Introduction
The foreign exchange market is, by most accounts, the oldest, largest, and most extensive financial market in the world. The foreign exchange (currency or forex or FX) market exists wherever one currency is traded for another. It is by far the largest financial market in the world, and includes trading between large banks, central banks, currency speculators, multinational corporations, governments, and other financial markets and institutions. The average daily trade in the global forex and related markets currently is over US$ 3 trillion.
Foreign exchange consists of trading one type of currency for another. Unlike other financial markets, the FX market has no physical location and no central exchange. It operates “over the counter” through a global network of banks, corporations and individuals trading one currency for another. The FX market is the world’s largest financial market, operating 24 hours a day with enormous amounts of money traded on a daily basis.
Unlike any other financial market, investors can respond to currency fluctuations caused by economic, political and social events at the time they occur, without having to wait for exchanges to open. Access to modern news services, charting services, 24- hour dealing desks and sophisticated online electronic trading platforms has seen speculation in the FX market explode, particularly for the individual trader.
The currency markets are not new. They’ve been around for as long as banks have been doing business. What is relatively new is the accessibility of these markets to the individual speculator, particularly the small- to medium-sized trader.
History of foreign exchange markets
Foreign exchange markets originally developed to facilitate cross border trade conducted in different currencies by governments, companies and individuals. While these markets primarily existed to provide for the international movement of money and capital, even the earliest markets had speculators.
Today, an enormous proportion of FX market activity is being driven by speculation, arbitrage and professional dealing, in which currencies are traded like any other commodity.
Traditionally, retail investors’ only means of gaining access to the foreign exchange market was through banks that transacted in large amounts of currencies for commercial and investment purposes. Trading volume has increased rapidly over time, especially after exchange rates were allowed to float freely in 1971.
From 1944 until 1971, most of the world’s major currencies were pegged to the US dollar under an arrangement called the Bretton Woods Agreement. Participating countries agreed to try and maintain the value of their currency with a narrow margin against the US dollar and a corresponding rate of gold, as needed. These countries were prohibited from devaluing their currencies to gain a foreign trade advantage. Consequently, the foreign exchange market was relatively static.
Characteristics of foreign exchange markets
- Barter exchange (Double coincidence of wants): In the foreign exchange market, for anybody wanting to sell dollars to get British pound, there must be someone else wanting to sell the pound for the dollar at the same exchange rate (like in barter exchange). The FE market performs an international clearing function by bringing two parties wishing to trade currencies at agreeable exchange rates.
- The FE market takes place between dealers and brokers in financial centers around the world. During the hours of business common to different time zones, they rapidly exchange shorthand messages expressing their bids for different currencies. To make a profit on FE maneuvers, a trader or broker has to make quick decisions correctly. Foreign exchange traders lead an exciting and hectic life, and the pressure often shortens many careers.
- The fastest possible communications are used. Before the trans-Atlantic cable was laid in 1865, somebody wanting to exchange dollars for pounds often had to wait the time required for a roundtrip voyage to clear up the transaction. Modern telephone links have reduced the transaction costs on foreign exchange to near zero for large transactions.
The situation of the market
Although participants in the foreign exchange market are increasingly scattered around the globe, most transactions still take place in London, New York, and Tokyo. London dominates the foreign exchange markets, with 30 percent of all transactions; New York’s share is 16 percent. Tokyo’s share, now 10 percent, has been whittled away by the markets of Singapore and Hong Kong, which are fast gaining prominence.
Singapore has become the world’s fourth largest foreign exchange market, and Hong Kong has overtaken Switzerland to become the fifth largest. Even though 56 percent of the world’s foreign exchange transactions are executed in the three largest financial centers, between one-half and three-fourths of daily turnover is cross-border during the centers’ business hours, suggesting that one side of many transactions occurs outside of their business hours.
Market concentration
Nearly two-thirds of daily foreign exchange transactions take place between bank dealers. About 16 percent of transactions involve nonfinancial customers, an increasingly diverse group. Originally, this group consisted primarily of customers executing transactions related to trade; it now includes international investors, speculators, and other new players. The remaining 20 percent of transactions involve financial institutions other than bank dealers, mostly securities firms active in the international debt and equity markets that have entered the foreign exchange market as intermediaries, providing one-stop shopping for their customers.
Despite the growing diversity of customers, market concentration has increased since 1992, as the proportion of trading carried out by the top banks continues to rise. This trend is most evident in the smaller markets, which are being abandoned by foreign banks seeking to consolidate their business in the major centers, but it is also being seen in the major centers. Between 1992 and 1995, the market share of the top ten dealers in Tokyo rose from 44 percent to 51 percent, in New York from 41 percent to 47 percent, and in London from 43 percent to 44 percent.
The top 20 banks accounted for 70 percent of daily foreign exchange transactions in New York in 1995, up from 60 percent in 1992, and 68 percent in London, up from 63 percent in 1992. The picture of the foreign exchange market that emerges from the 1995 survey resembles the flight map of a growing airline, in which the hubs are getting bigger and the spokes more numerous–and market participants are increasingly interconnected.
Liquidity
The foreign exchange market is highly liquid–transactions tend to be large and are executed frequently. A typical dealing institution writes between 3,000 and 4,000 trading tickets for foreign exchange transactions during an average 24-hour day, and about 50 percent more than that on a busy day. Quoted prices can change 20 times a minute for major currencies, with the dollar-deutsche mark rate changing up to 18,000 times during a single day. During periods of extreme stress, a single dealer may execute a trade every two to four minutes. Single transactions worth between $200 million and $500 million are not uncommon in the foreign exchange market and, at most times, do not affect prices.
While often overshadowed by the spot market, there is a growing and vibrant derivatives market based on foreign exchange. Over-the-counter (OTC) derivative contracts involving foreign exchange accounted for 37 percent of the estimated $47.5 trillion in outstanding notional principal of derivatives contracts at the end of March 1995, as reported by the first BIS survey of derivatives. Since notional principal provides information only about the outstanding face value of the contracts being held and not about their economic value, the BIS estimates their gross market value as well. Foreign exchange contracts account for 64 percent of the gross market value of $2.2 trillion, which itself represents roughly 5 percent of reported notional principal.
Of total OTC derivative contracts, 6 percent were foreign exchange options contracts. While this is still a relatively small percentage, there is keen interest in foreign exchange options products. The hedging strategies of many “exotic” and “plain vanilla” options require the continuous buying and selling of the underlying currencies to maintain risk-free hedges. Thus, they are often written on the most liquid foreign currencies, increasing the volumes traded in the spot market.
The advantages of the Foreign Exchange Market
The daily volume of business dealt with on the foreign exchange markets in 1998 was estimated to be over $2.5 trillion dollars. (Daily volume on New York Stock Exchanges is about $20 billion) Today (2006) it may be about $5 trillion dollars. The daily volume of the foreign exchange market in North America in October 2005 was about $440 billion. The Foreign Exchange market expanded considerably since President Nixon closed the gold window and currencies were left afloat vis-á-vis other currencies and speculators could profit from their transactions.
Until recently, this market was used mostly by banks, who fully appreciated the excellent opportunities to increase their profits. Today, it is accessible to any investor enabling him to diversify his portfolio.
The emergence of Yen as a major currency, and new Euro, in addition to the Dollar beside many other currencies, and the frequent fluctuations in relative value of these currencies provide a great opportunity to generate substantial profits. Chinese Renminbi is convertible on current account, but not on capital account. When it becomes fully convertible, which is not likely to occur until 2020 or later, it will fundamentally affect the foreign exchange market due to its sheer volume. The foreign exchange market operates 24 hours a day permitting intervention in the major international foreign exchange markets at any point in time.
Summary
- Foreign exchange consists of trading one type of currency for another. Not only is it the world’s largest financial market, but unlike any other financial market, investors can respond to currency fluctuations caused by economic, political and social events at the time they occur without having to wait for exchanges to open.
- An enormous proportion of FX market activity is driven by speculation, arbitrage and professional dealing, in which currencies are traded like any other commodity.
- CMC Markets is the world pioneer of online margin FX trading., executing the very first online margin FX trade in 1996 and was the driving force behind retail investors accessing global currency trading on interbank spreads, previously only available to major institutions.
References
- “The Foreign Exchange Market”. Web.
- Adam Kobor and Istvan P. Szekely, “Foreign Exchange Market Volatility in EU Accession Countries in the Run-Up to Euro Adoption: Weathering Uncharted Waters”. Web.
- Yin-Wong Cheung, “The Hong Kong Foreign Exchange Market”. Web.