Financial markets are not limited to just the equity market; they have a border prospect. Many diverse sets of markets fall under financial markets. Depending upon the risk-taking appetite, requirements, and interest, a trader chooses a financial market to trade.
One such financial market is the foreign exchange market. A foreign exchange market is a place where traders buy/sell various currencies. The forex market remains open from various parts of the world 24 hours. It starts on Sunday at 5 pm EST and closes on Friday at 4 pm EST. On the closing day, that is Friday, the demand for currencies is always higher.
In the forex exchange market, various exchange rates of currencies with floating rates are fixed. An exchange rate in the Forex market is the rate at which one country’s currency can buy another country’s currency. There are mainly two types of currency markets: the interbank market and the retail market. The forex market is the largest financial market in the world, with a daily estimated turnover of $6.6 trillion. A trader’s profit in the forex market depends on the demand and supply of currency pairs (in the forex market, currencies are traded in pairs) he/she is trading in.
An interbank market is a place where the large bank’s trade and exchange currencies with one another. As its highly vibrant market, it is suitable only for a few members like investment banks, hedge funds, etc. The main currency exchange values are being determined in this market.
For the majority of the population like individual companies and traders, over the counter market is the forex market place. There are numerous companies that provide the trading option for currencies online through trading platforms. One thing that the novice forex traders need to keep in mind is the fact that the forex exchange market is not a highly regulated market, and thus traders have to be cautious about their money and investments.
The largest over the counter market (geography-wise) is located in London, the U.K. As a result, most currencies have London’s quoted market rates. The forex exchange trading of the U.K as of April 2019 amounted to be 43.1% of the total trading volume in the world. As a result, London is a prominent forex trading canter across the globe.
Types of Currency Trades
In the Forex exchange market, trading is described as a contract between a buyer and a seller. It involves three types of currency trades; spot market trade, forward market trade, and swap trades. A swap market allows both the stated types of trading. It lets a trader buy a currency pair at the spot market price (current market price) and sell it at an agreed price on a future date in the forward market. It helps swap traders to mitigate the risk involved in the foreign exchange market. Swap traders’ risk becomes limited to the forward price, whereas they take advantage by investing in the spot market.
What is the Interbank Market?
In the interbank market, banks network and trade currencies with one another. It functions with a dealing desk that looks after trading currencies. Banks in this set up are constantly in touch with each other. As a result, they make sure that various exchange rates remain uniform across the globe.
In an interbank market, trades are gigantic; even a minimum trade deal is worth at least $1 million. Though most trades amount between $10 million to $100 million. That’s the reason why exchange rates are fixed in the interbank market.
In the interbank market, as mentioned above, trading takes place in three ways – the spot market, the forward market, and swap trading. In addition to that, banks also trade in the SWIFT (Society for World-Wide Interbank Financial Telecommunications) market. SWIFT market helps banks to transfer the trading transactions related data in a safe, secured, and reliable manner.
In the interbank market, the main reasons why a bank indulges are either for themselves, which is known as proprietary trading or either for their customers or clients. The purpose is to gain profit. It is noted that the customers here refer to governments, large corporations, sovereign wealth funds, hedge funds, and wealthy individuals. Retail investors are not included as it is quite expensive compared to individual foreign exchange trading.
According to Euromoney’s Forex Survey of 2018, below are the top 10 mammoth players of the foreign exchange market.
Name of Investment Bank
Overall Market Share Captured*
|Bank of America Merrill Lynch||6.20%|
Here, Overall Market Share Captured caters to various forms in which a bank indulges in the foreign exchange market like “Non-Financial Corporation”, “Real Money Asset Managers”, “Leveraged Funds”, “FX Trading Platforms”, and “Banks.”
What is Retail Market?
The forex trading market that is open to retail/individual traders that cannot trade in the interbank market is known as the retail market for forex. The first retail market for currency trading was The Chicago Mercantile Exchange which launched the International Monetary Market back in 1971. Apart from this, there are various retail markets for forex trading, like Forex Capital Markets LLC, OANDA, and Forex.com.
Compared to the interbank market, the retail market has more participants, but again, the amount being traded remains higher for the interbank market. Retail market participants are price takers as the currency exchange rates are decided by the interbank participants. Thus, they do not influence the Forex market that much.
Do Central Banks Trade in the Foreign Exchange Market?
Well, unlike the investment/commercial banks, central banks have the responsibility of a nation’s financial health as in many nations, they are responsible for setting the monetary policies and printing money. Thus, central banks are not regular participants of the forex market, but they do influence it magnificently.
The reason behind this influential persona is the fact that central banks across the globe are the largest holders of foreign exchange reserves. For example, the Japanese central bank holds $1.2 trillion, out of which the majority is U.S. dollars. For exports, Japanese businesses get paid in dollars so if the central bank of Japan wants these businesses to reduce their exports; they can sell off these dollars in the forex market which would slump the price of the dollar. It will eventually make exports cheap resulting in lesser profits. Such a procedure would not be this direct though.
Another way a central bank can affect various types of the currency market is through changes in interest rates. One such examples is when the Federal Reserve in 2014 announced that interest rates would be increased in 2015. It led to the value of the dollar hike by 15%. So, in such ways, central banks across the globe have a massive influence on various types of currency markets.
The Forex Manipulation Scandal
Biggest investment banks like JPMorgan Chase, Citigroup, Barclays, and the Royal Bank of Scotland were found guilty for illegally manipulating currency rates in 2014. The process of this manipulation came out and shocked the world.
For the forex market, the WM/Reuters fix price is set at 4 pm London Time every day. So, traders of the stated investment banks used to gather up in online chat rooms and would decide to unload a huge currency position at the same time around. It is noted that the WM/Reuters fixed price is set based on trades taking place in the last minute. By selling the currencies just before a minute of setting price would ensure a lower fixed price. WM/Reuters is also the rate that is used to calculate benchmarks in mutual funds; thus, traders of these banks, as well as other banks, used to benefit as they already were aware of the prices.
Want to Know How the Forex Market Started?
Foreign exchange markets have been in existence for the past 300 years in one form or another. In the beginning, in the U.S, only multinational corporations used to trade in currency markets. It was more to save themselves from the risk involved in trading with other nations. They used to use the forex market to hedge the currency of another country. It was easier to do so as to back than the U.S dollar rate was fixed with gold prices.
The next phase of the foreign exchange market started in 1973 when President Richard Nixon fixed the prices of U.S. dollars with an ounce of gold. It helped in keeping the dollar rates stable at 1/35 of an ounce of gold. When this gold standard was dropped, it led to a fall in the value of the dollar.
Though, in the third phase, the U.S. Dollar Index was established. The purpose was to give businesses the opportunity to hedge their risks, but soon it turned out to be a profit-making instrument for various banks, traders and hedge funds like it is today.
It is noted that the U.S. Dollar Index is used for measuring the dollar’s value in terms of 6 major currencies namely Euro, Japanese Yen, the Canadian Dollar, the British Pound, the Swiss Franc, and the Swedish Krona.
The Last Words
The foreign exchange market is the place where the price of a currency is getting fixed through demand and supply of that currency. There are two types of currency markets in the forex market- the interbank market and the retail market. The interbank market rules the forex market with its large volume chunk traded by the big investment banks.
If you are just starting in this field of currency, you are advised to apply your cautious thinking and start trading with a relatively small amount. You can also try an online dummy account for practicing forex trading, so you can get your hands on forex trading and don’t lose real money. Also, do not fall for the “Get Your Money Doubled in a Month” kind of schemes; money would definitely get double, but theirs, not yours! So be careful and remember, with practice, persistence, and dedication, everything is possible.