They may not know it, but most people who wonder how the foreign exchange market works have likely carried out an ‘FX’ transaction before. If you’ve ever been abroad on holiday, ordered something online from another country, or worked for a foreign company, you’re already an FX trader.
At first confusing to newcomers, the terminology of cash, spot, swaps and derivatives all have their history in the structure and development of the FX market over the centuries. Beneath its array of different terminology, FX is a simple concept – exchanging one currency for another.
In full ‘foreign exchange’, often simplified to forex, and usually just FX, this is the global, decentralised market for exchanging currencies. Currencies are the oldest financial assets in existence and are by far the most traded asset class in the world today, with over $6 trillion in daily transaction volume.
What is forex?
Currencies have a long history. Whatever form it takes, currency is just a physical representation of the concept of ‘value’: originally in the form of coins, currency later developed into paper and electronic equivalents.
The history of currency
Standardised coin-like objects were used as a unit of value in China as early as 900BC, but the first minted coins are Lydian, a small state on the west coast of what is now Turkey, and date from 650BC.
These coins quickly became accepted across the Greek-influenced Eastern Mediterranean, before spreading throughout Europe thanks to the Roman Empire. Thanks to their durable nature a continuous record of ancient coins exists today.
Originally coins included an amount of gold, silver or another precious metal equivalent to their value – this was gradually replaced with a system where the coin could be exchanged with an equivalent value of gold.
The first banknotes appeared in China in the seventh century AD and allowed for the further development of trade without prohibitively heavy and hard-to-produce coinage.
What is forex trading?
Now we’ve established the history and importance of currency for the FX market, it’s time to ask what forex trading is.
Simply put, an FX trade (sometimes referred to as a deal) is the exchange of one currency for another. As anyone who’s exchanged money for a holiday will know, there is no standard price, and the rate fluctuates freely.
From the earliest times, one of the main functions of currency was to facilitate trade over long distances, and it is this use which has seen the forex market grow to such an enormous size today.
Originally all FX transactions would have been carried out in cash and on the ‘spot’, with an immediate transfer of one currency for another. Today, most of the traded FX volume is in swaps and other derivative products, which are based on (derived from) changes in price rather than the currency itself.
The FX market runs 24 hours a day, with trading continuous across the time zones of financial centres such as New York, London, Hong Kong and Sydney. The only time the FX market stops is at weekends, or on major public holidays.
Top forex trading products:
- FX Swaps are the most popular FX products, accounting for 50% of traded volume
- The cash (spot) FX market is next at 30%
- Exchange traded derivatives (forwards)
- Off-exchange derivatives (particularly options, but also CFDs)
Spot FX is sometimes also referred to as cash FX – the two terms are identical in meaning.
Cash FX made up the overwhelming majority of all transactions until the 1970s and the development of new derivative products to manage risks.
Some terms to watch out for
As well as spot/cash FX, other identical terms to look out for are trading and dealing, with dealing favoured in Britain and trading in the USA.
A trader can be referred to as a dealer, and firms are often broker-dealers, where they both buy and sell currencies themselves (dealer) and facilitate trading between other counterparties (broker).
How is forex traded?
You might be familiar with the idea of exchanges from equities and commodities, as a centralised bourse where market participants come together to do business.
FX does not trade on an exchange – it is an ‘over the counter’ market, with deals made privately between participants. The exception to this are standardised contract FX futures.
Each FX deal does not result in someone counting out banknotes in the cellar of a bank; processed electronically, transactions amounting to billions of dollars can be made instantly, executed by trading robots that automatically find the best price between participants. Only very complex derivative transactions, or trades involving rare exotic currencies, require human input.
The majority of global FX transactions are cleared through London banks with New York and Tokyo the next largest. Other financial centres such as Hong Kong and Sydney are also important markets. In Australia, all forex brokers are strictly regulated by the Australia Security and Investment Commission.
How has the forex market changed?
Long before computers facilitated instantaneous FX trading, the FX market had to adapt to reflect new realities. The gold standard, or practice of allowing the exchange of a currency for its value in gold, was abandoned in the 1930s, but for most of the 20th century, FX transactions remained under strict state control.
Until the 1970s, under the Bretton-Woods agreement, currencies were ‘pegged’ within a certain rate of fluctuation with the US dollar. This agreement is no longer in force, but many countries still peg their currency to the US dollar.
To preserve their pegs, central banks intervene in the market by buying or selling large volumes of the currency to keep prices within a certain range. This is intended to stabilise the value of illiquid currencies, where large fluctuations could damage the ability of exporters and importers to plan ahead.
These systems can be expensive and have been known to break down suddenly, as when the Swiss central bank suddenly ended its peg to the euro in 2015, without warning investors.
Retail traders should exercise caution when dealing with exotic currencies, and not assume that pegs are always secure. Exotic currencies generally have higher risks attached.
Forex trading: The retail market
Following the advent of personal computers, retail traders began to be involved with the FX market. Popular online platforms such as MetaTrader provided the tools which fuelled an explosion in popularity continuing into the 21st century. Today retail FX trading is hugely popular, with retail traders trading both spot FX and derivatives such as FX options.
Estimates place the retail FX market at around 5% of global volumes, an enormous sum when the total volume is considered – as much as $50 billion per day.
To get a slice of this lucrative market, many banks and brokers compete to offer the best forex rates, with fierce competition on margins. Retail traders trade both for necessity, such as international travel, and to speculate, and different kinds of traders have different requirements.
Speculators use technical and fundamental analysis to make informed guesses as to future price movements – you can find detailed articles on both technical and fundamental analysis on the Rakuten site. For speculators, charts and financial information can be as important as rates. Traders buying out of necessity are usually solely interested in price and ease.
The vast majority of FX trades involve the US dollar, with the euro, Japanese yen, and British pound also heavily traded. Coming in just behind the main pairs, the Australian dollar is the fifth most traded currency in the world. Retail traders invest in all of these currencies.
Liquidity, the ease of buying and selling, is highest in major currency pairs, such as EURGBP or EURUSD, and lower with minor or ‘exotic’ currencies like SGD. Currencies with low liquidity are sometimes referred to as ‘thinly traded’ currencies.
Many retail FX brokers offer clients the opportunity to trade ‘on margin’, only putting down a partial deposit towards the value of their trade. This can create risks as well as opportunities.
How Rakuten can help
The world of foreign exchange can seem complex, but Rakuten is here to help find the best forex solutions for retail traders. Why not get started using one of our demo accounts, and see for yourself the simplicity and effectiveness of our proprietary trading platforms?
Sign up for a free demo account today and begin placing trades without risking any of your capital.