Picture this: you're planning a vacation abroad and need to exchange your country's currency for the one used at your destination. You go to your local bank, exchange your money, and go about your day. But have you ever stopped to wonder about the intricate web of transactions and participants that take place in the foreign exchange market every second of every day?
The forex market is the largest financial market in the world, with a daily trading volume exceeding $6 trillion. But who are the players in this market, and how does it function? Let's break it down:
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Forex market: how does it work?
Let's break down how the Forex market works:
- Trading currency pairs: In the Forex market, physical currencies are not exchanged. Instead, currencies are traded in pairs, such as the Pound (GBP) and the US Dollar (USD). Traders speculate on the future direction of these currency pairs. They buy a currency pair if they believe the base currency will appreciate relative to the quote currency, and sell if they think the opposite.
- Making profit: The goal is to profit from the appreciation or depreciation of one currency against another. If a trader believes the Pound will strengthen against the US Dollar, they would buy the GBP/USD pair. They're not actually buying Pounds or selling Dollars; instead, they're expressing a view on the exchange rate between the two currencies. If the Pound does indeed strengthen, they can sell the pair for a profit.
- Simultaneous buying and selling: It's important to understand that every transaction in the Forex market involves the simultaneous buying of one currency and selling of another. So, if you're buying the GBP/USD pair, you're buying Pounds and selling US Dollars at the same time.
- Trading from home: Thanks to modern technology, anyone can trade Forex from home. All you need is a trading account with a broker such as Skilling that operates in the Forex market.
- Market hours: The Forex market mostly operates nearly 24 hours a day, five days a week, with the exception of weekends. However, some brokers such as Skilling allow for Forex trading during weekends. This makes it highly accessible for traders around the globe.
- Liquidity and spreads: The Forex market is the most liquid market in the world, meaning currencies can be bought and sold in large amounts without significantly impacting their price. This high liquidity often results in lower spreads (the difference between the buying and selling price) compared to other markets, making it more cost-effective for traders.
History of Forex market
The history of the Forex market is fascinating and steeped in economic and political shifts.
Here's a brief overview:
Gold standard system: Prior to World War I, currencies were pegged to precious metals, primarily gold and silver. This was known as the Gold Standard System. The value of a currency was determined by its specific amount of gold or silver.
Bretton Woods System: Post-World War II, the Gold Standard System collapsed. In 1944, representatives from 44 nations met in Bretton Woods, New Hampshire, to devise a new monetary system. The Bretton Woods Agreement resulted in the creation of three international organisations to facilitate worldwide economic activity:
- International Monetary Fund (IMF): To promote global monetary cooperation and secure financial stability.
- General Agreement on Tariffs and Trade (GATT): To regulate international trade.
- International Bank for Reconstruction and Development (IBRD): To provide loans for reconstruction and development projects.
Under the Bretton Woods system, the U.S. dollar replaced gold as the standard for international currencies. The value of other currencies was pegged to the U.S. dollar, which was convertible into gold at a fixed rate. This made the U.S. dollar the world's primary reserve currency.
End of Bretton Woods system: However, this system could not sustain itself. In 1971, U.S. President Richard Nixon announced the "temporary" suspension of the dollar's convertibility into gold, which effectively ended the Bretton Woods system. This event is often referred to as the "Nixon Shock".
Modern Forex market: Post-Bretton Woods, currencies became free-floating, meaning their values were no longer tied to gold or the U.S. dollar. Instead, currency values are determined by supply and demand dynamics in the international Forex market. This marked the beginning of the modern Forex market as we know it today.
Types of Forex markets
The Forex market is divided into three key types: spot, forward, and futures markets. Each type operates in a slightly different way and serves different purposes.
- Spot Forex market: This is the most straightforward type of Forex market. In the spot market, currencies are bought and sold 'on the spot', meaning trades are settled immediately, or 'on the spot'. The exchange rate at which the transaction is done is called the spot exchange rate. The spot market accounts for a significant portion of currency trading and involves key participants such as commercial, investment, and central banks, as well as dealers, brokers, and speculators. Large commercial and investment banks play a major role in spot trades, trading not only for themselves but also for their customers.
- Forward Forex market: The forward market, on the other hand, deals with contracts for currency exchanges that will occur at a future date. These contracts specify the amount of currency to be exchanged, the exchange rate, and the future date of the exchange. The primary purpose of the forward market is to hedge against future currency risks. For example, an American company expecting to pay a British supplier in pounds six months from now might enter a forward contract to buy pounds at a specified rate to protect against the possibility of the pound appreciating in the meantime. However, forward markets lack centralised trading and are relatively illiquid due to the participation of just two parties. Additionally, there's counterparty risk — the risk that the other party will default on the contract.
- Futures Forex market: Futures markets are similar to forward markets in terms of basic functionality — they both deal with currency exchanges set to occur in the future. However, the crucial difference is that futures contracts are traded on centralised exchanges. This eliminates counterparty risk, as the exchange guarantees the completion of the trade. Futures contracts are standardised in terms of quantity and settlement date, making them more liquid than forward contracts. They are commonly used by speculators and hedgers who want to take advantage of price fluctuations or protect against potential price shifts in the currency market.
Who controls the Forex market?
Here are some of the major participants in the Forex market:
- Commercial banks: These entities play a dual role. They provide a channel for their clients to participate in the market and also trade on their own behalf. Proprietary trading desks within these banks speculate to make profits. Post the 2008 financial crisis, proprietary trading has reduced due to increased risk aversion but still exists, especially in less regulated countries.
- Hedge funds: These are the major speculators in the market, with global macro funds and currency funds being the most active. They can handle large market positions and are key participants in the Forex market.
- Retail traders: These are individual traders who usually access the market through a retail broker. With small amounts of money, they can open a trading account and utilise leverage.
- Sovereign wealth funds: State-owned investment funds that manage a country's wealth and invest in various markets. These funds, typically found in countries with large foreign currency inflows like Qatar or Kuwait, manage huge amounts and could significantly impact the Forex market.
- Proprietary trading firms: These firms hire individual traders to trade the company’s money and share a portion of the profits. Traders benefit from professional tools, a network of fellow traders, and capital allocation that can reach significant amounts for successful traders.
- Money transfer/remittance companies: Companies like Western Union and MoneyGram use the Forex market to facilitate cross-border transactions. They purchase and sell currencies to enable international money transfers.
- Commercial companies: Multinational companies like Apple or Toyota engage in Forex trading to pay for goods and services and to manage risk associated with currency fluctuations.
- Governments and Central banks: Central banks like the U.S. Federal Reserve and European Central Bank trade currencies to balance exchange rates and control inflation. Their actions can significantly influence currency values.
Summary
Remember: while the Forex market offers great opportunities, it also comes with significant risks. It's crucial to understand the market dynamics and have a solid trading plan and risk management plan before diving in.
