Welcome to the Foreign exchange marketThe 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.
Market size and liquidity
The foreign exchange market is unique because of• its trading volumes,
• the extreme liquidity of the market
• the large number of, and variety of, traders in the market
• its geographical dispersion
• its long trading hours: 24 hours a day (except on weekends)
• 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 leverage)
As such, it has been referred to as the market closest to ideal competition. Average daily turnover in traditional foreign exchange markets is estimated at $3.21 trillion. Daily averages in April for different years, in billions of US dollars, are presented on the chart above:
Exchange-traded forex futures contracts were introduced in 1972 on the Chicago Mercantile Exchange and are actively traded relative to most other futures contracts. Forex 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).
Average daily global turnover in traditional foreign exchange market transactions totaled $2.7 trillion in April, 2006, according to IFSL estimates based on semi-annual London, New York, Tokyo and Singapore Foreign Exchange Committee data. Overall turnover, including non-traditional foreign exchange derivatives and products traded on exchanges, averaged around $2.9 trillion per day. This was more than ten times the size of the combined daily turnover on all of the world's equity markets. 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 such as Internet trading platforms has also made it easier for retail traders to trade in the foreign exchange market.
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 trading center geographically 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 32.4% in April 2006 (RPP).
The inter-bank market caters to 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 inter-bank 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 inter-bank trading and is heard in most trading rooms, but turnover is noticeably smaller than just a few years ago.
Commercial companiesAn 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.
Central banksNational 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.
Investment management firmsInvestment management firms (which typically manage large accounts on behalf of customers such as pension funds and endowments) use the foreign exchange market to facilitate transactions in foreign securities. Some investment management firms also have more speculative specialist currency overlay operations, which manage clients' currency exposures with the aim of generating profits as well as limiting risk. While the number of these types of specialist firms is quite small, many have a large value of assets under management (AUM), and hence can generate large trades.
Hedge fundsHedge 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.
Retail forex brokersThere are two types of retail brokers: brokers offering speculative trading and brokers offering physical delivery i.e. the purchased currency is delivered to a bank account.