What is forex?
With trades amounting to trillions of dollars each day, the FX market is the world’s largest and most liquid financial market—bigger than stock, bond, and commodity markets. This article aims to explore the structure of the forex market, as well as its major players, and the most commonly traded currency pairs in the market.
Traders new to forex can orientate themselves with our ‘what is forex trading?’ introduction and our guide on ‘how to trade forex’, both of which contain basic concepts and terminology about the forex market that will be referred to on this page.
An introduction to the forex market
A brief history of the market
Alongside the bartering of goods, the concepts of currency and currency exchange have been around for more than a thousand years and have taken many forms. Throughout history, precious objects such as seashells, certain stones, gold, silver, and copper were shaped and minted to be adopted as currency.
In the past century, the first major transformation the forex market underwent occurred in the decades following World War II. The Bretton Woods Agreement between 44 nations fixed the exchange rate of national currencies against the US dollar, while the exchange rate of the US dollar was set against gold.
This agreement was an attempt to stabilise the global economy which had been volatile in the previous decades due to the increase of speculative trading. The agreement led to a standard with which international commerce could operate.
However, post-war prosperity saw a tremendous increase in trading volumes, which led to huge capital movements. The economies of countries around the world began to grow at vastly different speeds, and currencies became over or undervalued compared to the fixed exchange rates. This meant that fixed rates could no longer accurately represent market values, and the agreement was dissolved in the early 1970s.
Immediately following that, the modern forex market emerged as a new currency valuation system. This was the second major transformation for the forex market. The new system had freer market conditions, and exchange rates of currency pairs were driven by supply and demand of currencies instead of being fixed.
The supply and demand were naturally uneven, which meant that foreign exchange rates were in constant fluctuation. People saw potential in making a profit from these fluctuations, and they began participating in trading in the forex market with the intention of making money.
Initially, forex trades were only executed by big speculators and investment funds who had the means and capital. But by the 1990s, advancement in technology had led to the creation of forex trading platforms by banks which encouraged clients to execute trades themselves.
The forex market today
Today, the global forex market is worth trillions of dollars, and forex transactions can be completed in milliseconds with the touch of a finger or the click of a mouse. Almost anybody who wishes to participate in trading can do so, provided they have capital.
As trading becomes more accessible to individuals, more and more people have taken up trading with the aim of turning a profit. However, retail traders only make up a fraction of all forex transactions, and large volumes of daily trades continue to be executed without the specific goal of turning a profit.
For example, currency exchanges by corporations are done with the main purpose of doing business with other corporations and clients abroad. Similarly, investment managers make forex transactions to acquire overseas corporations or to purchase foreign bonds with no intention of benefiting financially from the currency side of the transaction itself.
The forex market structure
The forex market is not centralised nor is it owned by any one individual or entity. Instead, it is made up of many participants who contribute to it, such as banks, hedge funds, investors, corporations, and individuals. Due to this abundance of participants, it is very difficult for any one of them to be able to exert enough dominance over the forex market to manipulate it.
Central banks are also known as national banks, and they have arguably the most power in determining the exchange rate movements of the forex market.
Central banks are responsible for issuing the currency of the country in which they operate and fixing its price on the foreign exchange. They establish national monetary policies, such as the management of the interest and inflation rates of a country, and the regulation of the supply of its currency.
This regulation is done through the central bank’s holding of domestic and foreign currency reserves. Domestic reserves are held in the local currency, while foreign currency reserves can be held in any foreign currency. Most central banks outside of the United States hold their foreign currency reserves in the US dollar, as it is the most traded currency in the world.
Central bank reserves can be thought of as backup funds, and they are readily available to be used to manipulate the forex market as needed to ensure sustainable growth of the country’s economy.
For example, if there is excess demand for a currency in the forex market, it will put pressure on the currency market value to appreciate. In this case, its central bank can relieve this pressure by selling some of its domestic reserves and buying amounts of the currency it has in its foreign currency reserves. This ensures that its exchange rate can be maintained.
Other banks, such as retail and commercial banks, participate in the forex market by trading currencies and currency derivatives on two levels: on behalf of their clients, or on behalf of themselves.
Banks play a big part in forex trading. This is because the nature of forex requires the participation of both buyers and sellers of currencies, but it does not require exchanges to exist in the form of direct transactions between the two parties.
This means that if an individual wants to sell Singapore dollars and buy euros, they will not need to literally seek someone who wants to sell euros for dollars and arrange a trade between themselves. Instead, individuals can reach out to banks, which will act as intermediaries between the two parties. Banks can also take on the role of buyer or seller themselves, in which case they will provide the funds for exchange.
Many banks, large and small, supply foreign exchange for customers as a banking service. These banks are also known as dealers, and their participation in the forex market is part of what makes up the interbank market.
The interbank market is a global network of banks and other financial institutions that trade currencies between each other. It is largely made up of private banks, which handle short- to medium-term transactions that span anywhere from overnight to several months.
Hedge funds and investors
Speculative hedge funds, investors, and investment managers are significant participants in the forex market. These parties generally deal with enormous amounts of a currency to finance purchases of corporations, bonds, and securities around the world, many of them foreign-owned. There are two types of investors, differentiated by the nature of their investments.
The first type of investor invests fully or partially in foreign companies by purchasing at least 10% of its ownership. This is part of Foreign Direct Investment (FDI). This process calls for a demand of a specific currency in order to finalise the purchase, which the forex market supplies in exchange for another currency.
Corporations participate in the forex market when they are involved in the international trade of goods and services. They can be across any industry which has branches or production plants around the world, or which does business with other corporations from abroad. They can also be businesses with international clients and partnerships with other firms.
These corporations participate in the forex market every time they make an international transaction. This could be the buying of raw materials from suppliers abroad, or the selling of goods and services to international clients. For corporations with production plants outside of their home country, they will need to exchange currencies in order to pay local workers.
Additionally, financial corporations such as brokers participate in the forex market by directly dealing in foreign exchange. Brokers act as intermediaries between traders they take on as clients, with the aim of helping them obtain the best quotes. This could be done through obtaining the buying and selling prices of two currencies from several forex dealers.
Individuals who participate in the forex market can be separated into two types: those who trade forex intending to turn a profit, who are also known as retail traders, and those who make forex transactions without that aim.
Retail traders seek to make a profit by taking advantage of fluctuations in the forex market. They can be individuals who trade as a day job or as a hobby, and their strategies and techniques vary depending on personal preferences.
Retail traders can trade on platforms provided by forex brokers, who can also facilitate trading on margin, known as leveraged trading, which is a way for traders to increase the exposure of a position they open.
Learn more about leveraged trading
There are also individuals who participate in the forex market without intending to turn a profit. Most commonly, these are tourists who travel internationally, exchanging currencies for local spending at their destination. For example, a Singaporean tourist who visits Japan and sells their Singapore dollars to buy Japanese yen will have made a forex transaction.
Although these currency exchanges take place on a smaller scale, with smaller amounts of currency being bought and sold at a time, there are large numbers of travellers who travel internationally each day, and their exchanges add up.
Which currencies are traded most in forex?
Major currencies such as the US dollar, the euro, and the Japanese yen, are most traded in the forex market due to their stability. This is derived from their high liquidity and low volatility. In other words, these currencies are stable for two main reasons: they are abundant in the forex market, and they are derived from countries with strong economies that are less prone to financial intervention.
The major currencies in forex, in no particular order, are the US dollar (USD), the Canadian dollar (CAD), the Swiss franc (CHF), the euro (EUR), the Australian dollar (AUD), the New Zealand dollar (NZD), and the Japanese yen (JPY).
Out of these major currencies, the US dollar is the most commonly traded. It accounts for the vast majority of trades that take place daily in the forex market. This is because major currency pairs are the most traded in the market, and all of them are derived from quoting a major currency against the dollar. These include EURUSD, AUDUSD, and USDJPY.
Learn more about the types of currencies and currency pairs
One of the reasons for the US dollar’s strength and high participation in forex trading is because it is the global foreign exchange reserve currency, as designated by the International Monetary Fund (IMF).
A reserve currency, also known as a global currency, is a currency that is universally accepted for trade around the world. As such, it has high liquidity and can be seamlessly traded internationally. Reserve currencies are held in large quantities by central banks, monetary authorities, and major financial institutions, and they help to facilitate global commerce.
Following the dollar is the euro, as the world’s second most commonly held reserve currency. The euro is involved in a significant number of trades in the forex market. This is because it is a shared currency between 19 countries, including Germany, Italy, and France, all three of which have relatively stable economies and a high number of forex traders.
Comprised of the two most frequently traded currencies, it is unsurprising that EURUSD is the most traded currency pair in the forex market.
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