BUSINESS NEWS - Forex market or foreign currency exchange or FX is a global market where currencies are bought and sold in return for another. Forex market is the largest financial market in the world with an average daily trading volume of more than $6.6 trillion.

Unlike other capital markets, currencies are always traded in pairs. One currency needs to be sold in order to buy another one and vice versa. The prices of each currency with respect to other currencies keep on changing throughout the day. Each overseas transaction involving currency exchange adds to the forex market trading volume.

How Does Forex Market Work?

The forex market is not based on any particular exchange but is spread across the global network. Central banks, corporates, and market makers are the liquidity providers that adjust the prices of currency pairs depending on demand & supply and several other factors.

The forex market is active throughout the day five days a week. Any event across the globe can cause price movements for any currency. The interbank market is where banks and large corporates trade while small scale forex trades are executed through the OTC mechanism. 

Retail participants take part in the forex market for hedging and speculation on different currency pairs through brokers. These brokers offer leverage on forex trades to make it convenient for them.

A large number of regulated and unregulated retail forex brokers are available in the market.

There are 70 Non-bank & Bank entities that have application for licensed OTC derivatives Provider with FSCA. 13 Bank entities have their license approved with FSCA as ODPs as per their search page. Many entities have their license status ‘Applied’ which means their application is currently pending.

Many of the entities that have applied under ODP licensing are Retail CFD brokers that offer Forex Trading in South Africa among which 20+ are retail forex brokers offering CFDs on forex and other instruments to retail investors, and these retail brokers have applied under Category ‘Non-Banks’ as per FSCA’s ODP search website.

The bid-ask spread is the major source of income for online forex brokers. Some brokers can additionally charge commissions for trading and other services offered.

Traders can go long as well short on any of the available currency pairs with leverage. The leverage allows traders to open bigger positions with a small deposit but is risky.

History of Forex Market

The concept of the forex market is based on the valuation of one currency with respect to another. Before World War 2, each currency was pegged to commodities like gold and silver. The valuation of each currency depended on the amount of gold and silver possessed by the government.

After WW2, USD became the peg for each currency worldwide. After 1972, every country became free to use its own peg for the valuation of currency. Their valuation also started to have a major impact on demand and supply. This gave rise to frequent price fluctuation between currency pairs which were soon traded for hedging and speculation.

Importance of Forex Market in Global Economy

Currencies are the driving wheel of the economy. There are several ways in which the valuation of currency with respect to others can affect the economy.

Imports and exports are solely based on the exchange of goods and currencies. If a country with weaker currency is importing surplus, it can lead to a trade deficit.

The entire GDP of a nation can be affected by the supply and demand in the currency pair. Net capital flows, inflation, Interest rates, trades, etc. can be greatly affected by the price fluctuation of one currency with respect to another.

Currencies prices can also reflect the change in the economic condition of one country with respect to another.

Types of Forex Markets

There are three broad types of foreign exchange:

• Spot

As the name suggests, the currency exchange takes place at current or spot prices. The buyer and seller agree to exchange currency at prevailing exchange rates. A majority of the forex market is based on the spot market. The spot rates can change every second due to countless reasons.

Central banks, corporations, and large-scale dealers are the major participants in the spot market. Online retail forex trades are also carried out at spot rates. However, retail traders are responsible for a very small proportion of global foreign exchange.

• Forward

In a forward market, one party agrees to sell and the other party agrees to buy the currency in return for another currency at a particular date in the future. It is an OTC market and does not require an exchange or market maker to trade forex. There is a high counterparty and liquidity risk.

• Futures

The working of the futures market is almost similar to forward. Two parties agree to exchange at a future date at a predefined price. The major difference is that these parties will meet each other through a centralized exchange. Hence, there will be a very little third-party risk or illiquidity risk.

Players in the Forex Market

Different types of market participants constitute the forex market as a whole. Following is the description of some of the players in the forex market.

• Central and Commercial Banks

Central banks are responsible for the largest proportion of trading volume globally. Most of the currencies are exchanged via banks that also transact among themselves. Commercial banks are major participants but the central banks are more than just participants in the forex market.

Commercial Banks can speculate the currencies to enhance their asset base. While acting as a dealer for clients, they make the difference between the bid and ask price called spreads. Having units of multiple currencies also helps in the diversification of the portfolio.

Central banks are responsible for setting the price of the native currency with respect to every other currency. It can have a major impact on the overall economy of the nation.

• Corporations

Corporates can have a decent impact on the forex market but that depends on their business activities. Large-scale imports and exports will require payment to be made in a different currency. This currency will be exchanged through the forex market and will eventually impact the supply and demand. Bigger corporates with significant overseas revenue have a bigger impact on the currency prices.

Corporates also use the forex market to hedge against the risk of price movement. Some can also use it for portfolio diversification and speculation.

• Forex Dealers or Market Makers

Forex dealers and brokers seek to make money by matching up buyers and sellers of the same currency. Their income is mainly based on the bid-ask spread but they can also charge a commission for added services. Institutional investors and retail participants are their clients hence the forex brokers and dealers account for a small proportion in trading volume.

Market makers can also match the buyers and sellers of similar requirements but they can also take the other side of the trade if needed. In case a retail trader wants to buy but no seller is available, a market maker can become the seller and vice versa. The income of market makers does not depend only on spreads, they can also make profits by taking the other side.

• Retail Participants

Retail participants are the common individuals who use the forex market for hedging and speculation. Individuals may also require to exchange currency for traveling overseas or for overseas investment.

Most of the retail participants in the forex market are traders and speculators. They aim to book profits by buying and selling currencies with anticipation of price moving in a favorable direction and generating profits. In African countries like South Africa, Nigeria, and Kenya, the number of retail traders has spiked dramatically in recent years.

Article supplied by Forex Beginner SA.

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