The foreign exchange (currency or forex or FX) market
exists wherever one currency is traded for another. It is by far the largest
market in the world, in terms of cash value traded, and includes trading between
large banks, central banks, currency speculators, multinational corporations,
governments, and other financial markets and institutions. The trade happening
in the forex markets across the globe currently exceeds $2.3 trillion/day (on
average). Retail traders (individuals) are currently a very small part of this
market and may only participate indirectly through brokers or banks and may be
targets of forex scams.
History
The forex market is a cash inter-bank or inter-dealer market, which was
established in 1971 [citation needed] when floating exchange rates began to
appear. The foreign exchange market is huge in comparison to other markets. For
example, the average daily trading volume of US Treasury Bonds is $300 billion
and the US stock market has an average daily volume of less than $10 billion.
Ten years ago the Wall Street Journal estimated the daily trading volume in the
forex market to be in excess of $1 trillion. Today that figure has grown to
exceed $1.8 trillion a day.
Prior to 1971 an agreement called the Bretton Woods Agreement prevented
speculation in the currency markets. The Bretton Woods Agreement was set up in
1945 with the aim of stabilizing international currencies and preventing money
fleeing across nations. This agreement fixed all national currencies against the
dollar and set the dollar at a rate of $35 per ounce of gold. Prior to this
agreement the gold exchange standard had been used since 1876. The gold standard
used gold to back each currency and thus prevented kings and rulers from
arbitrarily debasing money and triggering inflation. Institutions like the
Federal Reserve System of the United States have this kind of power.
The gold exchange standard had its own problems however. As an economy grew it
would import goods from overseas until it ran its gold reserves down. As a
result the country’s money supply would shrink resulting in interest rates
rising and a slowing of economic activity to the extent that a recession would
occur.
Eventually the recession would cause prices of goods to fall so low that they
appeared attractive to other nations. This in turn led to an inflow of gold back
into the economy and the resulting increase in money supply saw interest rates
fall and the economy strengthen. These boom-bust patterns prevailed throughout
the world during the gold exchange standard years until the outbreak of World
War I which interrupted the free flow of trade and thus the movement of gold.
After the war the Bretton Woods Agreement was established, where participating
countries agreed to try and maintain the value of their currency with a narrow
margin against the dollar. A rate was also used to value the dollar in relation
to gold. Countries were prohibited from devaluing their currency to improve
their trade position by more than 10%. Following World War II international
trade expanded rapidly due to post-war construction and this resulted in massive
movements of capital. This destabilized the foreign exchange rates that had been
set-up by the Bretton Woods Agreement.
The agreement was finally abandoned in 1971, and the US dollar was no longer
convertible to gold. By 1973, currencies of the major industrialized nations
became more freely floating, controlled mainly by the forces of supply and
demand. Prices were set, with volumes, speed and price volatility all increasing
during the 1970’s. This led to new financial instruments, market deregulation
and open trade. It also led to a rise in the power of speculators.
In the 1980’s the movement of money across borders accelerated with the advent
of computers and the market became a continuum, trading through the Asian,
European and American time zones. Large banks created dealing rooms where
hundreds of millions of dollars, pounds and yen were exchanged in a matter of
minutes. Today electronic brokers trade daily in the forex market, in London for
example, single trades for tens of millions of dollars are priced in seconds.
The market has changed dramatically with most international financial
transactions being carried out not to buy and sell goods but to speculate on the
market with the aim of most dealers to make money out of money.
London has grown to become the world’s leading international financial center
and is the world’s largest forex market. This arose not only due to its
location, operating during the Asian and American markets, but also due to the
creation of the Eurodollar market. The Eurodollar market was created during the
1950’s when Russia’s oil revenue, all in US dollars, was deposited outside the
US in fear of being frozen by US authorities. This created a large pool of US
dollars that were outside the control of the US. These vast cash reserves were
very attractive to foreign investors as they had far less regulations and
offered higher yields.
Today London continues to grow as more and more American and European banks come
to the city to establish their regional headquarters. The sizes dealt with in
these markets are huge and the smaller banks, commercial hedgers and private
investors hardly ever have direct access to this liquid and competitive market,
either because they fail to meet credit criteria or because their transaction
sizes are too small. But today market makers are allowed to break down the large
inter-bank units and offer small traders the opportunity to buy or sell any
number of these smaller units (lots).
Market size and liquidity
Foreign Exchange
Exchange Rates
Currency band
Exchange rate
Exchange rate regime
Fixed exchange rate
Floating exchange rate
Linked exchange rate
Markets
Foreign exchange market
Futures exchange
Products
Currency
Currency future
Forex swap
Currency swap
Foreign exchange option
See also
Bureau de Change
The foreign exchange market is unique because of:
its trading volume,
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,
Global foreign exchange market turnover:
$621 billion spot
$1.26 trillion in derivatives, ie
$208 billion in outright forwards
$944 billion in forex swaps
$107 billion in FX options.
Exchange-traded forex futures contracts were introduced in 1972 at the Chicago
Mercantile Exchange and are actively traded relative to most other futures
contracts. Forex futures volume has grown rapidly in recent years, but only
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 totalled $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 a
day. This was more than ten times the size of the combined daily turnover on all
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.[1]
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 geographic trading centre 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. Other large
centres include the US (with a 18.2% global share), Japan (7.6%) and Singapore
(5.7%) (Chart 2). Most of the remainder was accounted for by trading in Germany,
Switzerland, Australia, Canada, France and Hong Kong.
The ten most active traders account for almost 73% of trading volume, according
to The Wall Street Journal Europe, (2/9/06 p. 20). These large international
banks continually provide the market with both bid (buy) and ask (sell) prices.
The bid/ask spread is the difference between the price at which a bank or market
maker will sell ("ask", or "offer") and the price at which a market-maker will
buy ("bid") from a wholesale customer. This spread is minimal for actively
traded pairs of currencies, usually only 0-3 pips. For example, the bid/ask
quote of EUR/USD might be 1.2200/1.2203. Minimum trading size for most deals is
usually $100,000.
These spreads might not apply to retail customers at banks, which will routinely
mark up the difference to say 1.2100 / 1.2300 for transfers, or say 1.2000 /
1.2400 for banknotes or travelers' checks. Spot prices at market makers vary,
but on EUR/USD are usually no more than 5 pips wide (i.e. 0.0005). Competition
has greatly increased with pip spreads shrinking on the major pairs to as little
as 1 to 1.5 pips.
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