Anupama Nair
What is the foreign exchange market? It is a global decentralized or over-the-counter (OTC) market for the trading of currencies and determines foreign exchange rates for every currency in the world. It would include all aspects of buying, selling and exchanging currencies at current or pre-determined prices. If you look at trading volume, it is by far the largest market in the world, followed by the credit market. Who are the participants in this market? The main participants in this market are the larger international banks.
The foreign exchange market works through financial institutions and operates on several levels. Behind the scenes, the 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 it is sometimes called the ‘interbank market’. Trades between foreign exchange dealers can be very big, involving hundreds of millions of dollars. Due to the sovereignty issue, while involving two currencies, Forex has little supervisory entity regulating its actions. The foreign exchange market assists international trade and investments by enabling currency conversion.
Turnover of exchange-traded foreign exchange futures and options was growing rapidly in the period 2004-2013, reaching $145 billion in April 2013 which was double the turnover recorded in April 2007. As of April 2019, exchange-traded currency derivatives represent 2% of OTC foreign exchange turnover.
Most developed countries permit the trading of derivatives such as futures and options on futures on their exchanges. All these developed countries already have fully convertible capital accounts. Some governments of emerging markets do not allow foreign exchange derivative products on their exchanges because they have capital controls. The use of derivatives is growing in many emerging economies like South Korea, South Africa, and India have established currency futures exchanges, despite having some capital controls.
The foreign exchange market is divided into levels of access. At the top is the interbank foreign exchange market, which is made up of the largest commercial banks and securities dealers. If a trader can guarantee large numbers of transactions for large amounts, they can demand a smaller difference between the bid and the 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’ i.e., the amount of money with which they are trading. The top-tier interbank market accounts for 51% of all transactions. Galati and Melvin, stated “pension funds, insurance companies, mutual 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”. In addition, it is said, “hedge funds have grown markedly over the 2001–2004 period in terms of both number and overall size”. Central 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 currency's exchange rate. Some MNCs can have a volatile 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 the money supply, inflation, and 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. 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.
The mere expectation or rumor of a central bank foreign exchange intervention might be enough to stabilize the currency. Aggressive intervention might be used several times each year in countries with a dirty float currency regime. Central banks do not always achieve their objectives. The combined resources of the market can easily overwhelm any central bank. Several scenarios of this nature were seen in the 1992–93 European Exchange Rate Mechanism collapse and in more recent times in Asia.
There are two main types of retail FX brokers offering the opportunity for speculative currency trading — brokers and dealers or market makers. Brokers serve 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. Dealers or market 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-bank foreign exchange companies offer currency exchange and international payments to private individuals and companies.
