Foreign Exchange Market

The Market That Dwarfs the Stock Market

Foreign Exchange Markets
••• Photo by David Silverman/Getty Images

The foreign exchange market is a global online network where traders buy and sell currencies. It has no physical location and operates 24 hours a day, seven days a week.  It sets the exchange rates for currencies with floating rates.

This global market has two tiers. The first is the Interbank Market. It's where the biggest banks exchange currencies with each other. Even though it only has a few members, the trades are enormous.

As a result, it dictates currency values.

The second tier is the over-the-counter market. That's where companies and individuals trade. The OTC has become very popular since there are now many companies that offer online trading platforms. New traders, starting with limited capital, need to know more about forex trading. It’s risky because the forex industry is not highly regulated and provides substantial leverage.

Foreign exchange trading is a contract between two parties. There are three types of trades. The spot market is for the currency price at the time of the trade. The forward market is an agreement to exchange currencies at an agreed-upon price on a future date.  A swap trade involves both. Dealers buy a currency at today's price on the spot market and sell the same amount in the forward market. This way, they have just limited their risk in the future. No matter how much the currency falls, they will not lose more than the forward price.

Meanwhile, they can invest the currency they bought on the spot market.

Interbank Market

The  is a network of banks that trade currencies with each other. Each has a currency trading desk called a dealing desk. They are in contact with each other continuously. That process makes sure exchange rates are uniform around the world.

The minimum trade is one million of the currency being traded. Most trades are much larger, between 10 million to 100 million in value. As a result, exchange rates are dictated by the interbank market.

The interbank market includes the three trades mentioned above. Banks also engage in the SWIFT market.  It allows them to transfer foreign exchange to each other. SWIFT stands for Society for World-Wide Interbank Financial Telecommunications.

to create profit for themselves and their clients. When they trade for themselves, it's called proprietary trading. Their customers include governments, sovereign wealth funds, large corporations, hedge funds, and wealthy individuals. 

Here are 10 biggest players in the foreign exchange market, according to Euromoney's .

BankMarket Share
Citi 10.74%
JP Morgan Chase 10.34%
UBS   7.56%
Bank of America Merrill Lynch   6.73%
Deutsche Bank   5.68%
HSBC   4.99%
Barclays   4.69%
Goldman Sachs   4.43%
Standard Chartered   4.26%
BNP Paribas   3.73%

Manipulation Scandal

In 2014, Citigroup, Barclays, JPMorgan Chase, and The Royal Bank of Scotland pled of currency prices. Here's how they did it.

Traders at the banks would collaborate in online chat rooms.

One trader would agree to build a huge position in a currency, then unload it at 4 p.m. London Time each day. That's when the WM/Reuters fix price is set. That price is based on all the trades taking place in one minute. By selling a currency during that minute, the trader could lower the fix price. That's the price used to calculate benchmarks in mutual funds. Traders at the other banks would also profit because they knew what the fix price would be. 

These traders also lied to their clients about currency prices.  One Barclays trader explained it as the “worst price I can put on this where the customer’s decision to trade with me or give me future business doesn’t change.”  

Retail Market

The Chicago Mercantile Exchange was the first to offer currency trading. It launched the International Monetary Market in 1971.

 Other trading platforms include OANDA, Forex Capital Markets LLC, and Forex.com.

The retail market has more traders than the Interbank Market. But the total dollar amount traded is less. The as much. 

Role of Central Banks

Central banks don't regularly trade currencies in foreign exchange markets. But they have a significant influence. Central banks hold billions in foreign exchange reserves. Japan holds around $1.2 trillion, mostly in U.S. dollars. Japanese companies receive dollars in payment for exports. They exchange them for yen to pay their workers.

Japan, like other central banks, could trade yen for dollars in the when it wants the value to fall. That makes Japanese exports cheaper. Japan prefers to use methods that are more indirect though, such as raising or lowering interest rate to affect the yen's value.

For example, the Federal Reserve announced it would raise interest rates in 2014. That sent the dollar's value up 15 percent, creating an asset bubble.

History

For the past 300 years, there has been some form of a foreign exchange market. For most of U.S. history, the only currency traders were multinational corporations that did business in many countries. They used forex markets to hedge their exposure to overseas currencies. That's because the U.S. dollar was fixed to the price of gold.  According to the gold price history, gold was the only metal the United States used to back up the value of the nation’s paper currency.

The foreign exchange market didn't take off until 1973. That's when President Nixon completely untied the value of the dollar to the price of an ounce of gold. The so-called gold standard kept the dollar at a stable value of 1/35 of an ounce of gold. The history of the gold standard explains why gold was chosen to back up the dollar.

Once Nixon abolished the gold standard, the dollar's value quickly plummeted. The dollar index was established to give companies the ability to hedge this risk. Someone created the U.S. Dollar Index to give them a tradeable platform. Soon, banks, hedge funds, and some speculative traders entered the market. They were more interested in chasing profit than in hedging risks.