Basics of FX

Introduction

The Foreign Exchange market (FX market) is a global over-the-counter (OTC) financial market for trading currencies. It is the largest market in the world, regardless of industry, with a daily value of transactions in excess of US$4 trillion.

The FX market trades around the clock from Monday morning New Zealand opening time (Sunday 20.30GMT), to Friday closing time in NYC (22.00 GMT), thus being open for almost 122 hours per week. Financial centres around the world act as hubs allowing a wide range of market participants to electronically trade with each other.

The main objective of the FX market is to assist international trade and investment, by allowing businesses to convert one currency to another currency. The FX market also supports direct speculation on the value of currencies and speculation on the change between short term interest rates of the two currencies in question.

The modern foreign exchange market was formed in the 1970s. After three decades of government restrictions on foreign exchange transactions countries gradually switched to floating exchange rates from the previous exchange rate regime, which remained fixed as per the Bretton Woods system. The Bretton Woods system of monetary management established the rules for commercial and financial relations among the world's major industrial states after World War II.

Market size

As previously stated, the FX market is the largest and most liquid market in the world. The size of the market has grown from around US$ 1.5 trillion per day in the late 90’s to over US$ 4 trillion as of 2010 and it continues to grow at a brisk pace.

Some interesting statistics on market size:

• Around 85% of daily flow (or 6 out of 7 units of currency traded anywhere) is a result of speculation and investment flows rather than commercial flows of international trade. Thus currencies are a very large and important asset class on their own.
• UK centres accounted for over 35% of global currency flows in 2010, making the UK the most important region in the market.
• Exchanged traded FX futures and options have also grown rapidly in recent years accounting for $160 billion as of 2010.
• The market size has increased by 30% in the last four years alone since the credit crisis of 2007.
• Retail FX trading and speculation has risen exponentially in the last 5-6 years amounting to a daily flow of close to $200 billion per day, or over 10% of total spot FX flows.

Instruments

The key foreign exchange products are:

Spot

A spot transaction is a two-day delivery transaction except in the case of trades between the US Dollar (USD), Canadian Dollar (CAD), Turkish Lira (TRY), Euro (EUR) and Russian Ruble (RUB), which settle the next business day. A spot trade represents a “direct exchange” between two currencies, has the shortest time frame, involves cash rather than a contract, and interest is not included in the agreed-upon transaction.

Forward

One way to deal with the foreign exchange risk is to engage in a forward transaction. This can be a transaction with a value date in the future, in fact any date up to three years. Funds do not actually change hands until the agreed upon future date. A buyer and seller agree on an exchange rate for any date in the future, and the transaction occurs on that date, regardless of what the market rates are then.

Swap

One of the most common types of forward FX transactions is a swap. In an FX swap, two parties exchange currencies for a certain length of time and agree to reverse the transaction at a later date. These are not standardised contracts and are not traded through an exchange. Swaps aid the extension of forward positions when they come due and also effectively act as collateralised foreign currency loans. Currency swaps are very popular.

Futures

Futures are standardised and are usually traded on an exchange created for this purpose. The average contract length is roughly 3 months. Futures contracts are usually inclusive of any interest amounts.

FX Options

A foreign exchange option (commonly shortened to just FX option) is a derivative product where the owner has the right but not the obligation to exchange one currency into another at a pre-agreed exchange rate on a specified date. The FX options market is the deepest, largest and most liquid market for options of any kind in the world.

Key Participants & Access

There is a wide range of market participants in the FX market. Starting from the top of the pyramid, the inter-bank market, sovereign investment authorities and reserve managers down to the smallest cash traders, the market can be split into the following categories:

• The Interbank market
• Central Banks, Reserve Managers and other Sovereign Institutions
• Commercial companies and other corporate entities
• Investment, Pension and Insurance companies
• Hedge funds and other professional speculating entities
• Retail investors and speculators

The Interbank Market

The interbank market is the wholesale currency market, where the majority of all currency transactions are handled. It serves the majority of commercial financial transactions as well as large amounts of speculative trading every day. Many large international banks may trade tens of billions of dollars, daily. Some of this trading is undertaken on behalf of customers, but much is conducted by proprietary desks, which are trading desks for the bank's own account, partaking in speculative trading of FX for their own gain.

Banks can be further split into the top-tier international banks that make up the interbank market; these are roughly 20-25 players globally and smaller second tier banks that operate and provide liquidity and market access to their own regional or national level.

Brokers also belong in this section. These are mostly commercial corporate entities whose sole purpose is to facilitate trading between counterparties for a fee. There are large interbank-only brokerage companies and also smaller ones, whose role is to provide market access to entities that otherwise wouldn’t have access to the top tier banks, such as mid-sized corporate companies, high net worth individuals etc. At the lower end of that scale one also finds the various money transfer companies, bureau de changes, etc.

Central Banks, Reserve Managers and other Sovereign institutions

National central banks play an important role in the foreign exchange markets. They try to control the money supply, inflation, and/or interest rates and often have official or unofficial target rates for their currencies. They can use their often substantial foreign exchange reserves to stabilize the market. Because of the size of their involvement, banks often try to keep central bank activity in the market under cover as otherwise it can have a large multiplying effect that can drive the market away from the central bank counterparty. For example, if the Bank of China (BOC), with reserves worth US $ 2.6 trillion, comes to the market to buy €5 billion, the BOC’s counterparty, who is selling the EUR to the BOC, will try and keep the transaction quiet from the market so to allow enough time to buy those EUR back before the market goes higher.

Commercial Companies and other Corporate Entities

An important part of the FX market comes from the financial activities of companies seeking foreign exchange to pay for goods or services or hedge themselves against adverse currency movements of future expected payables or receivables. Commercial companies often trade fairly small amounts compared to those of banks or speculators, and their trades often have little short term impact on market rates. Nevertheless, trade flows are an important factor in the long-term direction of a currency's exchange rate. Some multinational companies can have an unpredictable impact when very large positions are covered due to exposures that are not widely known by other market participants.

Investment, Pension and Insurance companies

These are also corporate entities whose main business activity is the investment and management of funds aiming at a longer term investment horizon and low to minimum risk. Their foreign exchange exposures arise from investing and diversifying in global portfolios whose assets are denominated in many currencies, whilst their liability profile usually remains in their home currency. Overall the FX flows arising from investment companies’ operations are substantial.

Hedge funds and other professional speculating entities

We mentioned above that 6 out of 7 currency units traded daily are speculative. A large part of the reason for this has been the growth of hedge funds or other professional speculators, a relatively new industry that has grown rapidly over the last 15 years because of an increasing desire for higher investment performance. Hedge funds control a huge amount of money and have the capacity to borrow more. Their investment patterns suit higher risk/return profiles and are thus not a suitable investment vehicle for everyone. In currency terms, they certainly are, collectively, the biggest player in the market today. Their usually short term trading patterns and style does have a major influence on currency valuations and, more importantly, the path leading to any given level.

Retail investors and speculators

Individual retail speculative traders constitute a growing segment of the market in the last few years with the advent of retail FX platforms, both in size and importance. Currently, the daily flow this market produces is estimated at over US$ 200 billion daily, or around 5% of the total market. World-Markets, like a number of brokers, operate from the UK under FSA regulations where FX trading using margin is part of the wider over-the-counter derivatives trading industry that includes CFDs and financial spread betting.

There are two main types of retail FX brokers offering the opportunity for speculative currency trading and spread betting. These are broker dealers and market makers. Broker dealers serve as an agent of the customer in the broader FX market, by electronically seeking the best price in the market and matching the customer order to the market. They charge a minimal commission or mark-up in addition to the price obtained in the market. Market makers, by contrast, typically act as principal in the transaction versus the retail customer, and quote a price they are willing to deal at. Market makers have occasionally caused controversy over accusations of running orders against customers and aiming to profiteer by customers’ losing positions. World-Markets is solely a broker dealer.

Terminology & Market Conventions

Currencies are traded against one another. Each currency pair thus constitutes an individual trading product and is traditionally noted XXXYYY or XXX/YYY, where XXX and YYY are the ISO 4217 international three-letter code of the currencies involved. The first currency (XXX) is the base currency that is quoted relative to the second currency (YYY), the term currency. For instance, the quotation EURUSD (EUR/USD) 1.4205 is the price of the euro expressed in US dollars, meaning 1 euro = 1.4205 US dollars. The market convention is to quote most exchange rates against the USD with the US dollar as the base currency (e.g. USDJPY, USDCAD, and USDCHF). The exceptions are the British pound (GBP), Australian dollar (AUD), the New Zealand dollar (NZD) and the euro (EUR) where the USD is the term currency (e.g. GBPUSD, AUDUSD, NZDUSD, EURUSD).

The currency pair values are quoted in 4 decimal places (e.g. GBPUSD 1.6117), the fourth and last decimal place called a “pip”. So if GBPUSD spot had moved higher by 30 “pips” from a rate of 1.6117, that would make the rate 1.6147 and would mean that the GBP had strengthened as 1 GBP would now be buying 0.3 more USD cents. It follows that one pip is different to 1 basis point, unless the currency pair is valued at 1.0000 (like occasionally USDCAD or USDCHF).

There is no unified or centrally cleared market for the majority of FX trades, and there is very little cross-border regulation. Due to the over-the-counter (OTC) nature of currency markets, there are rather a number of interconnected marketplaces, where different currency instruments are traded. This implies that there is not a single exchange rate but a number of different rates (prices), depending on what bank or market maker is trading, and where it is. In practice the rates are often very close, otherwise they could be exploited by arbitrageurs instantaneously.

The main trading centres in the FX market in order of significance are London, New York, Tokyo, Singapore, Hong Kong, Sydney and smaller centres Zurich and Dubai are also worth a mention. The spread of key locations allows the FX market to operate throughout all time zones on a 24/5 basis as mentioned earlier; as the Asian trading session ends, the European session begins, followed by the North American session and then back to the Asian session, excluding weekends.

Fluctuations in exchange rates are usually caused by actual monetary flows as well as by expectations of changes in monetary flows caused by changes in fundamental and other macroeconomic conditions. See our fundamentals page for more information on key fundamental factors affecting FX markets and also the main economic data releases that we go through in detail.

On the spot market, according to the 2010 Triennial Survey, the most heavily traded bilateral currency pairs were: EURUSD: 28%, USDJPY: 14% and GBPUSD (called Cable): 9%.

The USD is part of 84.9% of all FX transactions, followed by the euro (39.1%), the yen (19.0%), and sterling (12.9%). Note that volume percentages for all individual currencies should add up to 200%, as each transaction involves two currencies.

Trading in the euro has grown considerably since the currency's creation in January 1999, and how long the foreign exchange market will remain US dollar-centred is open to debate. Until recently, trading the euro versus a non-European currency which we’ll call ZZZ would have usually involved two trades: EURUSD and USDZZZ. The exceptions to this are EURJPY, EURGBP and EURCHF, which have always been established traded currency pairs in the interbank spot market. As the dollar's value has eroded during 2008, interest in using the euro as reference currency for prices in commodities (such as oil), as well as a larger component of foreign reserves by banks, has increased dramatically (to what is still quite a small %). Transactions in the currencies of commodity-producing countries, such as AUD, NZD, CAD, have also increased as well as the importance of their financial centres, Sydney in particular.