Foreign Exchange Market
Rob Kelley
Professor Bishnoi
December 2017
The foreign exchange market, or “Forex”, allows currencies to be converted, which helps individuals and organizations trade more efficiently across national boundaries. The Forex is the largest and most liquid market in the world. Each day trillions of dollars are traded 24 hours a day. I am going to explain what the foreign exchange market does, the history behind it, and the reasons why the Forex market its vital for the global economy.
What is the Foreign Exchange Market?
The Forex allows individuals to speculate on currencies and to place orders to buy one currency with another currency. The main participants who make up the Forex market are banks, commercial companies, central banks, hedge funds, brokers, and retail investors. Another interesting feature of the Forex is that there is no physical location like the New York Stock Exchange or London Exchange. Rather the Forex is a global network in which brokers make markets and bring buyers and sellers together. Forex brokers make money through bid-ask spreads and the fee they charge per transaction. The forex is open 24 hours a day, 5 days a week. The reason behind this is because when one market closes, the next opens. For example, when the US market closes in New York, the markets in Australia and Asia begin to open. Some markets overlap at certain times during the day and when more than one market is open at the same time, liquidity rises since there are more trades being placed. Three main overlaps in trading occur, starting with the US and London which is during 8am to noon. This is usually the heaviest trading period during the day because the USD and Euro are the most popular currencies traded. The second overlap is Sydney and Tokyo which takes place 2am to 4am, and the last overlap is London and Tokyo which is 3am to 4am. These are the times considering you are in New York with standard eastern time. Currencies are always in high demand and there are always traders somewhere in the world who are making and meeting demands for a particular currency. The forex market is broken down into two parts, the over the counter market and interbank market. In the over the counter market, or “OTC” market, retail investors trade through online brokerages or traditional brokerages. The interbank market is where the big players, such as large banks, trade. The biggest players in the Forex market in 2015 were Citigroup and Deutsche bank according to a Euromoney survey.
History of the Foreign Exchange Market
The Bretton Wood System was put into play after World War II, the agreement set the exchange rate of the USD against gold which allowed other countries peg their currencies to the USD. In 1971 the Bretton Wood System was abolished along with the gold standard by President Richard Nixon. There was more wealth in the world than physical gold, by 1970 the US held $14.5 billion in gold against foreign dollar holdings of $45.7 billion. The Chicago Mercantile Exchange launched the International money market, allowing people to participate in currency trading. Twenty years we arrive to the dot com era and companies started using the internet to view quotes and to place online trades. This new advance in technology allowed retail investors to trade in the forex exchange market much easier. SWIFT used to be used for currency trading until PayPal came out. PayPal quickly became the leader in sending money because it was quicker and more efficient.
Highest Traded Currencies
Each day trillions of dollars are traded on the Forex, between millions of market participants. The USD is the most traded currency in the world because of two main reasons. One being that the USD serves as the “global dollar” and is used as an intermediary in triangular currency transactions like the cross rate. The second reason is the dollar is used as a bench mark for countries that peg their currencies to the USD. For example, Bahrain, Cuba, Djibouti, Eritrea, Hong Kong, Jordan, Lebanon, Oman, Panama, Qatar, Saudi Arabia, United Arab Emirates and Venezuela are pegged to the USD. Countries peg their currencies for numerous reasons but the main reason is for stability and to lower volatility. The second most traded currency in the world is the Euro. The Euro is widely used between the 19 Euro-zone nations and many nations also use the Euro as a benchmark to peg their currency to. Even though the Euro is the second most traded currency in the world, it trails far behind the dollar. The USD accounts for 88% of total turnover as the Euro only accounts for about 32%. The third most traded currency is the Japanese Yen. The Yen accounts for around 22% of total turnover on the Forex. The Yen has been an attractive currency to trade due to Japan’s extremely low interest rates, an investor and essential borrow Yen for nothing and use it to invest in other currencies that yield higher interest rates and the difference would be the profit for the investor.