Foreign Exchange Market: How It Works, History, and Pros and Cons

What Is the Foreign Exchange Market?

The foreign exchange market (also known as forex, FX, or the currencies market) is an over-the-counter (OTC) global marketplace that determines the exchange rate for currencies around the world. Participants in these markets can buy, sell, exchange, and speculate on the relative exchange rates of various currency pairs.

Foreign exchange markets are made up of banks, forex dealers, commercial companies, central banks, investment management firms, hedge funds, retail forex dealers, and investors.

Understanding the Foreign Exchange Market

The foreign exchange market—also called forex, FX, or currency market—was one of the original financial markets formed to bring structure to the burgeoning global economy. This asset class makes up the largest financial market in the world in terms of the value of currency units being traded. Aside from providing a venue for the buying, selling, exchanging, and speculation of currencies, the forex market also enables currency conversion for international trade settlements and investments.

Currencies are always traded in pairs, so the "value" of one of the currencies in that pair is relative to the value of the other. This determines how much of country A's currency country B can buy, and vice versa. Establishing this relationship (price) for the global markets is the main function of the foreign exchange market. This also greatly enhances liquidity in all other financial markets, which is key to overall stability.

The value of a country's currency depends on whether it is a "free float" or "fixed float." Free-floating currencies are those whose relative value is determined by free-market forces, such as supply-demand relationships.

A fixed float is where a country's governing body sets its currency's relative value to other currencies, often by pegging it to some standard. Free-floating currencies include the U.S. dollar, Japanese yen, and British pound, while examples of fixed floating currencies include the Panamanian Balboa and the Saudi Riyal.

One of the most unique features of the forex market is that it's made up of a global network of financial centers that transact 24 hours a day, closing only on the weekends. As one major forex hub closes, another hub in a different part of the world remains open for business. This increases the liquidity available in currency markets, which adds to its appeal as the largest asset class available to investors.

The most liquid trading pairs are, in descending order of liquidity:

1. EUR/USD
2. USD/JPY
3. GBP/USD

Forex Leverage

The leverage available in FX markets is one of the highest that traders and investors can find anywhere. Leverage is a loan given to an investor by their broker. With this loan, investors can increase their trade size, which could translate to greater profitability. A word of caution, though: losses are also amplified.

For example, investors who have a $1,000 forex market account can trade $100,000 worth of currency with a margin of 1%. This is referred to as having a 100:1 leverage. Their profit or loss will be based on the $100,000 notional amount.

Types of Foreign Exchange Markets

There are three main forex markets: the spot forex market, the forward forex market, and the futures forex market.

Spot Forex Market: The spot market is the immediate exchange of currencies at the current exchange. On the spot. This makes up a large portion of the total forex market and involves buyers and sellers from across the entire spectrum of the financial sector, as well as those individuals exchanging currencies.

Forward Forex Market: The forward market involves an agreement between the buyer and seller to exchange currencies at an agreed-upon price at a set date in the future. No exchange of actual currencies takes place, just the value. The forward market is often used for hedging.

Futures Forex Market: The futures market is similar to the forward market, in that there is an agreed price at an agreed date. The primary difference is that the futures market is regulated and happens on an exchange. This removes the risk found in other markets. Futures are also used for hedging.

Advantages and Disadvantages of the Foreign Exchange Market

Advantages

• There are fewer rules than in other markets, which means investors aren't held to the strict standards or regulations found in other markets.
• There are no clearing houses and no central bodies that oversee the forex market.
• Most investors won't have to pay the traditional fees or commissions that they would on another market.
• Because the market is open 24 hours a day, you can trade at any time of day, which means there's no cut-off time to be able to participate in the market (except if you're heading into the weekend).
• Finally, if you're worried about risk and reward, you can get in and out whenever you want, and you can buy as much currency as you can afford based on your account balance and your broker's rules for leverage.

Disadvantages

• Though the market being unregulated brings advantages, it also creates risks, as there is no significant oversight that can ensure risk-free transactions.
• Leverage can help magnify profits but can also lead to high losses. As there are no set limits on leverage, investors stand to lose a tremendous amount of money if their trades move in the wrong direction.
• Unlike stocks that can also provide returns through dividends and bonds through interest payments, FX transactions solely rely on appreciation, meaning they have less residual returns than some other assets.
• Lack of transparency in the FX market can harm a trader as they do not have full control over how their trades are filled, may not get the best price, and may have a limited view of information, such as quotes.

History of the Foreign Exchange Market

As long as humans have been trading there has been a foreign exchange market. Ancient civilizations traded goods and currencies through metal coins, whose value was based on their weight.

The first true forex market was in Amsterdam, approximately 500 years ago. The exchange allowed people to freely trade currencies to stabilize exchange rates. In 1875, the gold standard was implemented, meaning countries were only allowed to print currency equal to the amount of their gold reserves. Gold was the metal of choice due to it being rare, malleable, tough to corrode, and hard to obtain.

In 1913, in London, there were 71 forex trading firms, an increase from three in 1903. But the gold standard could not hold up during the world wars, due to countries having to print more money to finance expenses.

After World War II, the Bretton Woods system was established. It called for most currencies to be pegged to the U.S. dollar, which was backed by gold reserves.

In 1971, President Nixon announced a freeze on the dollar's convertibility to gold due to rising inflation and a possible gold run. In 1973, the gold standard was completely abolished and the U.S. dollar was no longer backed by gold reserves, and foreign exchange switched to a free-floating system. Currencies were free to peg to any currency they chose or to remain unpegged and allow the supply and demand of the currency to determine its value.

The Bottom Line

The foreign exchange market is an over-the-counter global market where the buying and selling of global currencies occur, determining their exchange rates. The exchange market is made up of banks, forex dealers, commercial companies, central banks, investment management firms, hedge funds, retail forex dealers, and investors that all trade currency pairs.