The Forex market is an international over-the-counter market (OTC). It means that it is a decentralized, self-regulated market with no central exchange or clearing house, unlike stocks and futures markets. This structure eliminates fees for exchange and clearing, thereby reducing transaction costs to the investor.
The Forex OTC market is formed by many different participants, with varying needs and interests that trade directly with each other. These participants can be divided in two groups, the inter-bank market and the retail market.
Are Forex transactions that occur between central banks, commercial banks and large financial institutions.
Central Banks – National central banks (such as the US Fed and the BOE, BOJ etc.) play an important role in the Forex market. As principal monetary authorities, their role consists in achieving price stability and economic growth and inflation control. To do so, they regulate the entire money supply in the economy by setting interest rates and reserve requirements. They also manage the country’s foreign exchange reserves that they can use in order to influence market conditions and exchange rates.
Commercial Banks – Commercial banks (such as Deutsche Bank and Barclays etc.) provide liquidity to the Forex market, due to the huge trading volumes they process every day. Part of this trading represents foreign currency conversions on behalf of retail customers needs while some is carried out by the banks proprietary trading desk for speculative purposes.
Financial Institutions – Financial institutions such as money managers, investment funds, pension funds and brokerage companies all trade foreign currencies as part of their obligations to seek the best investment opportunities for their clients.
The retail market designates transactions made by smaller speculators and investors. These transactions are executed through Forex brokers/Market Makers who act as an intermediary between the retail market and interbank market. The participants of the retail market are hedge funds, corporations and individuals.
Hedge Funds – Hedge funds are private investment funds that speculate in various assets classes using leverage. Macro Hedge Funds pursue trading opportunities in the Forex Market. They design and execute trades after conducting a macro economic analysis that reviews the challenges affecting a country and its currency. Due to their large amounts of liquidity and aggressive strategies, they are a major contributor to the construction of the Markets.
Corporations – They represent the companies that are engaged in import/export activities with foreign counterparts. Their primary business requires them to purchase and sell foreign currencies in exchange for manufactured goods, exposing them to currency fluctuation risks. Through the markets, they convert currencies and hedge themselves against future price movement.
Individuals – Individual traders or investors trade Forex with their own capital in order to profit from speculation on future rates. They mainly operate through Forex platforms offered by online Broker/Market Makers that offer Bid/Ask spreads as a commission payment, they offer “immediate execution” and “leveraged” margin accounts.
Unlike a stock market, the foreign exchange market is divided into levels of access. At the top is the inter-bank market, which is made up of the largest commercial banks and securities dealers. Within the inter-bank 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 spread (bid and ask) prices widens (for example from 0-1 pip to 1-2 pips for a 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 55% of all transactions. After that there are usually 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 retail FX market makers.
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.” (2004) In addition, 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.
The interbank market caters for both the majority of commercial turnover and large amounts of speculative trading every day. A large bank may trade billions of dollars daily. Some of this trading is undertaken on behalf of customers, but much is conducted by proprietary desks, trading for the bank’s own account. Until recently, foreign exchange brokers did large amounts of business, facilitating interbank trading and matching anonymous counterparts for large fees. Today, however, much of this business has moved on to more efficient electronic (E.C.N.) systems.
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 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 multinational companies 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 the money supply, inflation, and/or 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, like other traders would, and there is no convincing evidence that they do make a profit trading.
Forex 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 behaviour of their currency. Fixing exchange rates reflects the real value of equilibrium in the Forex market. Banks, dealers and online foreign exchange traders use fixing rates as a trend indicator.
The mere expectation or rumour of central bank intervention might be enough to stabilize a currency, but 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 ERM collapse, and in more recent times in Southeast Asia.
About 70% to 90% of the foreign exchange transactions are speculative. In other words, the person or institution that bought or sold the currency has no plan to actually take delivery of the currency in the end; rather, they were solely speculating on the movement of that particular currency. Hedge funds have gained a reputation for aggressive currency speculation since 1996. They control billions of dollars of equity and may borrow billions more, and thus may overwhelm intervention by central banks to support almost any currency, if the economic fundamentals are in the hedge funds’ favour.
Investment management firms (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 specialist currency overlay operations, which manage clients’ currency exposures with the aim of generating profits as well as limiting risk. Whilst the number of this type of specialist firms is quite small, many have a large value of assets under management (AUM), and hence can generate large trades.
Retail traders (individuals) constitute a growing segment of this market, both in size and importance. Currently, they participate indirectly through brokers or banks. Retail brokers, while largely controlled and regulated in the USA by the CFTC and NFA have in the past been subjected to periodic foreign exchange scams. To deal with the issue, the NFA and CFTC began (as of 2009) imposing stricter requirements, particularly in relation to the amount of Net Capitalization required of its members. As a result many of the smaller, and perhaps questionable brokers are now diminishing.
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 principal in the transaction versus the retail customer, and quote a price they are willing to deal at—the customer has the choice whether or not to trade at that price.
In assessing the suitability of an FX trading service, the customer should consider the ramifications of whether the service provider is acting as principal or agent. When the service provider acts as agent, the customer is generally assured of a known cost above the best inter-dealer FX rate. When the service provider acts as principal, no commission is paid, but the price offered may not be the best available in the market—since the service provider is taking the other side of the transaction, a conflict of interest may occur.
Non-bank foreign exchange companies
Non-bank foreign exchange companies offer currency exchange and 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 currency exchange with payments. I.e., there is usually a physical delivery of currency to a bank account. “Send Money Home” offers an in-depth comparison into the services offered by all the major non-bank foreign exchange companies.
It is estimated that in the UK, 14% of currency transfers/payments are made via Foreign Exchange Companies. These companies’ selling point is usually that they will offer better exchange rates or cheaper payments than the customer’s bank. These companies differ from Money Transfer/Remittance Companies in that they generally offer higher-value services.
Money transfer Companies
Money transfer companies/remittance companies perform high-volume low-value transfers generally by economic migrants back to their home countries. In 2007, the Aite Group estimated that there were $369 billion of remittances. The largest and best known provider is Western Union