Global decentralized trading of international currencies

Forex redirects here. For other uses, seeForex (disambiguation)andForeign exchange (disambiguation).

Theforeign exchange market(Forex,FX, orcurrency market) is a globaldecentralizedorover-the-counter (OTC)market for the trading ofcurrencies. This market determinesforeign exchange ratesfor every currency. It includes all aspects of buying, selling and exchanging currencies at current or determined prices. In terms oftrading volume, it is by far the largest market in the world, followed by theCredit market.1

The main participants in this market are thelarger international banksFinancial centersaround the world function as anchors of trading between a wide range of multiple types ofbuyersand sellers around the clock, with the exception of weekends. Since currencies are always traded in pairs, the foreign exchange market does not set a currencys absolute value but rather determines its relative value by setting the market price of one currency if paid for with another. Ex: US$1 is worth X CAD, or CHF, or JPY, etc.

The foreign exchange market works throughfinancial institutionsand operates on several levels. Behind the scenes, banks turn to a smaller number of financial firms known as dealers, who are involved in large quantities of foreign exchange trading. Most foreign exchange dealers are banks, so this behind-the-scenes market is sometimes called theinterbank market(although a few insurance companies and other kinds of financial firms are involved). Trades between foreign exchange dealers can be very large, involving hundreds of millions of dollars. Because of the sovereignty issue when involving two currencies, Forex has little (if any) supervisory entity regulating its actions.

The foreign exchange market assists international trade and investments by enabling currency conversion. For example, it permits a business in theUnited Statesto import goods fromEuropean Unionmember states, especiallyEurozonemembers, and payEuros, even though its income is inUnited States dollars. It also supports direct speculation and evaluation relative to the value of currencies and thecarry tradespeculation, based on the differential interest rate between two currencies.2

In a typical foreign exchange transaction, a party purchases some quantity of one currency by paying with some quantity of another currency.

The modern foreign exchange market began forming during the 1970s. This followed three decades of government restrictions on foreign exchange transactions under theBretton Woods systemof monetary management, which set out the rules for commercial and financial relations among the worlds major industrial states afterWorld War II. Countries gradually switched tofloating exchange ratesfrom the previousexchange rate regime, which remainedfixedper the Bretton Woods system.

The foreign exchange market is unique because of the following characteristics:

its huge trading volume, representing the largest asset class in the world leading to highliquidity;

its continuous operation: 24 hours a day except for weekends, i.e., trading from 22:00GMTon Sunday (Sydney) until 22:00 GMT Friday (New York);

the variety of factors that affectexchange rates;

the low margins of relative profit compared with other markets of fixed income; and

the use ofleverageto enhance profit and loss margins and with respect to account size.

As such, it has been referred to as the market closest to the ideal ofperfect competition, notwithstandingcurrency interventionbycentral banks.

According to theBank for International Settlements, the preliminary global results from the 2019 Triennial Central Bank Survey of Foreign Exchange and OTC Derivatives Markets Activity show that trading in foreign exchange markets averaged $6.6trillionper day in April 2019. This is up from $5.1 trillion in April 2016. Measured by value, foreign exchange swaps were traded more than any other instrument in April 2019, at $3.2 trillion per day, followed by spot trading at $2 trillion.3

Currency trading and exchange first occurred in ancient times.4Money-changers (people helping others to change money and also taking a commission or charging a fee) were living in theHoly Landin the times of theTalmudicwritings (Biblical times). These people (sometimes called kollybistẻs) used city stalls, and at feast times theTemples Court of the Gentilesinstead.5Money-changers were also the silversmiths and/or goldsmiths6of more recent ancient times.

During the 4th century AD, theByzantinegovernment kept a monopoly on the exchange of currency.7

Papyri PCZ I 59021 (c.259/8 BC), shows the occurrences of exchange of coinage inAncient Egypt.8

Currency and exchange were important elements of trade in the ancient world, enabling people to buy and sell items like food,pottery, and raw materials.9If a Greek coin held more gold than an Egyptian coin due to its size or content, then a merchant could barter fewer Greek gold coins for more Egyptian ones, or for more material goods. This is why, at some point in their history, most world currencies in circulation today had a value fixed to a specific quantity of a recognized standard like silver and gold.

During the 15th century, theMedicifamily were required to open banks at foreign locations in order to exchange currencies to act on behalf oftextilemerchants.1011To facilitate trade, the bank created thenostro(from Italian, this translates to ours) account book which contained two columned entries showing amounts of foreign and local currencies; information pertaining to the keeping of an account with a foreign bank.12131415During the 17th (or 18th) century, Amsterdam maintained an active Forex market.16In 1704, foreign exchange took place between agents acting in the interests of theKingdom of Englandand theCounty of Holland.17

Alex. Brown & Sonstraded foreign currencies around 1850 and was a leading currency trader in the USA.18In 1880, J.M. do Esprito Santo de Silva (Banco Esprito Santo) applied for and was given permission to engage in a foreign exchange trading business.1920

The year 1880 is considered by at least one source to be the beginning of modern foreign exchange: thegold standardbegan in that year.21

Prior to the First World War, there was a much more limited control of international trade. Motivated by the onset of war, countries abandoned the gold standard monetary system.22

From 1899 to 1913, holdings of countries foreign exchange increased at an annual rate of 10.8%, while holdings of gold increased at an annual rate of 6.3% between 1903 and 1913.23

At the end of 1913, nearly half of the worlds foreign exchange was conducted using thepound sterling.24The number of foreign banks operating within the boundaries ofLondonincreased from 3 in 1860, to 71 in 1913. In 1902, there were just two London foreign exchange brokers.25At the start of the 20th century, trades in currencies was most active inParisNew York CityandBerlin; Britain remained largely uninvolved until 1914. Between 1919 and 1922, the number of foreign exchange brokers in London increased to 17; and in 1924, there were 40 firms operating for the purposes of exchange.26

During the 1920s, theKleinwortfamily were known as the leaders of the foreign exchange market, while Japheth, Montagu & Co. and Seligman still warrant recognition as significant FX traders.27The trade in London began to resemble its modern manifestation. By 1928, Forex trade was integral to the financial functioning of the city. Continental exchange controls, plus other factors in Europe andLatin America, hampered any attempt at wholesale prosperity from tradeclarification neededfor those of 1930s London.28

In 1944, theBretton Woods Accordwas signed, allowing currencies to fluctuate within a range of 1% from the currencys par exchange rate.29In Japan, the Foreign Exchange Bank Law was introduced in 1954. As a result, theBank of Tokyobecame the center of foreign exchange by September 1954. Between 1954 and 1959, Japanese law was changed to allow foreign exchange dealings in many more Western currencies.30

U.S. President,Richard Nixonis credited with ending the Bretton Woods Accord and fixed rates of exchange, eventually resulting in a free-floating currency system. After the Accord ended in 1971,31theSmithsonian Agreementallowed rates to fluctuate by up to 2%. In 196162, the volume of foreign operations by the U.S. Federal Reserve was relatively low.3233Those involved in controlling exchange rates found the boundaries of the Agreement were not realistic and so ceased thisclarification neededin March 1973, when sometime afterwardclarification needednone of the major currencies were maintained with a capacity for conversion to gold,clarification neededorganizations relied instead on reserves of currency.3435From 1970 to 1973, the volume of trading in the market increased three-fold.363738At some time (according toGandolfoduring FebruaryMarch 1973) some of the markets were split, and a two-tier currency marketclarification neededwas subsequently introduced, with dual currency rates. This was abolished in March 1974.394041

Reuters introduced computer monitors during June 1973, replacing the telephones andtelexused previously for trading quotes.42

Due to the ultimate ineffectiveness of the Bretton Woods Accord and the European Joint Float, the forex markets were forced to closeclarification neededsometime during 1972 and March 1973.43The largest purchase of US dollars in the history of 1976clarification neededwas when theWest Germangovernment achieved an almost 3 billion dollar acquisition (a figure is given as 2.75 billion in total by The Statesman: Volume 18 1974). This event indicated the impossibility of balancing of exchange rates by the measures of control used at the time, and the monetary system and the foreign exchange markets in West Germany and other countries within Europe closed for two weeks (during February and, or, March 1973.Giersch, Paqu, & Schmiedingstate closed after purchase of 7.5 million DmarksBrawleystates … Exchange markets had to be closed. When they re-opened … March 1 that is a large purchase occurred after the close).44454647

In developed nations, the state control of the foreign exchange trading ended in 1973 when complete floating and relatively free market conditions of modern times began.48Other sources claim that the first time a currency pair was traded by U.S. retail customers was during 1982, with additional currency pairs becoming available by the next year.4950

On 1 January 1981, as part of changes beginning during 1978, thePeoples Bank of Chinaallowed certain domestic enterprises to participate in foreign exchange trading.5152Sometime during 1981, the South Korean government ended Forex controls and allowed free trade to occur for the first time. During 1988, the countrys government accepted the IMF quota for international trade.53

Intervention by European banks (especially theBundesbank) influenced the Forex market on 27 February 1985.54The greatest proportion of all trades worldwide during 1987 were within the United Kingdom (slightly over one quarter). The United States had the second highest involvement in trading.55

During 1991,Iranchanged international agreements with some countries from oil-barter to foreign exchange.56

The foreign exchange market is the mostliquidfinancial market in the world. Traders include governments and central banks, commercial banks, otherinstitutional investorsand financial institutions, currencyspeculators, other commercial corporations, and individuals. According to the 2019 Triennial Central Bank Survey, coordinated by the Bank for International Settlements, average daily turnover was $6.6 trillion in April 2019 (compared to $1.9 trillion in 2004).3Of this $6.6 trillion, $2 trillion was spot transactions and $4.6 trillion was traded in outright forwards, swaps, and otherderivatives.

Foreign exchange is traded in anover-the-counter marketwhere brokers/dealers negotiate directly with one another, so there is no central exchange orclearing house. The biggest geographic trading center is the United Kingdom, primarily London. In April 2019, trading in theUnited Kingdomaccounted for 43.1% of the total, making it by far the most important center for foreign exchange trading in the world. Owing to Londons dominance in the market, a particular currencys quoted price is usually the London market price. For instance, when theInternational Monetary Fundcalculates the value of itsspecial drawing rightsevery day, they use the London market prices at noon that day. Trading in the United States accounted for 16.5%,SingaporeandHong Kongaccount for 7.6% and Japan accounted for 4.5%.3

Turnover of exchange-traded foreign exchange futures and options was growing rapidly in 2004-2013, reaching $145 billion in April 2013 (double the turnover recorded in April 2007).57As of April 2019, exchange-traded currency derivatives represent 2% of OTC foreign exchange turnover. Foreign exchangefutures contractswere introduced in 1972 at theChicago Mercantile Exchangeand are traded more than to most other futures contracts.

Most developed countries permit the trading of derivative products (such as futures and options on futures) on their exchanges. All these developed countries already have fully convertible capital accounts. Some governments ofemerging marketsdo not allow foreign exchange derivative products on their exchanges because they havecapital controls. The use of derivatives is growing in many emerging economies.58Countries such as South Korea, South Africa, and India have established currency futures exchanges, despite having some capital controls.

Foreign exchange trading increased by 20% between April 2007 and April 2010 and has more than doubled since 2004.59The increase in turnover is due to a number of factors: the growing importance of foreign exchange as an asset class, the increased trading activity ofhigh-frequency traders, and the emergence ofretail investorsas an important market segment. The growth ofelectronic executionand the diverse selection of execution venues has lowered transaction costs, increased market liquidity, and attracted greater participation from many customer types. In particular, electronic trading via online portals has made it easier for retail traders to trade in the foreign exchange market. By 2010, retail trading was estimated to account for up to 10% of spot turnover, or $150 billion per day (see below:Retail foreign exchange traders).

Unlike a stock market, the foreign exchange market is divided into levels of access. At the top is theinterbank foreign exchange market, which is made up of the largestcommercial banksandsecurities dealers. Within the interbank market, spreads, which are the difference between the bid and ask prices, are razor sharp and not known to players outside the inner circle. The difference between the bid and ask prices widens (for example from 0 to 1pipto 12 pips for currencies such as the EUR) as you go down the levels of access. 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 foreign exchange market are determined by the size of the line (the amount of money with which they are trading). The top-tier interbank market accounts for 51% of all transactions.61From there, smaller banks, followed by large multi-national corporations (which need to hedge risk and pay employees in different countries), large hedge funds, and even some of the retailmarket makers. According to Galati and Melvin, Pension fundsinsurance companiesmutual funds, and other institutional investors have played an increasingly important role in financial markets in general, and in FX markets in particular, since the early 2000s. (2004) In addition, he notes, Hedge funds have grown markedly over the 20012004 period in terms of both number and overall size.62Central banks also participate in the foreign exchange market to align currencies to their economic needs.

An important part of the foreign exchange market comes from the financial activities of companies seeking foreign exchange to pay for goods or services. Commercial companies often trade fairly small amounts compared to those of banks or speculators, and their trades often have a little short-term impact on market rates. Nevertheless, trade flows are an important factor in the long-term direction of a currencys exchange rate. Somemultinational corporations(MNCs) can have an unpredictable impact when very large positions are covered due to exposures that are not widely known by other market participants.

National central banks play an important role in the foreign exchange markets. They try to control themoney supplyinflation, and/orinterest ratesand often have official or unofficial target rates for their currencies. They can use their often substantial foreign exchange reserves to stabilize the market. Nevertheless, the effectiveness of central bank stabilizing speculation is doubtful because central banks do not go bankrupt if they make large losses as other traders would. There is also no convincing evidence that they actually make a profit from trading.

Foreign exchange fixingis the daily monetary exchange rate fixed by the national bank of each country. The idea is that central banks use the fixing time and exchange rate to evaluate the behavior of their currency. Fixing exchange rates reflect the real value of equilibrium in the market. Banks, dealers, and traders use fixing rates as amarket trendindicator.

The mere expectation or rumor of a central bank foreign exchange intervention might be enough to stabilize the currency. However, aggressive intervention might be used several times each year in countries with adirty floatcurrency regime. Central banks do not always achieve their objectives. The combined resources of the market can easily overwhelm any central bank.63Several scenarios of this nature were seen in the 199293European Exchange Rate Mechanismcollapse, and in more recent times in Asia.

Investment managementfirms (who typically manage large accounts on behalf of customers such as pension funds and endowments) use the foreign exchange market to facilitate transactions in foreign securities. For example, an investment manager bearing an international equity portfolio needs to purchase and sell several pairs of foreign currencies to pay for foreign securities purchases.

Some investment management firms also have more speculative specialistcurrency overlayoperations, which manage clients currency exposures with the aim of generating profits as well as limiting risk. While the number of this type of specialist firms is quite small, many have a large value ofassets under managementand can, therefore, generate large trades.

Individual retail speculative traders constitute a growing segment of this market. Currently, they participate indirectly throughbrokersor banks. Retail brokers, while largely controlled and regulated in the US by theCommodity Futures Trading CommissionandNational Futures Association, have previously been subjected to periodicforeign exchange fraud.6465To deal with the issue, in 2010 the NFA required its members that deal in the Forex markets to register as such (I.e., Forex CTA instead of a CTA). Those NFA members that would traditionally be subject to minimum net capital requirements, FCMs and IBs, are subject to greater minimum net capital requirements if they deal in Forex. A number of the foreign exchange brokers operate from the UK underFinancial Services Authorityregulations where foreign exchange trading usingmarginis part of the wider over-the-counter derivatives trading industry that includescontracts for differenceandfinancial spread betting.

There are two main types of retail FX brokers offering the opportunity for speculative currency trading:brokersanddealersormarket makers.Brokersserve as an agent of the customer in the broader FX market, by seeking the best price in the market for a retail order and dealing on behalf of the retail customer. They charge a commission or mark-up in addition to the price obtained in the market.Dealersormarket makers, by contrast, typically act as principals in the transaction versus the retail customer, and quote a price they are willing to deal at.

Non-bankforeign exchange companiesoffercurrency exchangeand international payments to private individuals and companies. These are also known as foreign exchange brokers but are distinct in that they do not offer speculative trading but rather currency exchange with payments (i.e., there is usually a physical delivery of currency to a bank account).

It is estimated that in the UK, 14% of currency transfers/payments are made via Foreign Exchange Companies.66These companies selling point is usually that they will offer better exchange rates or cheaper payments than the customers bank.67These companies differ from Money Transfer/Remittance Companies in that they generally offer higher-value services. The volume of transactions done through Foreign Exchange Companies in India amounts to about US$2 billion68per day This does not compete favorably with any well developed foreign exchange market of international repute, but with the entry of online Foreign Exchange Companies the market is steadily growing. Around 25% of currency transfers/payments inIndiaare made via non-bank Foreign Exchange Companies.69Most of these companies use the USP of better exchange rates than the banks. They are regulated byFEDAIand any transaction in foreign Exchange is governed by theForeign Exchange Management Act, 1999(FEMA).

Money transfer companies/remittance companies perform high-volume low-value transfers generally by economic migrants back to their home country. In 2007, theAite Groupestimated that there were $369 billion of remittances (an increase of 8% on the previous year). The four largest foreign markets (IndiaChinaMexico, and thePhilippines) receive $95 billion. The largest and best-known provider isWestern Unionwith 345,000 agents globally, followed byUAE Exchange.citation neededBureaux de changeor currency transfer companies provide low-value foreign exchange services for travelers. These are typically located at airports and stations or at tourist locations and allow physical notes to be exchanged from one currency to another. They access foreign exchange markets via banks or non-bank foreign exchange companies.

Currency distribution of global foreign exchange market turnover70RankCurrencyISO 4217code

There is no unified or centrally cleared market for the majority of 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 currenciesinstrumentsare traded. This implies that there is not asingleexchange rate but rather a number of different rates (prices), depending on what bank or market maker is trading, and where it is. In practice, the rates are quite close due toarbitrage. Due to Londons dominance in the market, a particular currencys quoted price is usually the London market price. Major trading exchanges includeElectronic Broking Services(EBS) and Thomson Reuters Dealing, while major banks also offer trading systems. A joint venture of the Chicago Mercantile Exchange andReuters, calledFxmarketspaceopened in 2007 and aspired but failed to the role of a central marketclearingmechanism.citation needed

The main trading centers are London and New York City, thoughTokyo, Hong Kong, and Singapore are all important centers as well. Banks throughout the world participate. Currency trading happens continuously throughout the day; as the Asian trading session ends, the European session begins, followed by the North American session and then back to the Asian session.

Fluctuations in exchange rates are usually caused by actual monetary flows as well as by expectations of changes in monetary flows. These are caused by changes ingross domestic product(GDP) growth, inflation (purchasing power paritytheory), interest rates (interest rate parityDomestic Fisher effectInternational Fisher effect), budget andtrade deficitsor surpluses, large cross-borderM&Adeals and other macroeconomic conditions. Major news is released publicly, often on scheduled dates, so many people have access to the same news at the same time. However, large banks have an important advantage; they can see their customersorder flow.

Currencies are traded against one another in pairs. Eachcurrency pairthus constitutes an individual trading product and is traditionally noted XXXYYY or XXX/YYY, where XXX and YYY are theISO 4217 international three-letter codeof the currencies involved. The first currency (XXX) is thebase currencythat is quoted relative to the second currency (YYY), called thecounter currency(or quote currency). For instance, the quotationEURUSD (EUR/USD) 1.5465is the price of the Euro expressed in US dollars, meaning 1 euro = 1.5465 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, 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 counter currency (e.g. GBPUSD, AUDUSD, NZDUSD, EURUSD).

The factors affecting XXX will affect both XXXYYY and XXXZZZ. This causes a positive currencycorrelationbetween XXXYYY and XXXZZZ.

On thespotmarket, according to the 2019 Triennial Survey, the most heavily traded bilateral currency pairs were:

The U.S. currency was involved in 88.3% of transactions, followed by the euro (32.3%), the yen (16.8%), and sterling (12.8%) (seetable). 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 currencys creation in January 1999, and how long the foreign exchange market will remain dollar-centered is open to debate. Until recently, trading the euro versus a non-European currency ZZZ would have usually involved two trades: EURUSD and USDZZZ. The exception to this is EURJPY, which is an established traded currency pair in the interbank spot market.

In afixed exchange rateregime, exchange rates are decided by the government, while a number of theories have been proposed to explain (and predict) the fluctuations in exchange rates in afloating exchange rateregime, including:

International parity conditions:Relative purchasing power parity, interest rate parity, Domestic Fisher effect, International Fisher effect. Though to some extent the above theories provide logical explanation for the fluctuations in exchange rates, yet these theories falter as they are based on challengeable assumptions [e.g., free flow of goods, services and capital] which seldom hold true in the real world.

Balance of paymentsmodel: This model, however, focuses largely on tradable goods and services, ignoring the increasing role of global capital flows. It failed to provide any explanation for the continuous appreciation of the US dollar during the 1980s and most of the 1990s, despite the soaring US current account deficit.

Asset market model: views currencies as an important asset class for constructing investment portfolios. Asset prices are influenced mostly by peoples willingness to hold the existing quantities of assets, which in turn depends on their expectations on the future worth of these assets. The asset market model of exchange rate determination states that the exchange rate between two currencies represents the price that just balances the relative supplies of, and demand for, assets denominated in those currencies.

None of the models developed so far succeed to explain exchange rates and volatility in the longer time frames. For shorter time frames (less than a few days),algorithmscan be devised to predict prices. It is understood from the above models that many macroeconomic factors affect the exchange rates and in the end currency prices are a result of dual forces ofsupply and demand. The worlds currency markets can be viewed as a huge melting pot: in a large and ever-changing mix of current events, supply and demand factors are constantly shifting, and the price of one currency in relation to another shifts accordingly. No other market encompasses (and distills) as much of what is going on in the world at any given time as foreign exchange.72

Supply and demand for any given currency, and thus its value, are not influenced by any single element, but rather by several. These elements generally fall into three categories: economic factors, political conditions and market psychology.

Economic factors include: (a) economic policy, disseminated by government agencies and central banks, (b) economic conditions, generally revealed through economic reports, and othereconomic indicators.

Economic policy comprises governmentfiscal policy(budget/spending practices) andmonetary policy(the means by which a governments central bank influences the supply and cost of money, which is reflected by the level ofinterest rates).

Government budget deficits or surpluses: The market usually reacts negatively to widening governmentbudget deficits, and positively to narrowing budget deficits. The impact is reflected in the value of a countrys curre