Reference manual introduction to FX

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, gove

The London Academy of Trading

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Level 5 Diploma in Applied Financial Trading

Reference Manual Introduction to Foreign Exchange

-Contents

The Global FX market trades more than $5 trillion each day Apart from the essential function of facilitating international trade, FX has become an asset class in its own right, traded actively by banks, funds, corporations and even individuals

This course covers an overview of the FX market, including:

 History of the FX Market

 Financial Centres

 Market size and liquidity

o Central Bank Survey

 Market Participants

o Banks

o Central Banks

o Hedge Funds

o Investment Management Firms

o International Commercial Companies

o FX Brokers

o FX Real Money Brokers

o Money Transfer Companies

Foreign Exchange Market

The 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, other financial institutions and even retail traders

The Creation of the Euro and the Role of the Dollar in International Markets

During the nineteenth and the first half of the twentieth centuries, the British pound was the preeminent international currency It was used in both international trade and

financial transactions and circulated throughout the British Empire With the decline of British economic power in the 20th century, the U.S dollar replaced the pound as the leading international currency

For over 60 years the U.S dollar has been the leading currency used in international trade and debt contracts Primary commodities are generally priced in dollars on world exchanges Central banks and governments hold the bulk of their foreign exchange reserves in dollars

In addition, in some countries dollars are accepted for making transactions as readily as (if not more so than) the domestic currency

On January 1, 1999, a new currency—the euro— was created, culminating the progress toward economic and monetary union in Europe The euro replaced the currencies of 11 European countries: Austria, Belgium, Finland, France, Germany, Ireland, Italy,

Luxembourg, the Netherlands, Portugal, and Spain Two years later Greece became the

12th member of the euro area

Although the Japanese yen and particularly the German mark have been used

internationally in the past several decades, neither currency approached the

international use of the dollar With the creation of the euro, for the first time the dollar has a potential rival for the status as the primary international currency

FUNCTIONS OF AN INTERNATIONAL CURRENCY

Economists define money as anything that serves the following three functions:

 a unit of account,

 a store of value, and

 a medium of exchange

To operate as a unit of account, prices must be set in terms of the money To function as

a store of value, the purchasing power of money must be maintained over time To function as a medium of exchange, the money must be used for purchasing goods and services For an international currency, one used as money outside its country of issue, these functions are generally divided by sector of use - private and official, as listed in Table 1.4 A currency serves as a unit of account for private international transactions if it

is used as an invoice currency in international trade contracts It serves as a store of value

if international financial assets are denominated in this currency It serves as a medium

of exchange internationally if it is used as a vehicle currency through which two other currencies are traded, and as a substitute for a domestic currency

History of the FX Market

The forex market is a cash inter-bank or inter-dealer market, which was established in 1971 when floating exchange rates began to appear

The FX market is huge in comparison to other markets For example, the average daily trading volume of US Treasury Bonds is $300 billion and the US Stock Market has an average daily volume of less than $10 billion Ten years ago the Wall Street Journal estimated the daily trading volume in the forex market to be in excess of $1 trillion By

2013 that figure had grown to exceed $5 trillion a day

According to David Krutz from the Financial Times website: "The FX market will have doublcontinues to rapidly grow in size thanks to increased participation by fund managers and pension funds, as FX has become accepted as an asset class in its own right "

Prior to 1971, an agreement called the Bretton Woods Agreement prevented speculation

in the currency markets The Bretton Woods Agreement was set up in 1945 with the aim

of stabilizing international currencies and preventing money fleeing across nations This agreement fixed all national currencies against the dollar and set the dollar at a rate of $35 per ounce of gold

Prior to this agreement the gold exchange standard had been used since 1876 The gold standard used gold to back each currency and thus prevented kings and rulers from arbitrarily debasing money and triggering inflation Institutions like the Federal Reserve System of the United States have this kind of power

The gold exchange standard had its own problems however As an economy grew it would import goods from overseas until it ran its gold reserves down As a result the country’s money supply would shrink resulting in interest rates rising and a slowing of economic activity to the extent that a recession would occur

Eventually the recession would cause prices of goods to fall so low that they appeared attractive to other nations This in turn led to an inflow of gold back into the economy and the resulting increase in money supply saw interest rates fall and the economy strengthen These boom-bust patterns prevailed throughout the world during the gold exchange standard years until the outbreak of World War I which interrupted the free flow of trade and thus the movement of gold

After the war the Bretton Woods Agreement was established, where participating countries agreed to try and maintain the value of their currency with a narrow margin against the US Dollar A rate was also used to value the dollar in relation to gold Countries were prohibited from devaluing their currency to improve their trade position by more than 10% Following World War II, international trade expanded rapidly due to post-war construction and this resulted in massive movements of capital which destabilized the foreign exchange rates that had been set-up by the Bretton Woods Agreement

The agreement was finally abandoned in 1971, and the US dollar was no longer convertible

to gold

By 1973, currencies of the major industrialized nations became more freely floating, controlled mainly by the forces of supply and demand Prices were set, with volumes, speed and price volatility all increasing during the 1970’s This led to new financial instruments, market deregulation and open trade It also led to a rise in the power of speculators

In the 1980’s the movement of money across borders accelerated with the advent of computers and the market became a continuum, trading through the Asian, European and American time zones Large banks created dealing rooms where hundreds of millions of dollars, pounds and yen were exchanged in a matter of minutes

Today electronic brokers trade daily in the forex market with single trades for tens of millions of dollars being priced and executed in seconds The market has changed dramatically with most international financial transactions being carried out not to buy and sell goods but to speculate on the market with the aim of most dealers to make money out of money

Financial Centres

The main trading centers are in London, New York, Tokyo, Hong Kong and Singapore, but banks throughout the world participate Currency trading happens continuously throughout the day; as the Asian trading session ends, the European session begins, followed by the North American session and then back to the Asian session, excluding weekends

London has grown to become the world’s leading international financial center and is the world’s largest forex market This arose not only due to its location, operating during the Asian and American markets, but also due to the creation of the Eurodollar market The Eurodollar market was created during the 1950’s when Russia’s’s oil revenue, all in US dollars, was deposited outside the US in fear of being frozen by US authorities This created

a large pool of US dollars that were outside the control of the US These vast cash reserves were very attractive to foreign investors as they had far less regulations and offered higher yields

Today London continues to dominate as American and European banks have come to the City to establish their regional headquarters The sizes dealt with in these markets are huge and the smaller banks, commercial hedgers and private investors hardly ever have direct access to this liquid and competitive market, either because they fail to meet credit criteria

or because their transaction sizes are too small But today, market makers are allowed to break down the large inter-bank units and offer small traders the opportunity to buy or sell any number of these smaller units (lots)

Market size and liquidity

Since FX is an OTC market where brokers/dealers negotiate directly with one another, there is no central exchange or clearing house The top four centres account for more than 65% of global turnover The chart of FX volume by region (below) illustrates the dominance

of London, but also highlights the increase in trading volumes across Asia between 2013 and 2016

Source - BIS Triennial Survey, 2016 (http://www.bis.org/publ/rpfx13fx.pdf)

FX trading has increased dramatically since 2001, largely due to the growing importance

of FX as an asset class and an increase in fund management assets, particularly of hedge funds and pension funds The diverse selection of execution venues such as internet trading platforms has also made it easier for retail traders to trade in the FX market The FX market is unique because of a number of factors:

 its trading volume,

 the extreme liquidity of the market,

 the large number (and variety) of traders in the market,

 its geographical dispersion,

 its long trading hours - 24 hours a day (except on weekends)

 the variety of factors that affect exchange rates

 low profit margins (although high volumes compensate for this)

 the use of leverage

The most respected survey of FX market turnover is published every three years by the Bank for International Settlements (BIS) According to their latest Triennial Central Bank Survey the average daily turnover in traditional FX markets was more than ten times the size of the combined daily turnover on all the world’s equity markets

Source - BIS Triennial Survey, 2016 (http://www.bis.org/publ/rpfx13fx.pdf)

As you descend the levels of access, the difference between the bid and ask prices widens (from from 0-1 pip to 1-2 pips for major currencies such as the EUR) This is due to volume

If a trader can guarantee large numbers of transactions for large amounts, they can demand a smaller difference between the bid and ask price, which is referred to as a better spread

The levels of access that make up the forex market are determined by the size of the “line” (the amount of money with which they are trading) The top-tier inter-bank market accounts for more than half of all transactions After that there are usually smaller investment banks, followed by large multi-national corporations (which need to hedge risk and pay employees in different countries), large hedge funds, and even some of the retail forex market makers

According to Galati and Melvin, “Pension funds, insurance companies, mutual funds, and other institutional investors have played an increasingly important role in financial markets

in general, and in FX markets in particular, since the early 2000s.” In addition, he notes,

“Hedge funds have grown markedly since the early 2000’s, both in terms of number and overall size” Central banks also participate in the forex market to align currencies to their economic needs

These large international banks continually provide the market with both bid (buy) and ask (sell) prices The bid/ask spread is the difference between the price at which a bank or market maker will sell ("ask", or "offer") and the price at which a market-maker will buy ("bid") from a wholesale customer This spread is minimal for actively traded pairs of currencies, usually only 1-3 pips

For example, the bid/ask quote of EUR/USD might be 1.3155/1.3156 Minimum trading size for most deals is usually $100,000, but $10,000,000 per trade is normal

These spreads might not apply to retail customers at banks and exchange brokers, which will routinely mark up the difference to say 1.2500 / 1.4300 for banknotes or travelers' cheques

Spot prices at market makers may vary, but on EUR/USD are usually no more than 2 pips wide (i.e 0.0002) However, competition has greatly increased with pip spreads shrinking

on the major pairs to less than 1 pip, with Barclays being the first bank to reduce spreads

to fractions of a pip for major currency pairs

Central Banks

National Central Banks (e.g Bank of England, US Federal Reserve, European Central Bank, Bank of Japan, etc.) play an important role in the FX 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 based on their more precise information Nevertheless, the effectiveness

of central bank "stabilizing speculation" is doubtful because 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 from trading

The mere expectation or rumour 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 (This is where but central banks attempt to influence their country’s own exchange rates by buying and selling in the market.)

However, central banks do not always achieve their objective since the combined resources of the market can easily overwhelm any central bank Several scenarios of this nature were seen in the 1992-93 Exchange Rate Mechanism (ERM) collapse, and in more recent times in Southeast Asia

Hedge Funds

Hedge Funds, such as George Soros’s Quantum Fund have gained a reputation for aggressive currency speculation since the 1990’s 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 fund’s favour

The number of hedge funds has rocketed in recent years (although the number has declined in recent months), with over 10,000 now in existence It should be noted, however, that only a small proportion of these are dedicated to FX trading, while others may employ currency overlay strategies in an aim to increase returns

Investment Management Firms

Investment management firms (who typically manage large accounts on behalf of customers such as pension funds and endowments) use the FX 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 purchases of foreign equities Since the forex transactions are secondary

to the actual investment decision, they are not seen as speculative or aimed at maximization

profit-However, some investment management firms also have more speculative specialist

“Currency Overlay” operations, which manage clients' currency exposures with the aim of generating additional profits as well as limiting risk Whilst the number of this type of specialist firms is quite small, many have a large value of assets under management (AUM), and hence can generate large trades

International Commercial Companies

An 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

Foreign Exchange Brokers

Until recently, FX 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 CME, Bloomberg and TradeBook The broker squawk box lets traders listen in on ongoing interbank trading and is heard in most trading rooms, but turnover is noticeably smaller than just a few years ago

Foreign Exchange Real Money Brokers

Non-bank FX companies offer currency exchange and international payments to private individuals and companies These are distinct from Retail Forex Brokers (see below) as they

do not offer speculative trading but currency exchange with payments i.e there is usually

a physical delivery of currency to a bank account (e.g HiFX)

It is estimated that in the UK around 15-20% of currency transfers/payments are made via Foreign Exchange Companies These companies' selling point is usually that they will offer better exchange rates or cheaper payments than the customer's bank These companies differ from Money Transfer/Remittance Companies in that they generally offer higher-value services

Money Transfer/Remittance Companies

Money Transfer/Remittance Companies perform high-volume low-value transfers generally by economic migrants back to their home country In 2007, the Aite Group estimated that there were $369 billion of remittances (an increase of 8% on the previous year) The four largest markets (India, China, Mexico and the Philippines) receive $95 billion The largest and best known provider is Western Union with 345,000 agents globally

Retail Forex Brokers

Retail forex brokers handle just a very small fraction of the total volume of the FX market According to CNN, one retail broker estimates retail volume at $25-50 billion daily, which

is about 2% of the whole market