What is Meant by "Foreign Exchange"?
In the simplest terms, what's meant by "foreign exchange" is the exchange of one currency for another. A "spot" foreign-exchange market transaction is a simple exchange of currencies at the current market price. A "forward" transaction is a contract to buy or sell a quantity of currency at an agreed price at some date in the future. Forward contracts are widely used by businesses to manage foreign-exchange market risks. "Futures" are standardized forward contracts traded on an exchange.
For businesses, foreign-exchange market transactions often have an underlying purpose, such as paying a supplier or hedging a risk. Individuals, too, typically perform such transactions when they need foreign currency for, say, going on holiday. But on the other side of every business or individual foreign exchange transaction is someone who makes money from trading currencies. These people are called "traders." They make money by selling currency at a higher price than they buy it for – a difference known as the "spread." The price at which traders will buy currency is known as the "bid" price, and the price at which they will sell is known as the "offer" price.
Forex traders take "positions" in currencies, which may be "long" or "short." If they are "long" a currency, they have bought more than they have sold; if they are "short" a currency, they have sold more than they have bought. Usually, a short position is covered by borrowing, but it is possible for traders to do a "naked short," where they enter into a contract to sell currency they do not have in the hopes of being able to buy it at a lower price before the contract expires. A naked short is an unhedged bet that the currency exchange rate will fall.
Many businesses gain access to foreign-exchange market transactions via forex "brokers." These are intermediaries who buy foreign-exchange trading services and sell them to corporate and individual clients. Brokers can help businesses find the most suitable foreign-exchange trading arrangements for their business needs.1
Foreign Exchange Market Overview
The forex market is the largest financial market in the world. According to the Bank of International Settlements (BIS), in April 2016 trading on forex markets averaged $5.1 trillion per day.2 It was 27 times larger than the equities (stock) market, and four times larger than the entire global GDP.3
The foreign exchange market is also decentralized. There are no dominant exchanges, except in futures trading. Instead, there is a global network of brokers and traders, linked by technology. Participants in the market include banks, corporations, investment management firms, hedge funds, retail investors and central banks.4
The forex market consists of two sections: the interbank market, in which banks and financial institutions trade currencies to manage their own forex risks as well as those of their clients; and the retail (over-the-counter) market, in which individuals and businesses trade through online platforms and brokers.5 Of these two, the interbank market is by far the larger. In April 2016, 93 percent of transactions were between financial institutions, the majority of them banks.6
Exchange rates are principally determined in the interbank market through trading activity by large banks and financial institutions. Central banks also use the foreign exchange market to stabilize their currency exchange rates by buying and selling currency in sufficient quantities to influence the price.
The forex market is the only financial market that operates 24 hours a day, everywhere in the world. However, it currently closes for two days plus an hour each week, from 4 p.m. Eastern Standard Time (EST) on Friday to 5 p.m. EST on Sunday.7
What Currencies are Traded in the Forex Market?
In theory, any currency that is not subject to exchange controls by its country government can be traded in the foreign exchange market. In practice, however, forex trading is dominated by four currency pairs, known as "the majors":
- USD/EUR (dollar/euro)
- USD/JPY (dollar/yen)
- USD/GBP (dollar/British pound)
- USD/CHF (dollar/Swiss franc)
There are also three currencies from countries whose economies are dominated by commodities that participate in widely traded "commodity-linked pairs:
- USD/AUD (dollar/Australian dollar)
- USD/CAD (dollar/Canadian dollar)
- USD/NZD (dollar/New Zealand dollar)
These seven currency pairs, together with their combinations (such as EUR/GBP, EUR/JPY, GDP/JPY), account for more than 95% of all speculative forex trading.8 The currencies in these pairs are the easiest to price and trade; of them, by far the most dominant is the U.S. dollar. In April 2016, the dollar was on one side of 88 percent of forex transactions.9
Settlement in the Forex Market
Although the foreign exchange market itself is decentralized, settlement is not. About a third of forex transactions by corporations are settled through large banks.10 Of the remainder, the majority are settled through the "Continuous Linked Settlement" (CLS) system. CLS links the real-time gross settlement (RTGS) systems of central banks around the world so that the different currency legs of forex transactions settle at the same time.11 This eliminates Herstatt risk, the risk that settlement in one currency fails while the other completes. Currently, CLS settles approximately $1.85 trillion in forex spot, forward, and swap transactions daily.12
Final settlement of forex market transactions is typically two days after the transaction date.13
