Although we are not aware of it, the foreign exchange market has a profound impact on our daily lives, from the most obvious currency exchange we have to do when we visit a foreign country, to the way the prices of our products, and sometimes even wages, fluctuate due to variation of the value of our currencies in relation to those of other countries. countries with which we do business. Even the money under your mattress continually changes value!
What is the foreign exchange market?
We define a market as a place where people can meet to buy or sell things, whether tangible like a food market or virtual like websites like eBay.
There are some well-established financial markets in the world, such as the New York Stock Exchange (NYSE) and the Chicago Mercantile Exchange (CME) located physically, or electronic markets such as NASDAQ. In these markets, traders can trade stocks, commodities, bonds, or currencies. In the foreign exchange market, also known as forex tradingbuyers and sellers have a place to exchange Dollars, Euros, Pounds, Yen, etc.
But why is there a need for a forex market? The forex market is an important tool to allow trading to take place between different currencies. Imagine, for example, the Chinese manufacturer that has an order for ten thousand T-shirts from a European wholesaler. Most likely, the Chinese manufacturer wants to be paid in US dollars by the European wholesaler, that he will have to change his euros to US dollars to pay the Chinese manufacturer. At the same time, the Chinese manufacturer will have to buy cotton on the cotton market, which is traded in US dollars. In the end, this manufacturer will probably change the US dollars of profits into Chinese yuan, to spend on goods and salaries in China, or maybe he is thinking of opening a business in England, so he will change some of his US dollars. to pounds sterling. Without a foreign exchange market, none of these transactions could be done fairly. Having a free market where thousands of participants can decide on the value of an asset is the most logical and fair way to value anything.
The foreign exchange market provides the machinery to make international payments, to transfer purchasing power from one currency to another, and to ensure that the relative value of each currency is clear and universal.
There were even money changers in Ancient Greece, but currency exchange as we know it has come a long way since then. Since the 1970s, profound structural changes have occurred in the financial system and the world economy:
- A change in the international monetary system, from the fixed exchange rate specified in the Bretton Woods agreements, at floating exchange rates in the early 1970s to the present day
- financial deregulation around the world, resulting in greater freedom for financial transactions and increased competition among financial institutions.
- Liberalization of international trade, within multilateral trade agreements. Huge expansion of international capital transactions.
- Enormous advances in technologyallowing the instant transmission of market information, and the fast and reliable execution of financial transactions.
- The development of new financial instruments and advances in understanding the financial system.
All of these provide fertile ground for the development of forex trading.
In the first decade of the 21st century, the great technological advances in Internet Transaction-based trading has allowed the small retail trader to easily access the forex market, traditionally the domain of global banks.
Who are the participants?
Because you will be trading with them (or maybe against them), it is very important to know who the players are in the forex market:
At the top of the hierarchy is a group of large banks whose operations massively affect exchange rates. They are connected for this trading through two electronic services, EBS and Reuters Dealing. These banks form a network known as the interbank market, which is the center of the Forex Market, and from which the exchange rates offered by your dealer are derived. These big banks trade for customers, but also for the banks’ own accounts (known as proprietary desksor simply “prop desks”).
Governments and Central Banks they are a special type of participants, since they cause changes in the prices of exchange rates due to their monetary or fiscal policy, especially with interest rate changes.
dealers Y runners provide customers with access to the foreign exchange market, charging them a portion of the spreadhas commission, or both. They make their profits through these charges, but very often they also hold positions against their own clients. In the worst cases, they also benefit from misleading customers, shadowing the price, increasing order execution zones, or using requotes or slippage when there was no actual price slippage. These practices are why many people prefer to trade only on regulated markets and why you should be careful when choosing a dealer.
The difference between intermediaries and brokers is that brokers only give access to the interbank market (some of the banks they work with by acting for them as liquidity providers), sending your order to the market, while the distributors do not send your order to the market, but give you compensation. Note that many so-called ECN brokers use this denomination mainly for advertising purposes, but they will also give you a counterparty unless your orders (or the sum of several client orders) reach the minimum acceptable in the interbank market, 10 lots. or 1 million units. .
The rest of the participants in the foreign exchange market could generally be classified into two categories: financial traders and speculators. Although people who make financial transactions must participate in the foreign exchange market as part of their general business, speculators do it expressly for the money.
Financial traders are primarily hedgers and financial investors. As financial traders, companies participate in the foreign exchange market to coverage currency risk to protect profits, while financial investors Need to exchange currencies to make international investments. Therefore, their business is in other places than the foreign exchange market, but they need to serve themselves from this market to manage their business and reduce risks.
Secondly, speculatorswhich generates about 90% of the forex volume, are those participants whose main objective is to profit from their views on the market. hedge funds, CTA or the already mentioned bank support tables are the big ones in this category, while the little ones retail traders They are usually found at the bottom of the forex pyramid.
punctual effects
When we talk about trading Forex, we generally refer to only one type of product, the place, which means that the trade is made with the price that is traded now, or “on the spot”. It is the operation of the current exchange price, with a settlement of a maximum of two days. Spot is the most traded commodity in the foreign exchange market, with $1.5 trillion in volume out of a total of $4 trillion traded each day, according to figures from the 2010 survey by The Bank for International Settlements ( BIS), the international supervisor for banks around the world. opposes others forex instruments such as forwards or swaps in which in these products settlements are made on any pre-agreed date three or more business days after the trading date.
Apart from these Over the counter (OTC) products, we could find two Forex products on organized exchanges: currency futures and currency options.
Main characteristics of the Forex market
Why would you like to trade FX? The forex market has some features that make it very attractive to traders, such as high liquidity, low trading costs, or the ability to trade at any time.
First of all, the Forex market is a unregulated market, also known as OTC (over the counter). Being unregulated means that it does not have a central market or a regulator that dictates prices and rules, but rather is made up of a series of banks and intermediaries that allow trade between participants, allowing each bank or intermediary to decide its own prices.
For many people, this is the main disadvantage of the foreign exchange market, due to the opportunity for dealers to manipulate prices. But, at the same time, this deregulation generates competition among dealers by offering tighter spreads and better service.
However, being a regulated market does not mean being free from price manipulation. It simply means that the manipulation can only be done by the market regulator, like the CME in futures markets, which has a monopoly on the market rules and can change them at any time.
Because it is an unregulated market, FX does not have a strict predefined schedule, but it is possible to trade it every day at any time, largely avoiding the risk of gap opening, which is so important in other markets. In practice, due to a large drop in liquidity due to bank closures, weekends used to be non-tradable because there are often no big moves and the spread is very wide due to very low liquidity. Also, because their liquidity providers (the banks) are closed, most forex brokers use this time for server maintenance and close between the close of the Friday New York session and the opening of the Friday session. Monday in Wellington and Sydney. So it is better to take advantage of the weekend to unwind and refresh your head, and to plan and prepare for the next trading week.
Thesis sessions they are practically defined due to the opening hours of the banks in each time zone. The week is widely considered to start with the Monday opening of banks in Wellington and the rest of the Asian areas, and close when New York closes on Friday afternoon. Also this means that when banks are closed (holidays) in an area, liquidity drops during that time. The session in which more volume is involved is the European (or London) session, mainly due to the coincidence with the last hours of the Asian session and the opening hours of the American session.
Another important feature of the foreign exchange market is its high liquidity, which allows for low operating costs. It is common for dealers not to charge a direct commission; this does not mean that it is free, but this commission is included in the spread between the offer price and the sale price.
The Forex market is also a market with a large number of instruments to trade, so it is possible to diversify and scan the market for the best opportunities. There are four major currency pairs (EUR/USD, USD/JPY, GBP/USD, and USD/CHF) that account for just over half of all daily trading volume. Minor pairs (USD/CAD, AUD/USD, and NZD/USD) round out the major trading pairs that include the US dollar. Pairs that consist of two currencies other than USD are called cross currency pairs or crosses (for example, EUR/GBP, NZD/JPY, or GBP/NOK).
I hope this article has been helpful, and thanks for reading.