The foreign exchange market (forex, FX, or currency market) is a global, worldwide decentralized financial market for trading currencies. Financial centers around the world function as anchors of trading between a wide range of different types of buyers and sellers around the clock, with the exception of weekends. The foreign exchange market determines the relative values of different currencies.
The primary purpose of the foreign exchange is to assist international trade and investment, by allowing businesses to convert one currency to another currency. For example, it permits a US business to import British goods and pay Pound Sterling, even though the business’ income is in US dollars. It also supports direct speculation in the value of currencies, and the carry trade, speculation on the change in interest rates in two currencies.
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 began forming during the 1970s after three decades of government restrictions on foreign exchange transactions (the Bretton Woods system of monetary management established the rules for commercial and financial relations among the world’s major industrial states after World War II), 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 huge trading volume representing the largest asset class in the world leading to high liquidity;
- its geographical dispersion;
- its continuous operation: 24 hours a day except weekends, i.e. trading from 20:15 GMT on Sunday until 22:00 GMT Friday;
- the variety of factors that affect exchange rates;
- the low margins of relative profit compared with other markets of fixed income; and
- the use of leverage to enhance profit and loss margins and with respect to account size.
As such, it has been referred to as the market closest to the ideal of perfect competition, notwithstanding currency intervention by central banks. According to theBank for International Settlements, as of April 2010, average daily turnover in global foreign exchange markets is estimated at $3.98 trillion, a growth of approximately 20% over the $3.21 trillion daily volume as of April 2007. Some firms specializing on foreign exchange market had put the average daily turnover in excess of US$4 trillion.
The $3.98 trillion break-down is as follows:
- $1.490 trillion in spot transactions
- $475 billion in outright forwards
- $1.765 trillion in foreign exchange swaps
- $43 billion Currency swaps
- $207 billion in options and other products
Market Size and liquidity
The foreign exchange market is the most liquid financial market in the world. Traders include large banks, central banks, institutional investors, currency speculators, corporations, governments, other financial institutions, and retail investors. The average daily turnover in the global foreign exchange and related markets is continuously growing. According to the 2010 Triennial Central Bank Survey, coordinated by the Bank for International Settlements, average daily turnover was US$3.98 trillion in April 2010 (vs $1.7 trillion in 1998). Of this $3.98 trillion, $1.5 trillion was spot foreign exchange transactions and $2.5 trillion was traded in outright forwards, FX swaps and other currency derivatives.
Trading in the UK accounted for 36.7% of the total, making UK by far the most important global center for foreign exchange trading. In second and third places, respectively, trading in the USA accounted for 17.9%, and Japan accounted for 6.2%.
Turnover of exchange-traded foreign exchange futures and options have grown rapidly in recent years, reaching $166 billion in April 2010 (double the turnover recorded in April 2007). Exchange-traded currency derivatives represent 4% of OTC foreign exchange turnover. FX futures contractswere introduced in 1972 at the Chicago Mercantile Exchange and are actively traded relative to most other futures contracts.
Most developed countries 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. A number of emerging countries do not permit FX derivative products on their exchanges in view of controls on the capital accounts. The use of foreign exchange derivatives is growing in many emerging economies. Countries such as Korea, South Africa, and India have established currency futures exchanges, despite having some controls on the capital account.
| Rank | Name | Market share |
|---|---|---|
| 1 |  Deutsche Bank |
15.64% |
| 2 |  Barclays Capital |
10.75% |
| 3 |  UBS AG |
10.59% |
| 4 |  Citi |
8.88% |
| 5 | JPMorgan |
6.43% |
| 6 | HSBC |
6.26% |
| 7 | Royal Bank of Scotland |
6.20% |
| 8 | Credit Suisse |
4.80% |
| 9 | Goldman Sachs |
4.13% |
| 10 | Morgan Stanley |
3.64% |
Foreign exchange trading increased by 20% between April 2007 and April 2010 and has more than doubled since 2004. The increase in turnover is due to a number of factors: the growing importance of foreign exchange as an asset class, the increased trading activity of high-frequency traders, and the emergence of retail investors as an important market segment. The growth of electronic execution methods and the diverse selection of execution venues have lowered transaction costs, increased market liquidity, and attracted greater participation from many customer types. In particular, electronic trading via online portals has made it easier for retail traders to trade in the foreign exchange market. By 2010, retail trading is estimated to account for up to 10% of spot FX turnover, or $150 billion per day (see retail trading platforms).
Because foreign exchange is an over-the-counter (OTC) market where brokers/dealers negotiate directly with one another, there is no central exchange or clearing house. The biggest geographic trading center is the UK, primarily London, which according to TheCityUK estimates has increased its share of global turnover in traditional transactions from 34.6% in April 2007 to 36.7% in April 2010. Due to London’s dominance in the market, a particular currency’s quoted price is usually the London market price. For instance, when the International Monetary Fund (IMF) calculates the value of its Special Drawing Rights (SDRs) every day, they use the London market prices at noon that day.
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 not known to players outside the inner circle. The difference between the bid and ask prices widens (for example from 0-1 pip to 1-2 pips for a currencies such as the EUR) as you go down the levels of access. 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 interbank market accounts for 53% of all transactions. From there, 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 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. Many large banks may trade billions of dollars, daily. Some of this trading is undertaken on behalf of customers, but much is conducted by proprietary desks, which are trading desks for the bank’s own account. Until recently, foreign exchange brokers did large amounts of business, facilitating interbank trading and matching anonymous counterparts for large 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 mosttrading 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.