Chapter 4: The Forex Market

What makes the forex market so great to trade is its size. It is the biggest market in the world. Despite being dominated by large banks, corporations, and governments, participants of any size can join in and trade at almost the same relative cost. It is unusual, in that forex is one market where we can say that size does not matter.

The trading volumes are truly enormous in forex, dwarfing all stock markets in the world many times over. In its latest triannual survey, the Bank of International Settlements said trading in forex markets reached USD 6.6 trillion per day as of April 2019. This was up from USD 5.1 trillion three years earlier. In a 2004 survey, the daily turnover was just USD 2 trillion. See bis.org/statistics/rpfx19_fx.htm

The Interbank Market

The interbank market is a global network of financial institutions, usually the largest banks in the world, trading with each other. These banks may be trading for their customers (other banks or corporations) or as a principle, which means for their own accounts. Banks use the interbank market to manage their exposure and risk to exchange rate changes and interest rate movements. Trading is usually closed out within the day but rarely held for much longer. According to The Bank of International Settlements data, approximately 50% of all forex transactions are strictly interbank trades.

To be a member of the interbank market, you must be willing to be a market maker to the other banks in size. This means that you must be willing to make a two-way price, to buy or sell and for a large minimum amount. This restricts the membership to only the largest, most active, wealthiest and most creditworthy banks. Amongst the biggest players today are Citibank, JPMorgan Chase, Deutsche Bank and HSBC. There are other members, including a few hedge funds and trading firms.

What makes membership of this club so exclusive is the typical size of a deal. In the interbank market, one is USD 1,000,000, but the minimum deal size is USD 5,000,000. So, a deal of ten is USD 10 million. It is not uncommon to have deals of USD 1 billion done in a split second between banks. (USD 1 billion is called a ‘yard’ in the interbank market. It is rhyming slang for milliard, the European name for a billion). It is used because million and billion sound too similar and could cause serious errors. It is a relic of the days when deals were arranged and executed over the phone or over the counter (OTC). This is what makes the interbank market so exclusive. Other participants must know that the people they're dealing with will be good for deals of that size.

The Interbank market is non-regulated and decentralised. Most central banks collect data from the participants to ascertain economic risk implications and are concerned about global financial stability. Despite being unregulated, there have been few defaults and scandals since the Interbank market started in the 1970s. The interbank market is the wholesale forex market place.

Today, all interbank trading in G7 currencies is done using computers and no longer on the phone. Humans can't do the pre-trade credit checks and settlement process without error in the split second that is required today. Exotic pairs and cross rates are still traded, dealer to dealer, over the telephone. The trend suggests this will happen less and less. The interbank forex dealers are gradually being replaced by computerised systems that can scan large numbers of traders (computers) to trade billions of dollars at once.

The interbank market informally came together after the collapse of the Bretton Woods Agreement and the decision in 1971 by President Richard Nixon to take the US off the gold standard. Currency rates of most large industrialised nations were then allowed to float freely, with only occasional and unusually unsuccessful government intervention. There is no centralised location for the market as trading coincides worldwide and stops only for weekends and holidays.

Hedgers and Corporates

The forex market sits at the centre of global commercial transactions and investing. American multinational companies, European hedge funds, South American coffee producers all have to go through the forex market. It is unavoidable for globally trading entities.

There are two types of participants in the forex market: commercial transactions and speculation. Companies make commercial transactions as part of their overall business and not necessarily for currency reasons. They may simply be making a change transaction – transferring money from a home currency into the country's currency with whom it is making a purchase or sale.

Corporate transactions are important to forex markets because:

  • Their transaction size can be exceptionally large, typically hundreds of millions of dollars, or even billions.
  • There may be a proper hedge – protecting against the currency risk over time. These will be automatically entered into and exited when the currency fluctuation risk has gone.
  • They are usually one-time events.
  • They are generally not price-sensitive or profit-maximising. The company merely wants to change money to buy or sell goods in another currency.

Hedging

A producer of copper pipes in Chile may sell a cargo to a European housebuilder. They will fix the price when they have done the deal, but the payment will take place after receiving the copper pipes in Europe. It takes time to fabricate the copper pipes and ship them to their destination in Europe. During this time, both parties, the buyer and the seller, are exposed to adverse movements in the forex market. Both may initiate an opposite currency hedge at the start of the contract and then undo the hedges on completion and payment. The hedges are the opposite because the risk to each party is the opposite. Both parties are not interested in making money out of the forex movements during the goods' delivery. But it could go in their favour, it could go against them. They fix the rates and therefore neutralise the risk with their hedges. The copper producer’s business is mining and fabricating pipes. The housebuilder’s business is construction. Neither wants the uncertainty of a move in the currencies’ prices. Neither is interested in currency movements as such. They see it as a risk that they want to neutralise and profit from their actual manufacturing and consuming businesses. This is an entirely different mindset to that of the speculator.

Speculators

Most short-term forex transactions are speculative. It is estimated that upwards of 90% of daily forex trading volume is based solely on speculation.

Specs are in the market for one reason only: to make money. While hedges reduce risk, speculators embrace it. Speculators, by bringing capital to the market, they give the marketplace a vital source of liquidity. Liquidity smooths out price movements, keeps the spread between the Bid and Ask (transaction costs) narrow, and allows the market to function smoothly. Speculators have an essential and beneficial role in the market. If you are trading forex, you are a speculator.

Speculators come in many shapes and sizes. A small private speculator may be on one side of the trade, with a large hedge fund on the other side. These participants trade continuously with each other.

It is essential to know who these players are and how they act.

Hedge Funds

A hedge fund is unlikely to be a hedger. Rather than offset risk, they will seek to exploit it. The hedge fund industry had around USD 3.58 trillion of assets under management in 2018. The most significant proportion of the funds were between USD 500 million and one billion. Funds in this region are average-sized hedge funds. Funds with fewer assets under management (AUM) are considered small hedge funds, and funds with AUM above are called large hedge funds. All hedge funds deal in forex, but only a subset is exclusively focused on the forex market.

Along with banks, hedge funds are the most prominent players in the market. Hedge funds are often highly geared or leveraged, and so their trading size is many multiples of AUM. A USD 100 million AUM fund may have trading limits of USD 500 million to USD 2 billion.

Relatively few forex hedge funds use macro-economic news as their driver. They are more likely to use technical analysis or a quantitative approach. Some hedge funds use a black-box approach to buying and selling. The black box refers to the proprietary quantitative formula used to generate trading decisions. Price and other data go in, trading signals come out and are executed by the computer itself. What is inside the black box, no one knows. The black box may be learning and teaching itself. Its rationale for buying and selling is changing as it learns more and gains more experience. Between a technical analysis approach and a black-box approach is a rules-based trading system or systematic approach. These systems employ tested defined rules to enter and exit the trades. The technical analysis approach and systematic approach are popular with non-institutional traders. Indeed, in these trading styles, big banks and hedge funds have no particular advantage over the private investor. In fact, due to their immense size, they often operate at a disadvantage.

Another type of trading is called discretionary. For legal reasons, banks and hedge funds rarely employ discretionary traders these days. If they do the trader will be called a proprietary or prop trader. This is still the most popular way of trading among private investors. Discretionary trading is trading when it feels right. Today, after the excesses of the period up to the Global Financial Crisis (GFC), this trading style is considered too risky for institutions.

High-Frequency Trading

High-Frequency Trading (HFT) is exclusively the domain of banks and hedge funds. To get an edge or advantage, you must have expensive equipment, low transaction latency, extremely clever programming and the ability to execute in time periods measure in nanoseconds. Because of the difference between the entry and exit of the trade, the position sizes must be substantial to generate a meaningful profit. HFT is the sole domain of well-heeled participants and is not as prevalent in the forex market as it is in the equities market. This is because forex is too efficient and, therefore, it is more difficult for the HFT machines to make money. There is enough inefficiency in the equities market to allow HFT machines to profit without excessive risk. The trading that they do is has no discernible impact on private investors’ trading. In reality, it may be good for the private investor as it adds liquidity to the market, meaning a better execution.

Private investors

Most currency trading is speculative and short term in nature. Short term can be minute to minute or hour to hour, but positions are usually not held for days or weeks. Private investors are often Day Traders and focus on profiting from the next 20 to 30 pips in the market.

Government Policy and Central Banks

Governments worldwide are in the forex markets daily, not to manipulate the value of their currency but to make government operations, make transfer payments, and manage their foreign exchange reserves. Government operations and making government transfer payments, although large, have little impact on the price of currency pairs. Currency reserve management has become bigger and bigger in recent years. Market talk of central bank buying or selling has become an almost daily occurrence. The impact of this on the markets can frequently lead to multi-day highs and lows being maintained in the face of an otherwise compelling trend. Traders need to follow the real-time market commentaries closely for signs of central bank intervention and involvement.

Trade surpluses arise when a country exports more than it imports. Countries with large trade surpluses will accumulate reserves of foreign exchange currency over time. Since it is receiving more foreign currency for its exports than it is spending to buy imports, foreign currency balances build over time.

Since the collapse of the Bretton Wood Agreement and floating of currencies, the US dollar has been the primary currency for international reserve holdings for most countries in the world. International Monetary Fund (IMF) data shows that the US dollar accounted for almost 80% of global currency reserve holdings. This is a growing trend; 15 years ago, the dollar accounted for 65% of global currency reserve holdings. The US dollar is the world's currency.

Over the decades, the US has run up massive trade and current account deficits with the rest of the world. On the other side of this has been the accumulation of large trade surpluses in other countries, Asia and even countries on its borders, Canada and Mexico.

The US’ ballooning deficit essentially amounts to the US borrowing more and more money from countries with trade surpluses. In contrast, those countries buy IOUs in the form of US Treasury (government) debt securities.

There is increasing concern over the dominance of the US dollar in international trade. Governments and international traders and corporations are getting queasy over being forced to use a currency which is so controlled – some say erratically and politically controlled. While there is much talk about an alternative to the US dollar as the worlds reserve currency, there has been little real move away from it. One day we may be using a new basket of currencies, the Renminbi, or a cryptocurrency. For the moment, the Dollar is king.

The G7, G8 and G20

The Group of Seven (G7) meets annually to discuss global issues, mainly politics. After the first oil shock in the 1970s, global leaders wanted to do something about it when economies across the world were suffering. A group of government officials decided to meet and figure things out. The members of G7 are Canada, France, Germany, Italy, Japan, the UK and the US. Also, the presidents of the European Council and Economic Commission represent the EU at G7 summits. Russia joined the club in 1998, making it the G8, but was kicked out in 2014 after the annexation of Crimea.

The members of G20 represent 85% of the world’s economic output. It is a less exclusive club than G7. G20 members are Argentina, Australia, Brazil, Canada, China, Germany, France, India, Indonesia, Italy, Japan, Mexico, Russia, Saudi Arabia, SA, South Korea, Turkey, the UK, the US and the European Union.

Both summits can be contentious, attracting large and sometimes quite violent demonstrations. Traders closely follow the preparations leading up to the meetings for several weeks in advance of the event. The markets are looking first to see which currencies will be discussed (if any). The market will generally have a sense of whether currencies are an issue and the general feeling of what the G7 would like to see done. Comments from ministers holding the prior consultation set the stage for the market's expectations and can cause significant market movements even before the meetings themselves.

Tip: As is the case so often in the markets, it is not the content of the final communiqué that matters; it is the perception of the tone and sincerity of it that matters. Do the ministers mean it and will they do anything about it?

Bank for International Settlements (BIS)

The BIS is the central banker’s central bank. It is in Basel, Switzerland and also acts as a regulator of the international banking system. The BIS established the capital adequacy requirements for banks that today underpin the international banking system. It also collects and distributes anonymous statistic on global forex market trading. If you see a quoted size of global forex trading; the source is probably the BIS.

As the BIS is a bank to central banks and national governments, it frequently acts as a market intermediary for those nations seeking to diversify their currency reserves, perhaps into gold. The BIS is a deposit taker for central banks and holds much of the gold owned by nations in safekeeping. By going through the BIS, those countries can remain relatively anonymous and prevent speculation from driving the market against them. The BIS is a routine but large player in the markets acting on behalf of its clients — countries. Sometimes it may be involved in large transactions while a national central bank adjusts its reserves or cashing in or building its gold holdings.

Read more about Bretton Wood Agreement in our glossary

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