Introduction to Currency Markets
The foreign exchange market represents a globally decentralized marketplace for trading currencies. This includes buying, selling or exchanging currencies at ongoing or pre-determined prices. Central governments, central banks, financial institutions, multi-national corporations and individual speculators are the various market participants.
Currencies trade in an over-the-counter (OTC) market. Brokers negotiate directly with one another, without the presence of any central exchange or clearinghouse. The leading global trading centres include London, New York, Tokyo, Singapore and Hong Kong.
Until the early 1970s, currency trading matched to the demands of large companies. These companies engaged in business transactions internationally across borders. Retail speculative trading and investing was not frequent until then. After the Second World War, economies in Europe were in a fragile state. To help them recover, the Bretton Woods Accord appeared in July of 1944. Several key resolutions came out of the accord. However, it was the “pegging” of currencies to the US dollar that had an impact on the global economy.
Pegging the various foreign currencies against the US dollar made them dependent on the value of the dollar. The latter had a dependency on the gold price. The US Government always had to retain gold reserves. Gold’s value should have been equal to the amount of dollars in circulation across the world.
US President Richard Nixon eliminated the gold standard requirement for the US dollar in 1971 to combat spiralling bullion prices. This action directly contributed to the advent of free-floating exchange rates. The latter is the bedrock of the modern currency OTC market.
How the Currency Market Operates
The major participants in the currency market are large international banks. Hubs like London and New York attract the broadest range of sellers and buyers. Since a currency always trades in pair, the market does not denote any absolute value to a single currency. It instead determines its value relative to another currency. The first currency in any pair is the base currency, relatively quoted to second currency, which is the counter currency. For example, the value of GBP/USD signifies how many dollars can purchase one British pound.
The currency market functions on several tiers. At the very top is the inter-bank market, made up of the largest commercial banks. These banks, in turn, rely on smaller financial firms called “dealers”. They deal with vast volumes of foreign exchange (also known as Forex) trading. Trades between these dealers can amount to billions of dollars in daily turnover. The dealers are part of a network. Since currency trading is beyond the scope of geographical boundaries, there is no single regulatory authority supervising the activities in the market.
Currency Market Instruments
The most popular currency market instruments are spot Forex, Forex futures, Forex options, and currency ETFs.
A spot Forex trade is a two-day delivery transaction. This trade represents a “direct exchange” between the two underlying currencies. As a result, it has the shortest time frame and requires cash rather than a contract. This makes it the most common type of Forex transaction.
Futures, in general, are contracts to buy or sell a specific asset at a defined price at a future date. Forex futures were first introduced on the Chicago Mercantile Exchange in 1972. Since futures contracts represent standardized financial instruments and you can trade them on a centralized exchange, the market is highly regulated, ensuring greater transparency for participants.
An “option” is another derivative instrument. It gives the buyer the right but not the obligation to buy or sell an underlying asset at a defined price on the date of expiration of the options contract. You can trade options on the Chicago Mercantile Exchange. However, the disadvantage, compared to Forex futures, is that liquidity is lower and limited in terms of fewer trading hours.
A currency exchange-traded fund (ETF) provides exposure to a single currency or a group of currencies. ETFs are constructed and managed by financial institutions, who buy and hold the underlying assets in a fund. Shares of the ETF are then listed on an exchange. Here the public can buy and trade these shares just like stocks. The one drawback, however, is that the market for Forex ETFs is not open round the clock. Also, Forex ETFs are subject to trading commissions and other charges.
The currency market is the largest and the most liquid financial market in the world. An April 2016 survey by the Bank for International Settlements found the average daily turnover in the currency market stood at a whopping $5.1 trillion, eclipsing nearly every other asset class. With currencies traded 24 hours a day for five days a week, an endless amount of opportunities are open to investors of all sizes and backgrounds.