The foreign currency exchange market is the largest financial market in the world. This market, also known as the forex, FX, or spot currency market, handles over 3.74 trillion AUD in transactions each day. The basic premise of the market is to allow traders to purchase a volume of one country’s currency by paying with another country’s currency. The top five currencies traded on the market are the US dollar, the euro, the Japanese yen, the pound sterling and the Australian dollar.
Although it is considered a financial market, the foreign currency exchange has several important differences that put it into a class all its own. Among these differences are a much larger trading volume, the liquidity of the assets traded and a tiered access system. Another important difference is that forex is decentralised, meaning all transactions are over-the-counter and do not necessarily have to go through a central hub such as what is required for stock trading. The decentralized nature of the forex market means it is more competitive, and those looking to make a trade can go to any one of thousands of sources, each with a different exchange rate. Many of these forex traders are available online, and an online currency converter on their website tells potential traders the exact result of any foreign currency exchange.
Five basic types of traders participate in the foreign currency exchange market: commercial/investment banks, central banks, corporations, investment funds/institutional investors, and retail/individual traders. At the top-tier, the trading rates are thin and extremely precise. Lower-tiered traders do not have access to these rates.
The top-tier of the market is reserved for trades between commercial and investment banks. This tier is called the interbank market, and it makes up 53 per cent of the forex market as a whole. Commercial and investment banks make trades on this level both for themselves and for their customers. Although central banks, large corporations and some institutional investment companies trade on the interbank tier, it is unavailable to individual retail traders. The best rates are reserved for traders at this level because of the sheer volume of trading done. Some banks can trade billions of dollars on the foreign currency exchange in a single day.
The foreign currency exchange is critical to central banks. Nearly every country in the world has adopted a central banking system in order to issue currency, maintain national reserves and balance the economy. Foreign reserves are often traded in attempts to control inflation and interest rates while stabilising the home market. Central banks can influence the market by buying and selling government securities to increase or decrease the supply of currency. The buying and selling of a central bank’s own currency may also influence interest rates in the country. Many financial experts, however, doubt that foreign currency trading has any positive effect on economic stability except in instances of great devaluation in current reserve currency. In addition, central banks cannot go bankrupt as a result of heavy losses, so they are always at an advantage over other traders.
Corporations trade on the foreign currency exchange when they operate internationally. They buy and sell large volumes of currency in countries where they do business in order to prevent being forced to convert currency at the time of a business transaction when rates may not be as advantageous. Keeping a reserve of foreign currency bought at a low rate can have a substantial effect on a corporation’s bottom line at the end of the year.
Investment funds and other institutions speculate on the foreign exchange market for the purpose of making a profit for investors or for the institution itself. Hedge funds have increasingly been using the forex market since the beginning of the 21st century. In addition, mutual funds, pension funds and even insurance companies have delved into the market. Profit-seeking funds account for approximately 20 per cent of the forex market’s total volume.
One of the fastest growing segments of the foreign currency exchange is that of retail traders, individuals seeking to make a profit through personal speculation of future exchange rates. Individual traders make trades through foreign exchange brokers or through banks. Individuals using a broker have the benefit of being able to jump through several different trading options to get the best rate. A good broker looks for the best rates for his or her client, but charges a fee for completing the trade. Banks, however, give an individual a single rate that is slightly marked up from the interbank exchange rate, so the bank’s profit is built into the offered rate.
The history of the foreign currency exchange began with the widespread use of a floating market currency valuation system. While many countries removed their currency from a precious metal standard for short periods, the long-term removal of currencies from the gold and silver standards did not take place until the 1970s. After World War II, an initiative was taken to create a more stable global economy through what was known as the Bretton-Woods system. The International Monetary Fund was established to help the ailing economies of countries in the post-war environment. Although the Bretton Woods system was successful in re-establishing many economies, it collapsed after its purpose was met, and most major world currencies converted to a floating system.
When computer and communications technology advanced during the 1980s and 1990s, interest in the foreign currency exchange market grew. The speed at which transactions could be performed and the speed at which new information about market movement could be relayed made forex trading a distinct investment possibility. The foreign currency exchange handled an average of $1 billion in daily transactions in the early 1980s. As of 2010, the average daily volume of transactions amounted to $3.74 trillion AUD. Some of the greatest growth in the market has been in the most recent years, and the propensity of major corporations to operate on an international scale has led to even greater growth.