Introduction to the Currency Market

Although we may not be aware of it, the currency market has a deep impact on our everyday life, from the most obvious currency exchange we have to do when visiting a foreign country, to the way our goods prices and sometimes even salaries fluctuate due to the variance of value of our currencies relative to those of foreign countries with which we do business. Even the money under your mattress is continually changing in value!

What is the currency market?

We define a market as a place where people could meet each other for buying or selling things, be they tangible like in a food market, or virtual like web sites such as eBay.

There are in the world some well established financial markets like the physically located New York Stock Exchange (NYSE) and the Chicago Mercantile Exchange (CME), or electronic based markets like NASDAQ. In these markets traders are able to exchange shares, commodities, bonds, or currencies. On the currency market, also known as forex market, buyers and sellers have a place to exchange Dollars, Euros, Pounds, Yen, etc.

But why is there a need for a foreign exchange market? The forex market is an important tool for allowing business transactions be done between different currencies. Imagine, for example, the Chinese manufacturer who has an order of ten thousand t-shirts from a European wholesaler. The Chinese manufacturer, most probably will want to be paid on US dollars from the European wholesaler, who will have to change its euros to US dollars to pay the Chinese manufacturer. At the same time the Chinese manufacturer will need to buy cotton on the cotton market, traded in US dollars. In the end, this manufacturer probably will change the US dollars of profit to Chinese yuans, to spend it on goods and salaries in China, or maybe he or she is thinking of opening a business on England, so will change some of his US dollars to British pounds. Without a currency market, none of these transactions could be made fairly. Having a free market where thousands of participants could decide on the value of an asset is the most logical and fair way to give anything a value.

The foreign exchange market provides the machinery for making international payments, for transferring purchasing power from one currency to another, and ensuring that the relative value of each currency is clear and universal.

There were even money changers in Ancient Greece, but the foreign exchange as we know it has evolved a lot since then. Since the 1970’s, deep structural changes have occurred in the world financial system and economy:

  • A change in the international monetary system, from the fixed exchange rate specified on the Bretton Woods agreements, to the floating exchange rates in the early 70s ’til our days
  • Financial deregulation through the world, resulting in higher freedom for financial transactions and increased competition among financial institutions.
  • International trade liberalization, within multilateral trade agreements. Enormous expansion of international capital transactions.
  • Huge advances in technology, allowing instantaneous transmission of market information, and fast and reliable execution of financial transactions.
  • The development of new financial instruments and advances in the understanding of the financial system.

All of these provide fertile ground for development in foreign exchange trading.

In the first decade of the 21st century, the great technological advances in internet based trading have enabled the small retail trader easy access to the forex market, traditionally the domain of global banks.

Who are the participants?

Because you will trade with (or perhaps against) them, it’s very important to know who are the players in the currency market:

On the top of the hierarchy there are a group of major banks whose trades massively affect exchange rates. They are connected for this trading through two electronic services, EBS and Reuters Dealing. These banks form a network known as the interbank market, which is the center of the Forex Market, and from where is derived the exchange rates your dealer offers you. These major banks trade for costumers, but also for the banks’ own accounts (what is known as proprietary desks, or just “prop desks”).

Governments and Central Banks are special kind of participants, as they cause changes on the exchange rates prices due to their monetary or fiscal policy, especially with interest rate changes.

Dealers and Brokers provide clients access to the forex market, charging them a part of the spread, a commission, or both. They make their profits through these charges, but very often also maintain positions against their own costumers. In the worst cases, they also profit from cheating the costumers, shading the price, spiking zones to run orders, or using requotes or slippage when there was no real slippage of the price. These practises are the reason many people prefer to trade just on regulated markets, and why you should be careful when choosing a dealer.

The difference between dealers and brokers is that brokers just give you access to the interbank market (to some of the banks they work with acting for them as liquidity providers), sending your order to the market, while dealers don’t send your order to the market, but give you counterpart. Have in mind that many so-called ECN brokers use this denomination mainly for advertising purposes, but will give you also counterpart unless your orders (or the sum of various customer orders) reach the minimum acceptable in the interbank, 10 lots or 1 million units.

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