to take advantage of the weekend to disconnect and refresh the head, and to plan and prepare the next trading week.

These sessions are practically defined due to the open hours of banks in every timezone. It’s widely considered that the week starts with the Monday opening of the Wellington banks and the rest of the Asian zones, and closes when New York closes Friday afternoon. Also this means that when banks are closed (bank holidays) in a zone, liquidity drops during that time. The session in which more volume is involved is on the European (or London) session, mainly due to the overlap with the last hours of the Asian session, and the opening hours of the American session.

Another important characteristic of the FX market is the huge liquidity, which permits low operational costs. It’s usual that dealers don’t charge a direct commission; this doesn’t mean it’s free of charge, but this commission is included in the spread between the bid and ask price.

The Forex market is also a market with a great number of instruments to trade, so it’s possible to diversify and to scan the market to look for the best opportunities. There are four major currency pairs (EUR/USD, USD/JPY, GBP/USD and USD/CHF) that involve a little more than half of all daily trading volume. The minor pairs (USD/CAD, AUD/USD and NZD/USD) complete the principal trading pairs that include the U.S. dollar. Those pairs that consist of two non-USD currencies are called cross-currency pairs, or crosses (for example EUR/GBP, NZD/JPY or GBP/NOK).

Hope this article has been of help, and thanks for reading.

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