Foreign Exchange MarketThe
foreign exchange (
currency or
forex or
FX)
market exists wherever one currency is traded for another. It is by far the largest market in the world, in terms of cash value traded, and includes trading between large banks, central banks, currency speculators, multinational corporations, governments, and other financial markets and institutions. Retail traders (small speculators) are a small part of this market. They may only participate indirectly through brokers or banks and may be targets of forex scams.
Market liquidityForeign exchange markets are unique in the financial world in that exchange rates are highly sensitive to a great variety of factors, many different types of investors have access to the market, the market is very liquid, and currencies are traded around the clock. The main international banks continually provide the market with both bid (buy) and ask (sell) offers.
In the foreign exchange market there is little or no 'inside information'. Exchange rate fluctuations are usually caused by actual monetary flows as well as anticipations on global macroeconomic conditions. Significant news is released publicly so, at least in theory, everyone in the world receives the same news at the same time.
Currencies are traded against one another. Each pair of currencies thus constitutes an individual product and is traditionally noted XXX/YYY, where YYY is the ISO 4217 international three-letter code of the currency into which the price of one unit of XXX currency is expressed. For instance, EUR/USD is the price of the euro expressed in US dollars, as in 1 euro = 1.2045 dollar.
Market participantsSome of the participants in this market are simply seeking to exchange a foreign currency for their own, like multinational corporations which must pay wages and other expenses in different nations than they sell products in. However, a large part of the market is made up of currency traders, who speculate on movements in exchange rates, much like others would speculate on movements of stock prices. Currency traders try to take advantage of even small fluctuations in exchange rates. Sometimes they are able to profit from arbitrage.
BanksThe 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 small fees. Today, however, much of this business has moved on to more efficient electronic systems, such as EBS, Reuters Dealing 3000 Matching (D2), the Chicago Mercantile Exchange, Bloomberg and TradeBook(R). The broker squawk box lets traders listen in on ongoing interbank trading is heard in most trading rooms, but turnover is noticeably smaller than just a few years ago.
Commercial CompaniesAn important part of this market comes from 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.
Central BanksNational 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. Milton Friedman argued that the best stabilization strategy would be for central banks to buy when the exchange rate is too low, and to sell when the rate is too high - that is, to trade for a profit. Nevertheless, 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.
The mere expectation or rumor 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, however. 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 South East Asia.
Investment Management FirmsInvestment Management firms (who typically manage large accounts on behalf of customers such as pension funds, endowments etc.) utilise the Foreign exchange market to facilitate transactions in foreign securities. For example, an investment manager with an international equity portfolio will need to buy and sell foreign currencies in the 'spot' market in order to pay for, and redeem, purchases and sales of foreign equities. Since these transactions are secondary to the actual investment decision, they are not seen as speculative or aimed at profit-maximisation.
Some investment management firms also possess specialist Currency Overlay units, which have the specific objective of managing clients' currency exposures with the aim of generating profits whilst limiting risk. Whilst the number of dedicated currency managers is quite small, the size of their assets under management (AUM) can be quite significant, which can lead to large trades.
Hedge FundsHedge funds, such as George Soros's Quantum fund have gained a reputation for aggressive currency speculation since 1990. 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' favor.
Retail Forex BrokersRetail forex brokers handle a minute fraction of the total volume of the foreign exchange market. According to CNN, one retail broker estimates retail volume at $25-50 billion daily, which is about 2% of the whole market. CNN also quotes an official of the National Futures Association "Retail forex trading has increased dramatically over the past few years. Unfortunately, the amount of forex fraud has also increased dramatically."
In the retail Forex industry market makers more often than not run two separate trading desks- one that they use to actually trade foreign exchange (sometimes called a "non-dealing desk" and essentially serving as a proprietary trading desk) and one that is set up for the expressed purpose of off-exchange trading with retail customers (called the "dealing desk" or "trading desk"). Despite various' market makers claims to "offset" clients' trades on the interbank market (the market maker takes the same position that its clients take), there are many reasons why this is implausible, foremost being that the vast majority of retail currency speculators are novices and not profitable. This being the case, if all trades were offset, market makers would simply be giving up substantial profits to the interbank market. Offsetting almost certainly does occur, but only when the market maker judges its clients' net position as being exceedingly risky.
The dealing desk operates much like the currency exchange counter at a bank. Interbank exchange rates, those coming in from the interbank system and displayed at the non-dealing desk, are adjusted to incorporate spreads that safegaurd the bank’s (in this instance the market makers’s) profit before they displayed in the lobby (at the dealing desk) to the retail customer. Dealing desk pricing is, therefore, not a direct reflection of the currency exchange but artificial pricing created and controlled by the originating broker.
The existence of sometimes off-market pricing on retail trading platforms means that arbitrage opportunities may exist, but retail market makers have become highly efficient at removing arbitragers (commonly referred to as "pickers") from their systems or severly limiting their trading activity.
There are only a limited number of retail Forex brokers offering consumers direct access to the interbank Forex market, the vast majority do not for two apparent reasons. First, the number of clearing banks willing to process the orders of private investors is extremely limited so most brokers couldn’t offer traders direct access if they wanted to. More importantly, the dealing desk model (e.g. that which is employed by firms such as Gain Capital, SaxoBank, FXCM, GFT, and FX Solutions) is decidedly more profitable, as a large portion of retail traders' losses are directly turned into market maker profits.
Whereas a retail non-dealing desk broker’s income is limited to transaction fees (commissions), dealing desk brokers can generate income in a variety of ways because they not only control the trading process, they also control pricing which they can skew at any time to maximize profits and to take advantage of internal and external trading opportunities. As evidence of this, some traders point to the “reorder” or "requote", a market maker counteroffer that is issued in response to a trader’s execution order. Instead of the filling an order based on displayed terms, the market maker rejects the order, issuing one that detractors believe favors the market maker’s interests.
Perhaps more important is the simple fact that the "rules of the game" for retail speculators are highly disadvantageous. Many lack trading experience and are attracted to the market due to the potential for large returns. Most are severly undercapitalized (account minimums at some firms are as low as 250-500 USD). This is compounded by minimum position sizes, which on most platforms ranges from 10,000 to 100,000 units, forcing some traders to take imprudently large positions. What is perhaps the greatest disadvantage and most dishonest practice of retail Forex firms is defaulting of accounts to extremely high leverage. Professional forex traders rarely use more than 10:1 leverage, yet many retail Forex firms default client accounts to 100:1 or even 200:1, without disclosing that this is highly unusual for currency traders. This drastically increases the risk of a margin call (which, if the speculator's trade is not offset, is pure profit for the market maker).
Dealing desk brokers are market makers. They not only create and manage artificial, off exchange trading environments (markets), they also function as market makers for the interbank system and, thereby, serve as independent and competing sources of liquidity for participating banks. This dual capacity is seen by many as posing an inherent conflict of interest because there is nothing to prevent brokers from taking out (spiking or stop hunting) off-exchange trades.
Like the rebellion that started over a quarter of a century ago that led most small investors to abandon large stock brokerage firms in favor of discount, on-line brokerage firms like Schwab, E-trade, Ameritrade, Datek, and Fidelity, there are those who think retail Forex trading will go much the same way. Investors abandoned large stock brokerage firms not only because the trading costs were lower but because their stockbrokers were more interested in making markets for themselves (churning accounts) and their corporate partners rather than serving the financial needs of the individual trader. Similarly, dealing desk brokers may inevitably be forced to abandon their artificial trading platforms, offering traders direct market access through their non-dealing desks.
According to the Wall Street Journal (Currency Markets Draw Speculation, Fraud July 26, 2005) "Even people running the trading shops warn clients against trying to time the market. 'If 15% of day traders are profitable,' says Drew Niv, chief executive of FXCM, 'I'd be surprised.' "
In the US, "it is unlawful to offer foreign currency futures and option contracts to retail customers unless the offeror is a regulated financial entity" according to the Commodity Futures Trading Commission. Legitimate retail brokers serving traders in the U.S. are most often registered with the CFTC as "futures commission merchants" (FCMs) and are members of the National Futures Association (NFA). Potential clients can check the broker's FCM status at the NFA. Retail forex brokers are much less regulated than stock brokers and there is no protection similar to that from the Securities Investor Protection Corporation. The CFTC has noted an increase in forex scams.
Around-the-clock marketUnlike stocks and futures exchange, foreign exchange is indeed an interbank, over-the-counter (OTC) market which means there is no single universal exchange for specific currency pair. The foreign exchange market operates 24 hours per day throughout the week between individuals with forex brokers, brokers with banks, and banks with banks. If the European session is ended the Asian session or US session will start, so all world currencies can be continually in trade. Traders can react to news when it breaks, rather than waiting for the market to open, as is the case with most other markets.
All informations are brought to you from Wikipedia, the free encyclopedia.
