The Foreign Exchange

The Foreign Exchange

The foreign exchange (also known as currency, forex or FX) market exists wherever one currency is traded for another. It is considered to be, by far, the largest financial market in the world. It includes trading between central banks, currency speculators, multinational corporations, governments, and other financial markets and institutions. The average daily trade in the global forex market currently exceeds US$1.9 trillion. Individuals or retail traders make up a very small fraction of this market, and can only participate indirectly through brokers or banks.

The foreign exchange market is unique because:

• its trading volume

• the extreme liquidity of the market

• the large number and variety of traders in the market

• its geographical dispersion

• its trading hours - 24 hours a day (except on weekends)

• the variety of factors that affect exchange rates

• According to the BIS, the average daily turnover in traditional foreign exchange markets was estimated at $1,880 billion.

The average daily global turnover in traditional foreign exchange market transactions totaled $2.7 trillion in April 2006 according to IFSL estimates based on semi-annual London, New York, Tokyo and Singapore Foreign Exchange Committee data. The overall turnover averaged around $2.9 trillion a day. This was more than ten times the size of the combined daily turnover on all the world’s equity markets. Foreign exchange trading increased by 38% between April 2005 and April 2006 and has more than doubled since 2001. The increase is due largely to the growing importance of the foreign exchange as an asset class and an increase in fund management assets.

Because foreign exchange is an OTC market where brokers negotiate with each another directly, there is no central exchange or clearing house. The biggest trading center is the UK, primarily London. The London Stock Exchange is the largest exchange in terms of equity trading value, accounting for 36% of European trading turnover and 20% of trading volume, as of June 2007. Unlike a stock market, where all participants have access to the same prices, the forex market is divided into various levels of access. The top access is the inter-bank market, which is made up of the largest investment banking firms. As you descend the levels of access, the difference between the bid and ask prices widens. This is due to volume. If a trader can guarantee large numbers of transactions for large amounts, they can demand a smaller difference between the bid and ask price, which is referred to as a better spread. The levels of access that make up the forex market are determined by the size of the “line”. This is the amount of money with which they are trading. The top-tier inter-bank market accounts for 53% of all transactions. After that, there are usually smaller investment banks, followed by large multi-national corporations, large hedge funds, and even some of the retail forex market makers. Central banks also participate in the forex market to align currencies to their economic needs.