What is the Forex Market?

The Foreign Exchange Market is the hub of all money flow around the world. The Forex Market enables corporations, banks, financial institutions, governments and individual investors and speculators to trade just about anything in the currency of the asset they are wanting to trade. Without the Forex Market money couldn’t flow between countries. It is essentially the ‘glue’ or ‘hub’ that enables international trade. Because of this it is the world’s largest financial market. Current estimates put daily turnover at USD5 Trillion for 2016, according to the Bank of International Settlements. Some predictions indicated that by 2020 it will reach USD10 Trillion.

Forex Market Turnover - Bank of International Settlements

What is the function of the Forex Market?

The Forex Market facilitates international trade where businesses and individuals need to transact in foreign currencies to their own.

Business Transactions

An example of this would be Qantas. The Australian national airline wishes to buy an aircraft from Boeing the American aircraft manufacturer. Qantas operating currency is the Australian Dollar (AUD) and the operating currency of Boeing is the US Dollar (USD). Qantas needs to convert AUD into USD. So it will contact its bank to facilitate this transaction. Their bank will convert their AUD into USD in the forex marketplace to pay Boeing for their product.

Individual Transactions

This would be a similar transaction as an individual going from the UK to the USA on holiday. They will need to convert UK Pounds (GBP) to US Dollars (USD) to enable them to buy products and services whilst they are in the USA.

These two participants in the Forex market are an important part. However by far the largest proportion of the daily Forex Market turnover is what is known as Capital Market Transactions.

Capital Market Transactions

Capital Markets, generally known as the Financial Markets include such markets as Real Estate, Stocks (Equities), Treasury Bonds (Fixed Income), Commodities (Oil, Gold, Silver and Copper) and Derivatives. We’ll tackle explanations of these individual markets in a later article. Markets such as Stocks.Equities are found in all countries that trade stocks. So there are US Equities, European Equities to name a few. To enable investment managers to quickly sell let’s say European Equities which are in Euros and buy US Equities. They need to convert from EUR to USD to facilitate that change in asset allocation. It’s converted using what’s known as the Spot Forex Market, which is in essence immediate exchange of currencies. There are other methods to allow you to ‘order your rate’ in advance and these are Currency Forwards, Futures and Options. A future article will cover these.

So as you can see money is continually moving around the world. It is this global money flow that makes the Forex Market so huge, and understanding the global money flow is critical to success in the Forex Market.

Who are the Forex Market Participants?

Those that use the Forex Market are very diverse from Institutions, Governments to Individual Investors such as retail traders. The Forex Market began to emerge in 1978 when the worldwide currencies could ‘float’ in accordance with ‘Supply and Demand’. Originally it was the sole domain of the banks and central banks, as various reforms, regulation and technological changes occurred over the years. This eliminated the credit risk when the forex market opened up to literally anyone and hence the boom in the forex market in recent years. Whilst all transactions still go through the largest FX banks such as Citigroup, UBS and Deutsche Bank, known as the ‘Sell Side’ ie they sell the fx financial products to the ‘Buy Side’ those participants that buy those FX products. It is these that we’re interested in.

The buy side participants are (in no order of importance):

Corporations

These are corporations such as Qantas as mentioned above transacting cross-border purchases.

Investment Managers and Bankers

These are institutional investors such as Pension Funds, Insurance Companies, Mutual Funds Exchange Traded Funds (ETF’s), Hedge Funds, Proprietary Trading Firms, Commodity Trading Advisors (CTA’s) and the Proprietary Traders at the banks.

Governments

Governments also need the FX Market to enable them to buy and sell such items as military equipment.

Central Banks

Whilst Central Banks do not commonly use the FX market they need access to it to enable them to manage and maintain Monetary Policy, they may intervene. Why are the Government and Central Banks in different categories? Central Banks are responsible for managing Monetary policy with any political interference, so they act alone from their government in implementing monetary policy.

So it can be seen from the above market players that the Forex Market is diverse and creates an extremely dynamic marketplace creating opportunities everyday for forex traders.

The latest survey by BIS was April 2016.

Forex Market Infrastructure?

Knowing who are the majority of the participants is key to understanding the movement in the forex market.

Non Centralised Market – Over The Counter

The Forex Market is a non-centralised market. Unlike Stocks bought and sold through a central exchange like the New York Stock Exchange where all trades pass through, the Forex Market is an Over The Counter (OTC) market, that means is all transactions go through the major banks known as the Interbank. This also means there is no way to see the volume of trading happening at any one time. To be able to monitor the activities in the Forex Market the Bank of International Settlements undertake a survey every three years from participating central banks and report on the activity in the Forex Market.

Interbank

Ever since the collapse of the Bretton Woods Agreement in 1974. The Forex Market has been essentially an unregulated market. It is now self regulated when servicing their clients with the banks competeing in price with each other.

The Triennial Central Bank Survey captures the turnover of foreign exchange instruments in spot and OTC derivatives markets. These statistics are collected every three years during the month of April and reported on an unconsolidated basis, by the sales desks of reporting dealers.
Bank of International Settlements