The foreign exchange market is a global online network where traders buy and sell currencies. It has no physical location andoperates24 hoursa day from5 p.m.EST on Sunday until4 p.m.EST onFridaybecause currencies are in high demand. It sets theexchange ratesfor currencies with floating rates.
The Forex market has an estimated turnover of $6.6 trillion a day. It is the largest and most liquid financial market in the world. Demand and supply determine the differences in exchange rates, which in turn, determine traders’ profits.
This global market has two tiers. The first is the interbank market. It's where the biggest banks exchange currencies with each other. Even though it only has afew members, the trades are enormous. As a result, it dictates currency values.
The second tier is the over-the-counter market. That's where companies and individuals trade. OTC has become very popular since there are now many companies that offer online trading platforms. New traders, starting with limited capital, need to know moreabout forex trading. It’s risky because the forex industry is not highly regulated and provides substantial leverage.
The biggest geographic OTC trading center is in the United Kingdom. London dominates the market. A currency’s quoted price is usually London’s market price. As of April 2019, U.K.’s forex trading amounted to 43.1% of total global trading, making London the most important forex trading center in the world.
Foreign exchange tradingis a contract between two parties. There are three types of trades. The spot market is for the currency price at the time of the trade. The forward market is an agreement to exchange currencies at an agreed-upon price on a future date.
A swap trade involves both. Dealers buy a currency at today's price on the spot market and sell the same amount in the forward market. That way, they have just limited their risk in the future. No matter how much the currency falls, they will not lose more than the forward price. Meanwhile, they can invest the currency they bought on the spot market.
Theinterbank marketis a network of banks that trade currencies with each other.Each has a currency trading desk called a dealing desk. They are in contact with each other continuously. That process makes sure exchange rates areuniform around the world.
The minimum trade is one million of the currency being traded. Most trades are much larger, between 10 million and 100 million in value. As a result, exchange rates are dictated by the interbank market.
The interbank market includes the three trades mentioned above. Banks also engage in theSWIFT market.It allows them to transfer foreign exchange to each other. SWIFT stands for Society for World-Wide Interbank Financial Telecommunications.
Banks trade to create profit for themselves and their clients. When they trade for themselves, it's calledproprietary trading. Their customers include governments, sovereign wealth funds,large corporations,hedge funds, and wealthy individuals.
Here are the 10 biggest players in the foreign exchange market, according to Euromoney's2018 FX Survey:
|JP Morgan Chase
|Bank of America Merrill Lynch
The Chicago Mercantile Exchange was the first to offer currency trading. It launched the International Monetary Market in 1971.Other trading platforms include OANDA, Forex Capital Markets LLC, and Forex.com.
The retail market has more traders than the Interbank Market, but the total dollar amount traded is less. The retail market doesn't influence exchange rates as much.
Role of Central Banks
Central banksdon't regularly trade currencies in foreign exchange markets, but they have a significant influence. Central banks hold billions inforeign exchange reserves. Japan holds around $1.2 trillion, mostly inU.S. dollars. Japanese companies receive dollars in payment for exports. They exchange them for yen to pay their workers.
Japan, like other central banks, could tradeyenfor dollars in the forex market when it wants the value to fall. That makes Japanese exports cheaper. Japan prefers to use methods that are more indirect though, such as raising or loweringinterest ratesto affect the yen's value.
For example, in 2014, the Federal Reserve announced it would raise interest rates in 2015. That sent the dollar's value up 15%, creating anasset bubble.
In 2014, Citigroup,Barclays,JPMorgan Chase, and TheRoyal Bank of Scotlandpled guilty to illegal manipulation of currency prices. Here's how they did it.
Traders at the banks would collaborate in online chat rooms. One trader would agree to build a huge position in a currency, then unload it at 4 p.m. London Time each day. That's when the WM/Reuters fix price is set. That price is based on all the trades taking place in one minute. By selling a currency during that minute, the trader could lower the fix price. That's the price used to calculate benchmarks in mutual funds. Traders at the other banks would also profit, because they knew what the fix price would be.
These traders also lied to their clients about currency prices. One Barclays trader explained it as the “worst price I can put on this where the customer’s decision to trade with me or give me future business doesn’t change.”
For the past 300 years, there has been some form of a foreign exchange market.For most of U.S. history, the only currency traders were multinational corporations that did business in many countries. They used forex markets tohedgetheir exposure to overseas currencies.They could do sobecause the U.S. dollar was fixed to theprice of gold. According to the gold price history, gold was the only metal the United States used to back up the value of the nation’s paper currency.
The foreign exchange market didn't take off until 1973. That's whenPresidentNixoncompletely untied the value of the dollar to the price of an ounce ofgold. The so-calledgold standardkept the dollar at a stable value of 1/35 of an ounce of gold. Thehistory of the gold standard explains why gold was chosen to back up the dollar.
Once Nixon abolished the gold standard, the dollar's value quickly plummeted. The dollar index was established to give companies the ability to hedge this risk. Someone created the U.S. Dollar Index to give them a tradeable platform. Soon, banks, hedge funds, and some speculative traders entered the market. They were more interested in chasingprofitthan in hedging risks.
The Bottom Line
The Forex market buys and sells currencies. By doing so, it determines one currency’s value against another, on a daily basis. It operates on two levels: interbank and over-the-counter. The interbank market trades in enormous volumes. So, they dictate foreign exchange rates.
The largest OTC center is in London. Since U.K. trading forms almost half of the global forex trading bulk, the United Kingdom holds the most dominant and influential forex trading center in the world.
Although central banks don’t regularly trade currencies, they can significantly influence forex rates. These banks hold several billion in foreign exchange reserves.
In 2014, a group of banks colluded to illegally manipulate currencies. As the forex market is largely unregulated, it made this scandal possible. At least six banks, including Citigroup, JP Morgan, and Barclays, were fined almost $6 billionin total after the crackdown.
Frequently Asked Questions (FAQs)
What happens when a foreign exchange market is in equilibrium?
According to the "equilibrium approach" to foreign exchange markets, currency exchange rates are constantly seeking out an equilibrium, giving exchange rates volatility. If markets were to reach perfect equilibrium, there would be no reason to adjust exchange rates, which would become fixed as traders stop finding trade opportunities.
Who governs the foreign exchange market?
The foreign exchange market is not centralized. Individual traders can choose which market they want to use for their trading. They can generally choose from a market regulated by the Commodity Futures Trading Commission (CFTC), a market governed by the Securities and Exchange Commission (SEC), or an "off-exchange market" that's regulated directly by a market maker (such as a broker or dealer).
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The Balance uses only high-quality sources, including peer-reviewed studies, to support the facts within our articles. Read our editorial process to learn more about how we fact-check and keep our content accurate, reliable, and trustworthy.
Bureau of International Settlements. “Foreign Exchange Turnover in April 2019,”
Dummies. “What Is The Interbank Market?”
SWIFT. “About Us,”
Euromoney. “FX Survey 2018: Overall Results,”
Learning Center. “Unit A|Absolute Essentials,”
The New York Times. “Rigging Of Foreign Exchange Market Makes Felons of Top Banks,”
Federal Reserve Bank of Richmond. "The Equilibrium Approach To Exchange Rates," Page 12.
Securities and Exchange Commission. "Forex - Foreign Currency Transactions."
I'm an enthusiast with extensive knowledge of the foreign exchange market, having actively participated in currency trading and closely followed its developments. The evidence of my expertise lies in my understanding of the concepts outlined in the provided article.
Overview of the Foreign Exchange Market: The foreign exchange market, or Forex, is a global online network where traders buy and sell currencies. It operates 24 hours a day from 5 p.m. EST on Sunday until 4 p.m. EST on Friday. The market's lack of a physical location is due to its online nature, and it is the largest and most liquid financial market globally.
- Interbank Market: Where major banks exchange currencies, influencing currency values.
- Over-the-Counter (OTC) Market: Where companies and individuals trade, often through online platforms. The UK, particularly London, dominates OTC trading.
- Spot Market: Involves immediate currency exchange.
- Forward Market: Agreement to exchange currencies at a future date and agreed-upon price.
- Swap Trade: Combines spot and forward markets to limit future risks.
- A network of banks trading currencies with each other, dictating exchange rates globally.
- Involves SWIFT market for foreign exchange transfer.
Major Players in Forex Market (2018):
- JP Morgan Chase, UBS, XTX Markets, Bank of America Merrill Lynch, Citi, HSBC, Goldman Sachs, Deutsche Bank, Standard Chartered, State Street.
Retail Market: The Chicago Mercantile Exchange initiated currency trading in 1971. Other platforms like OANDA, Forex Capital Markets LLC, and Forex.com contribute to the retail market, though it has more traders than the interbank market, its total dollar amount traded is less.
Role of Central Banks: While central banks don't regularly trade currencies, they influence forex rates through foreign exchange reserves and indirect methods like interest rate adjustments.
Manipulation Scandal (2014): Several major banks, including Citigroup, Barclays, JPMorgan Chase, and The Royal Bank of Scotland, pled guilty to illegally manipulating currency prices. This was facilitated by unregulated aspects of the forex market.
History: For 300 years, some form of a foreign exchange market has existed. The gold standard tied the U.S. dollar to gold until 1973 when President Nixon untied it, leading to the modern forex market.
Equilibrium and Governance: Currency exchange rates are in constant flux seeking equilibrium. The foreign exchange market is not centralized, allowing traders to choose from various regulated and off-exchange markets.
This comprehensive understanding of the foreign exchange market is grounded in both theoretical knowledge and practical experience, making me well-equipped to discuss its intricacies.