Understanding the Forex Market

The forex market, also known as the foreign exchange market, is where the globalised trading of currencies is carried out. The essence of trading currencies is to attempt to profit from the variations in the rate of exchange between one currency and another. Currency trading is possible because many of the world’s currencies are allowed to “float”, i.e. their values are determined by the forces of demand and supply. Currencies that are under fixed exchange rate regimes are not amenable to trading in the forex market.

Currencies are traded offline by banks and Bureaux de Change operators. This is a closed market as operators usually need to have some sort of license to do this. In online forex trading, anyone can participate, as long as they have the right tools and have access to this global, decentralized market. The forex market can therefore be understood to be a globalized marketplace where decentralized trading of currencies takes place.

The forex market has several components, which all come together to make the market work. These components are:

  1. The market participants (banks and traders).
  2. The brokers.
  3. The assets that are traded.
  4. The exchanges.
  5. The support service providers.

The Participants

Who are the participants that make the forex market what it is? The participants are those who provide the currencies that are traded in the market (banks) as well as the traders themselves. The forex market is a zero-sum market. It is the participants who add money to it and take money from it, with money flowing from the losing traders to the winning traders. Apart from the traders, there are also the government institutions that are responsible for creating money and controlling the supply of currencies: the central banks. So we can list out the forex market participants as follows:

  • The central banks: control the supply of currencies. They increase the supply of a national currency or create demand for a foreign currency by buying large quantities of as an interventionist strategy.
  • Banks at all levels (major banks, investment banks, commercial banks).
  • Financial institutions such as hedge funds, prime brokerages.
  • Multi-national corporations.
  • High net-worth individuals.
  • Retail/individual traders

 

According to the last triennial survey performed by the Bank of International Settlements (BIS), more than $5trillion is turned over in the forex market daily. The market participants trade through the major hubs located in New York, London, Sydney and Tokyo. Access to these hubs is made possible by the broker platforms.

What is Traded?

Currencies are the only assets that are traded in the forex market. However, they may be traded in different ways as follows:

  1. Spot forex
  2. Forwards
  3. Options

The commonest form of currency trading in the online forex market is spot forex. Spot forex involves instant execution and settlement of forex trades and are conducted by retail and institutional investors. Currency forwards (deliverable and non-deliverable) as well as forex options are usually traded by the institutional players in the market.

The Exchanges

The forex market differs from other financial markets in the sense that forex trading is not performed from a centralized, regulated exchange. Rather, forex trading is decentralized, carried out across various trading hubs, and traders get access to these hubs using trading platforms that are delivered to them by their brokers.

The Brokers

No trader can get access to the forex market without going through a broker. Brokers perform a number of important functions in the forex market.

  • They provide access to the market through the provision of the trading platforms.
  • They hold the trading capital of traders in trust.
  • They perform clearing and settlement of trades.
  • Brokers are increasingly getting involved in trader education and provision of value-added services such as technical analysis.

Two types of brokers exist. We have the market makers, who execute orders of their clients in-house in the dealing desk department, and the direct market access brokers who provide access to interbank market executions.

Some people may ask: why do all traders not get access to interbank market executions, which is where direct market action is? This is because of liquidity requirements. Most retail brokers cannot afford the capital required to bridge liquidity gaps in the forex market. These traders must then rely on market makers who bridge the liquidity gaps on their behalf with the proviso that they must then buy the positions from the market makers at a slight premium.

The Support Services

There are several support services which provide services to the market away from the core aspect of trading. These services render support to the brokerages and traders. What are these support services all about?

  1. Programmers: programmers are required at many levels in the forex market. They design and maintain the trading platforms, code the various custom indicators and expert advisors as well as other software used in the forex market.
  2. Web developers are responsible for the development of the websites of forex brokers and those of vendors of forex products.
  3. Ever seen the glittering info graphics, logos and depictions seen on forex sites? This is the job of graphics designers.
  4. Third party forex product vendors provide tools to traders such as indicators, forex robots, signals and copy trade services, social trading platforms, etc.
  5. Sales: Forex brokers have to compete with each other for clients all over the world. Each brokerage has a sales team whose jobs are to generate leads, follow up on those prospects and convert them to trading customers.
  6. Digital marketing specialists: Working as independent contractors, many companies and freelancers now provide digital marketing services to forex brokers to boost their social media presence.
  7. Compliance specialists typically work in banks and brokerages to maintain Anti-Money laundering (AML) protocols and to keep the forex market free of flow of illicit funds.
  8. Research and analysis is a field dominated by certified market technicians, whose job is to provide technical and fundamental analysis on the movements of currency assets.

Conclusion

The forex market is a complex interplay of several components, each coming together to make the forex market what it is today. It is hoped that this short article has provided some insight as to what the forex market is all about, and what makes it tick.