The foreign exchange market (currency, forex, or FX) trades currencies.
It lets banks and other institutions easily buy and sell currencies.
The purpose of the foreign exchange market is to help international trade and investment.
A foreign exchange market helps businesses convert one currency to another.
For example, it permits a U.S. business to import European goods and pay Euros,
even though the business's income is in U.S. dollars.
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
started forming during the 1970s when countries gradually switched to floating exchange
rates from the previous exchange rate regime, which remained fixed as per the Bretton Woods system.
The foreign exchange market is unique because of
* its trading volumes,
* the extreme liquidity of the market,
* its geographical dispersion,
* its long trading hours: 24 hours a day except on weekends (from 20:15 UTC on Sunday until 22:00 UTC Friday),
* the variety of factors that affect exchange rates.
* the low margins of profit compared with other markets of fixed income (but profits can be high due to very large trading volumes)
* the use of leverage
As such, it has been referred to as the market closest to the ideal perfect competition,
notwithstanding market manipulation by central banks. According to the Bank for International
Settlements, average daily turnover in global foreign exchange markets is estimated at $3.98
trillion. Trading in the world's main financial markets accounted for $3.21 trillion of this.
This approximately $3.21 trillion in main foreign exchange market turnover was broken down as follows:
* $1.005 trillion in spot transactions
* $362 billion in outright forwards
* $1.714 trillion in foreign exchange swaps
* $129 billion estimated gaps in reporting.
Wednesday, December 16, 2009
Market size and liquidity
The foreign exchange market is the largest and most liquid financial market in the world.
Traders include large banks, central banks, currency speculators, corporations, governments,
and other financial institutions. The average daily volume in the global foreign exchange and
related markets is continuously growing. Daily turnover was reported to be over US$3.2 trillion
in April 2007 by the Bank for International Settlements. Since then, the market has
continued to grow. According to Euromoney's annual FX Poll, volumes grew a further 41% between
2007 and 2008.
Of the $3.98 trillion daily global turnover, trading in London accounted for around $1.36 trillion,
or 34.1% of the total, making London by far the global center for foreign exchange.
In second and third places respectively, trading in New York accounted for 16.6%, and
Tokyo accounted for 6.0%. In addition to "traditional" turnover, $2.1 trillion was traded in derivatives.
Exchange-traded FX futures contracts were introduced in 1972 at the Chicago Mercantile Exchange
and are actively traded relative to most other futures contracts.
Several other developed countries also permit the trading of FX derivative products
(like currency futures and options on currency futures) on their exchanges.
All these developed countries already have fully convertible capital accounts.
Most emerging countries do not permit FX derivative products on their exchanges
in view of prevalent controls on the capital accounts. However, a few select emerging
countries (e.g., Korea, South Africa, India) have already successfully experimented
with the currency futures exchanges, despite having some controls on the capital account.
FX futures volume has grown rapidly in recent years, and accounts for about 7% of the total
foreign exchange market volume, according to The Wall Street Journal Europe (5/5/06, p. 20).
Foreign exchange trading increased by 38% between April 2005 and April 2006 and has more
than doubled since 2001. This is largely due to the growing importance of foreign exchange
as an asset class and an increase in fund management assets, particularly of hedge funds
and pension funds. The diverse selection of execution venues have made it easier for retail
traders to trade in the foreign exchange market. In 2006, retail traders constituted over
2% of the whole FX market volumes with an average daily trade volume of over US$50-60 billion
(see retail trading platforms). Because foreign exchange is an OTC market where brokers/dealers
negotiate directly with one another, there is no central exchange or clearing house.
The biggest geographic trading centre is the UK, primarily London, which according to IFSL
estimates has increased its share of global turnover in traditional transactions from
31.3% in April 2004 to 34.1% in April 2007. The ten most active traders account for almost
80% of trading volume, according to the 2008 Euromoney FX survey. These large international
banks continually provide the market with both bid (buy) and ask (sell) prices.
The bid/ask spread is the difference between the price at which a bank or market maker
will sell ("ask", or "offer") and the price at which a market taker will buy ("bid") from
a wholesale or retail customer. The customer will buy from the market-maker at the higher
"ask" price, and will sell at the lower "bid" price, thus giving up the "spread" as the
cost of completing the trade. This spread is minimal for actively traded pairs of currencies,
usually 0–3 pips. For example, the bid/ask quote of EUR/USD might be 1.2200/1.2203 on a retail
broker. Minimum trading size for most deals is usually 100,000 units of base currency, which
is a standard "lot".
These spreads might not apply to retail customers at banks, which will routinely mark up the
difference to say 1.2100/1.2300 for transfers, or say 1.2000/1.2400 for banknotes or travelers'
checks. Spot prices at market makers vary, but on EUR/USD are usually no more than 3 pips wide
(i.e., 0.0003). Competition is greatly increased with larger transactions, and pip spreads
shrink on the major pairs to as little as 1 to 2 pips.
Traders include large banks, central banks, currency speculators, corporations, governments,
and other financial institutions. The average daily volume in the global foreign exchange and
related markets is continuously growing. Daily turnover was reported to be over US$3.2 trillion
in April 2007 by the Bank for International Settlements. Since then, the market has
continued to grow. According to Euromoney's annual FX Poll, volumes grew a further 41% between
2007 and 2008.
Of the $3.98 trillion daily global turnover, trading in London accounted for around $1.36 trillion,
or 34.1% of the total, making London by far the global center for foreign exchange.
In second and third places respectively, trading in New York accounted for 16.6%, and
Tokyo accounted for 6.0%. In addition to "traditional" turnover, $2.1 trillion was traded in derivatives.
Exchange-traded FX futures contracts were introduced in 1972 at the Chicago Mercantile Exchange
and are actively traded relative to most other futures contracts.
Several other developed countries also permit the trading of FX derivative products
(like currency futures and options on currency futures) on their exchanges.
All these developed countries already have fully convertible capital accounts.
Most emerging countries do not permit FX derivative products on their exchanges
in view of prevalent controls on the capital accounts. However, a few select emerging
countries (e.g., Korea, South Africa, India) have already successfully experimented
with the currency futures exchanges, despite having some controls on the capital account.
FX futures volume has grown rapidly in recent years, and accounts for about 7% of the total
foreign exchange market volume, according to The Wall Street Journal Europe (5/5/06, p. 20).
Foreign exchange trading increased by 38% between April 2005 and April 2006 and has more
than doubled since 2001. This is largely due to the growing importance of foreign exchange
as an asset class and an increase in fund management assets, particularly of hedge funds
and pension funds. The diverse selection of execution venues have made it easier for retail
traders to trade in the foreign exchange market. In 2006, retail traders constituted over
2% of the whole FX market volumes with an average daily trade volume of over US$50-60 billion
(see retail trading platforms). Because foreign exchange is an OTC market where brokers/dealers
negotiate directly with one another, there is no central exchange or clearing house.
The biggest geographic trading centre is the UK, primarily London, which according to IFSL
estimates has increased its share of global turnover in traditional transactions from
31.3% in April 2004 to 34.1% in April 2007. The ten most active traders account for almost
80% of trading volume, according to the 2008 Euromoney FX survey. These large international
banks continually provide the market with both bid (buy) and ask (sell) prices.
The bid/ask spread is the difference between the price at which a bank or market maker
will sell ("ask", or "offer") and the price at which a market taker will buy ("bid") from
a wholesale or retail customer. The customer will buy from the market-maker at the higher
"ask" price, and will sell at the lower "bid" price, thus giving up the "spread" as the
cost of completing the trade. This spread is minimal for actively traded pairs of currencies,
usually 0–3 pips. For example, the bid/ask quote of EUR/USD might be 1.2200/1.2203 on a retail
broker. Minimum trading size for most deals is usually 100,000 units of base currency, which
is a standard "lot".
These spreads might not apply to retail customers at banks, which will routinely mark up the
difference to say 1.2100/1.2300 for transfers, or say 1.2000/1.2400 for banknotes or travelers'
checks. Spot prices at market makers vary, but on EUR/USD are usually no more than 3 pips wide
(i.e., 0.0003). Competition is greatly increased with larger transactions, and pip spreads
shrink on the major pairs to as little as 1 to 2 pips.
Market participants
Unlike a stock market, the foreign exchange market is divided into levels of access.
At the top is the inter-bank market, which is made up of the largest commercial banks
and securities dealers. Within the inter-bank market, spreads, which are the difference
between the bid and ask prices, are razor sharp and usually unavailable, and not known
to players outside the inner circle. The difference between the bid and ask prices widens
(from 0-1 pip to 1-2 pips for some currencies such as the EUR). This is due to volume.
If a trader can guarantee large numbers of transactions for large amounts, they can demand
a smaller difference between the bid and ask price, which is referred to as a better spread.
The levels of access that make up the foreign exchange market are determined by the size of
the "line" (the amount of money with which they are trading). The top-tier inter-bank market
accounts for 53% of all transactions. After that there are usually smaller banks, followed
by large multi-national corporations (which need to hedge risk and pay employees in different
countries), large hedge funds, and even some of the retail FX-metal market makers.
According to Galati and Melvin, “Pension funds, insurance companies, mutual funds,
and other institutional investors have played an increasingly important role in financial
markets in general, and in FX markets in particular, since the early 2000s.”
(2004) In addition, he notes, “Hedge funds have grown markedly over the 2001–2004
period in terms of both number and overall size” Central banks also participate in
the foreign exchange market to align currencies to their economic needs.
At the top is the inter-bank market, which is made up of the largest commercial banks
and securities dealers. Within the inter-bank market, spreads, which are the difference
between the bid and ask prices, are razor sharp and usually unavailable, and not known
to players outside the inner circle. The difference between the bid and ask prices widens
(from 0-1 pip to 1-2 pips for some currencies such as the EUR). This is due to volume.
If a trader can guarantee large numbers of transactions for large amounts, they can demand
a smaller difference between the bid and ask price, which is referred to as a better spread.
The levels of access that make up the foreign exchange market are determined by the size of
the "line" (the amount of money with which they are trading). The top-tier inter-bank market
accounts for 53% of all transactions. After that there are usually smaller banks, followed
by large multi-national corporations (which need to hedge risk and pay employees in different
countries), large hedge funds, and even some of the retail FX-metal market makers.
According to Galati and Melvin, “Pension funds, insurance companies, mutual funds,
and other institutional investors have played an increasingly important role in financial
markets in general, and in FX markets in particular, since the early 2000s.”
(2004) In addition, he notes, “Hedge funds have grown markedly over the 2001–2004
period in terms of both number and overall size” Central banks also participate in
the foreign exchange market to align currencies to their economic needs.
Banks
The interbank market caters for both the majority of commercial turnover and large amounts
of speculative trading every day. A large bank may trade billions of dollars daily.
Some of this trading is undertaken on behalf of customers, but much is conducted by
proprietary desks, trading for the bank's own account. Until recently, foreign exchange
brokers did large amounts of business, facilitating interbank trading and matching anonymous
counterparts for small fees. Today, however, much of this business has moved on to more
efficient electronic systems. The broker squawk box lets traders listen in on ongoing
interbank trading and is heard in most trading rooms, but turnover is noticeably smaller
than just a few years ago.
of speculative trading every day. A large bank may trade billions of dollars daily.
Some of this trading is undertaken on behalf of customers, but much is conducted by
proprietary desks, trading for the bank's own account. Until recently, foreign exchange
brokers did large amounts of business, facilitating interbank trading and matching anonymous
counterparts for small fees. Today, however, much of this business has moved on to more
efficient electronic systems. The broker squawk box lets traders listen in on ongoing
interbank trading and is heard in most trading rooms, but turnover is noticeably smaller
than just a few years ago.
Commercial companies
An important part of this market comes from the financial activities of companies seeking
foreign exchange to pay for goods or services. Commercial companies often trade fairly small
amounts compared to those of banks or speculators, and their trades often have little short
term impact on market rates. Nevertheless, trade flows are an important factor in the long-term
direction of a currency's exchange rate. Some multinational companies can have an unpredictable
impact when very large positions are covered due to exposures that are not widely known by
other market participants.
foreign exchange to pay for goods or services. Commercial companies often trade fairly small
amounts compared to those of banks or speculators, and their trades often have little short
term impact on market rates. Nevertheless, trade flows are an important factor in the long-term
direction of a currency's exchange rate. Some multinational companies can have an unpredictable
impact when very large positions are covered due to exposures that are not widely known by
other market participants.
Central banks
National central banks play an important role in the foreign exchange markets.
They try to control the money supply, inflation, and/or interest rates and often have
official or unofficial target rates for their currencies. They can use their often
substantial foreign exchange reserves to stabilize the market. Milton Friedman argued that
the best stabilization strategy would be for central banks to buy when the exchange rate
is too low, and to sell when the rate is too high—that is, to trade for a profit based on
their more precise information. Nevertheless, the effectiveness of central bank
"stabilizing speculation" is doubtful because central banks do not go bankrupt if they
make large losses, like other traders would, and there is no convincing evidence that
they do make a profit trading.
The mere expectation or rumor of central bank intervention might be enough to stabilize
a currency, but aggressive intervention might be used several times each year in countries
with a dirty float currency regime. Central banks do not always achieve their objectives.
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 Southeast Asia.
They try to control the money supply, inflation, and/or interest rates and often have
official or unofficial target rates for their currencies. They can use their often
substantial foreign exchange reserves to stabilize the market. Milton Friedman argued that
the best stabilization strategy would be for central banks to buy when the exchange rate
is too low, and to sell when the rate is too high—that is, to trade for a profit based on
their more precise information. Nevertheless, the effectiveness of central bank
"stabilizing speculation" is doubtful because central banks do not go bankrupt if they
make large losses, like other traders would, and there is no convincing evidence that
they do make a profit trading.
The mere expectation or rumor of central bank intervention might be enough to stabilize
a currency, but aggressive intervention might be used several times each year in countries
with a dirty float currency regime. Central banks do not always achieve their objectives.
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 Southeast Asia.
Hedge funds as speculators
About 70% to 90% of the foreign exchange transactions are speculative. In other words,
the person or institution that bought or sold the currency has no plan to actually take
delivery of the currency in the end; rather, they were solely speculating on the movement
of that particular currency. Hedge funds have gained a reputation for aggressive currency
speculation since 1996. They control billions of dollars of equity and may borrow billions
more, and thus may overwhelm intervention by central banks to support almost any currency,
if the economic fundamentals are in the hedge funds' favor.
the person or institution that bought or sold the currency has no plan to actually take
delivery of the currency in the end; rather, they were solely speculating on the movement
of that particular currency. Hedge funds have gained a reputation for aggressive currency
speculation since 1996. They control billions of dollars of equity and may borrow billions
more, and thus may overwhelm intervention by central banks to support almost any currency,
if the economic fundamentals are in the hedge funds' favor.
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