The foreign exchange market is a global decentralized or over the counter 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 we 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.Financial Markets around the world function as anchors of trading between a wide range of multiple types of buyers and sellers around the clock, with the exception of weekends. Since currencies are always traded in pairs, the foreign exchange market does not set a currency's absolute value but rather determines its relative value by setting the market price of one currency if paid for with another.
The foreign exchange market works through financial markets and 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 it is sometimes called the internet market. Trades between foreign exchange dealers can be very big, involving hundreds of millions of dollars. Because of 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. For example, it permits a business entity in the US to import goods from the EU or India and pay inEuros, or Rupees even though its income is in USD. It also supports direct assumption and evaluation virtual to the value of currencies and the carry trade speculation, based on the differential interest rate between two currencies.
In a typical foreign exchange transaction, a party purchases some quantity of one currency by paying with some quantity of another currency. The foreign exchange market is unique because of the following features:
- It’s huge trading volume, representing the largest asset class in the world leading to high liquidity;
- its geographical scattering;
- it is continuous operation i.e., 24 hours a day except for weekends.
- the variety of factors that affect exchange rates;
- the low margins of relative profit compared with other markets of fixed income; and
- the use of leverage to 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 of perfect competition.
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.
Foreign exchange trading increased by 20% between April 2007 and April 2010 and has more than doubled since 2004. The increase in turnover is due to a number of factors like the growing importance of foreign exchange as an asset class, the increased trading activity of high-frequency traders, and the emergence of retail investors as an important market segment. The growth of electronic execution and 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.
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.
‘Foreign Exchange Fixing is 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 a market trend indicator.
Money Transfer Companies or and remittance companies perform high-volume low-value transfers generally by economic migrants back to their home country. In 2007, the Aite Group estimated that there were $369 billion of remittances. The four largest foreign markets — India, China, Mexico, and the Philippines receive $95 billion. The largest and best-known provider is Western Union with 345,000 agents globally, followed by UAE Exchange. Bureaux de change or 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. USD, Euro and Yen occupy the top three position in the most-traded currencies in the world, and we can be proud our Rupee is in the top 20 – we occupy the 16th position.