The Foreign Currency Exchange Market
Also known as the spot currency or forex market, the foreign currency exchange market is the largest market in the world, consisting of about $1.9 trillion in transactions every day. It is different from other markets not only because of its tremendous volume but also because of its extreme liquidity. The forex market is an over the counter, or decentralized market. This means that traders may choose from a number of dealers to make a trade with, as opposed to the stock market for example, in which all trades of a particular stock must pass through one point. This allows for much more price competition.The market is essentially composed of six types of participants: commercial and investment banks, central banks, corporations, global funds, and retail clients (individual traders). Commercial and investment banks trade on what is known as the ‘interbank’ market and make up the largest portion of forex trading. They trade for themselves as well as for their customers, and balance accounts by trading with each other. Central banks, large corporations, and hedge funds all trade on the interbank system as well. As the largest investors in forex, and with their well-established credit relationships, the members of the interbank system trade with the best rates. About three quarters of the daily volume of the forex market is exchanged in the interbank system.
Central banks function in the forex market as regulatory agencies with the responsibility of maintaining their country’s money supply, and therefore do not speculate. Some directly influential actions they take include setting overnight lending rates, buying and selling government securities to adjust the size of the money supply, and buying/selling their own currency in the open market to influence interest rates.
The main uses of the forex market for corporations are hedging against currency depreciation to protect future transactions and buying/selling currencies to pay international employees. Global managed profit-seeking funds generate a lot of volume in the forex market through foreign financial investments. They constitute about 20% of total market volume. Individuals account for the rest, using the forex market mostly for speculative purposes and sometimes to hedge. Because of online retail dealers, individuals can participate in forex trading under similar conditions as those on the interbank level; spreads are only slightly wider and execution is just as easy and effective.
