Updated: Oct 6, 2020
What Are the International Currency Markets?
The international currency market is a market in which participants from around the world buy and sell different currencies. Participants include Banks, Corporations, Central Banks, Investment Management Firms, Hedge Funds, Retail Forex Brokers, and Investors. The international currency market is important because it helps to facilitate global transactions, including loans, investments, corporate acquisitions, and global trade.
I. How the International Currency Markets Work
The international currency market is the largest financial market in the world, with an average daily trading volume of $5 trillion. In this market, transactions do not occur on a single exchange, but in a global computer network of large banks and brokers from around the world.
The currency market, or foreign exchange market ("forex"), was created to facilitate the exchange of currency that is necessary as the result of foreign trade. For example, if a Canadian company sells a product to a U.S. firm, it'll want to be paid in Canadian dollars. The U.S. firm would need to facilitate a foreign exchange conversion through its bank to pay the Canadian company. The U.S. firm's bank account would be debited in U.S dollars. The U.S. bank would transfer the funds to the Canadian company's bank. The funds would be converted to Canadian dollars at a preset exchange rate and credited to the Canadian company's account.
The global currency market helps to facilitate foreign trade because it allows companies to sell their goods globally and get paid in their local currency. Companies need to be paid in their local currency since their expenses, such as payroll, are in their local currency.
The forex market differs from the stock market in that it does not involve a clearinghouse. Transactions occur directly between parties without an intermediary to ensure that each party complies with its obligations. Currencies do not come with a single price but are priced in terms of other currencies.
The main functions of the market are to (1) facilitate currency conversion, (2) provide instruments to manage foreign exchange risk (such as forward exchange), and (3) allow investors to speculate in the market for profit
II. The Major Currency Pairs
The foreign exchange market or forex market is the market where currencies are traded. The forex market is the world’s largest financial market where trillions are traded daily. It is the most liquid among all the markets in the financial world. Moreover, there is no central marketplace for the exchange of currency in the forex market. It is an OTC market. The currency market is open 24 hours a day, five days a week, with all major currencies traded in all major financial centers. Trading of currency in the forex market involves the simultaneous purchase and sale of two currencies. In this process the value of one currency (base currency) is determined by its comparison to another currency (counter currency). The price at which one currency can be exchanged for another currency is called the foreign exchange rate. The major currency pairs that are traded include the EUR/USD, USD/JPY, GBP/USD, and USD/CHF.6 The most popular forex market is the euro to US dollar exchange rate (EUR to USD), which trades the value of euros in US dollars.
Below are the major currency pairs that are most widely exchanged for each other.
EUR/USD: the euro of the Eurozone versus the U.S. dollar
USD/JPY: the U.S. dollar versus the Japanese yen
GBP/USD: the Great British pound versus the U.S. dollar
USD/CHF: the U.S. dollar versus the Swiss franc of Switzerland
USD/CAD: the U.S. dollar versus the Canadian dollar
AUD/USD: the Australian dollar versus the U.S. dollar
The U.S. dollar is considered the world's reserve currency since the U.S. has a stable economy and financial system. Many products, commodities, and investments are transacted in U.S. dollars, which is why it's involved most of the major transactions and currency exchanges. Countries that don't have a stable market or currency exchange rate might opt to trade in dollars to attract investment and facilitate trade.
However, there are many other currency pairs that are traded globally. Although China has the yuan and the renminbi as their currencies, most of the transactions involving U.S. trade with China are facilitated in U.S. dollars.
III. Safe-Haven Currencies
Certain currencies have taken on a specific identity or role in the global markets. For example, Switzerland has long been considered a safe place to store money in times of political and economic upheaval. During troubling times, forex conversions from the other global currencies into Swiss francs tends to increase significantly.
Japan is also considered a safe-haven for investment flows since Japan is considered a stable economy. In times of economic recessions, many investors exchange their investments denominated in dollars, euros, and pounds for Japanese government bonds (JGBs), which are guaranteed by the government of Japan. As a result, the yen tends to appreciate against other major currencies during recessions. For example, U.S. investors might sell their dollar-denominated mutual funds or investments for yen-denominated Japanese government bonds, and in doing so, cause the yen to appreciate against the dollar due to the forex conversion.
The interbank forex markets comprise transactions directly between banks and through electronic brokering platforms. Interdealer brokers facilitate many of these transactions through highly developed trading platforms. The largest of these brokers, the UK-based NEX Group, formerly known as ICAP Plc, is very active in both voice and electronic markets, averaging over $1.5 trillion daily in all of its brokering services.
FX dealers and certain other financial institutions are permitted to participate in the major electronic broking services. These services provide quotes, permit entry of quotes, and trade execution services. The largest of these with respect to forex trading is EBS BrokerTec, which was created as Electronic Broking Services, a joint venture of several of the world’s major foreign exchange market–making banks, and then ultimately acquired by BrokerTec in 2014 to form EBS BrokerTec. It provides quotations, data and news feeds, analytical services and handles close to $200 billion daily in spot FX transactions as well as contracts for several commodities. A major competitor is Reuters Eikon. These services permit straight-through processing, improving speed of transactions and reduced errors.
IV. International Currency Market Players
Although there are many participants involved in the global currency markets, below are some of the major players that are involved in the forex markets.
Sometimes Corporations enter the forex market in order to hedge their international money transfers and foreign profits. A U.S. company with extensive operations in Mexico, for example, may enter into a Forward Contract, which merely locks in the exchange rate between the dollar and the Mexican peso. So, when it comes time to bring those Mexican profits home, the profits earned in pesos would not be subject to unexpected exchange rate fluctuations. Instead, the pesos would be converted to dollars at the preset forward exchange rate. Companies use forwards as part of an overall risk-management strategy to help prevent currency exchange rates from impacting earnings or profits.
2. Governments and Central Banks
Governments may seek to influence the value of their currencies–called devaluation–to help increase their exports or foreign sales. A country's central bank, which manages a country's money supply, may enter the market to sell the country's currency, helping to push the value down. When the exchange rate declines versus the other major currencies, the country benefits from having cheaper exports solely due to the exchange rate.
For example, if the U.S. and British pound exchange rate was $2, and an investor wanted to buy a home in Britain that costs 200,000 pounds, it would cost the investor $400,000 (2 * 200,000 pounds). If Britain lowered their exchange rate to $1.50, the U.S. investor could now buy the same property for $300,000 (1.50 * 200,000 pounds).
As a result, the devaluing of the British currency would likely attract enormous buying interest from foreign investors boosting demand for British goods, real estate, and bolstering the British economy. Sometimes countries that engage in currency exchange rate devaluations can be labeled a "currency manipulator."
The foreign exchange market consists of a number of different aspects and is the largest and most liquid market in the world, measured by dollar volume of trade. It is open around the clock (i.e. 24 hours) as the major financial centres where currencies are traded have different geographic locations. Major trading centres, which have been arranged according to relative opening times, include Wellington, Sydney, Tokyo, Osaka, Hong Kong, Singapore, Copenhagen, Frankfurt, Zurich, Paris, London, New York, Chicago and Los Angeles. This market incorporates a multiplicity of heterogeneous market participants and as such it is not surprising to find that the behaviour of exchange rates is relatively complex.
The most important aspect of this market includes the interbank market, which comprises of the wholesale part of the foreign exchange market where banks manage inventories of currencies. This diverse, over-the-counter (OTC) market, does not have a physical trading place where buyers and sellers gather to agree on a price to exchange currencies. Rather, traders, who are employees of financial institutions in the major financial cities around the world, deal with each other via computer or over the phone, with back-office confirmations of transactions occurring at a later point in time.
Since most transactions on the interbank market are made up of large trades with values of $1 million or more, most retail investors and small businesses do not have direct access to this part of the foreign exchange market. As a result, many in need of foreign exchange deal with small regional banks or branches of banks that quote less advantageous rates than those that prevail on the interbank market. Retail investors also participate in the foreign exchange markets through their stockbrokers, who place orders on derivative markets that trade in futures and options contracts.
Large multinational corporations (such as Anglo American) and very large money-management firms (such as Investec) would usually have directly access to the foreign exchange interbank market. In addition, some multinational companies also have their own foreign exchange trading desks to manage these transactions. An important recent development that has affected the market is the rapid growth in electronic trading, both in the interbank market (through an electronic brokerage) and on the retail side of the market.
To contextualise the various components of the foreign exchange market, we can make use of Figure 1, which is taken from Bekaert and Hodrick (2012). This diagram shows that all the foreign exchange transactions are centered around the interbank market.
One interesting feature of this market is that the volume of trading activity has increased rapidly since the 1970s. For example, during 1973 the estimated daily volume of currency trading was between $10 and $20 billion. By the late 1980s, the daily volume had increased to around $500 billion, while in September 1993, the estimated daily volume in all currencies had increased to over $1 trillion. This figure then increased to almost $2 trillion in 2004 and it had almost doubled again in April 2010 when the daily turnover reached $3.9 trillion.1 The Bank for International Settlements (BIS) has since estimated that daily trading volume in 2016 was $5.1 trillion per day,2 and as of April 2019, it had increased to approximately $6.6 trillion per day. This dollar volume of trade dwarfs the corresponding dollar volume of transactions on stock markets such as the New York Stock Exchange (NYSE), where average daily dollar volume was roughly $87 billion in 2015. In addition, it also dwarfs the annual Gross Domestic Product (GDP) of a country like South Africa, which in 2016 was about ±± $232 billion3 for the calendar year and $359 billion for 2019.
V. Foreign currency markets and risk management
The dynamics of foreign currency markets and deals are quite intriguing. To start with, the markets are volatile and risky. Yet, they also present interesting risk-return paradoxes. Ironically, dealers in the markets seem to embrace these features. Let me first examine the main features and dynamics of the two types of foreign exchange markets in developing economies (The FX dealers trade on behalf of their banks in foreign currency markets. It follows that “banks” can be substituted for “dealers” in this and other discussions in this chapter without change of meaning. For example, “quoting bank” substitutes for “quoting dealer” and implies the dealer who quotes rates to the “calling bank”—meaning the “calling dealer.”).
The interbank FX market refers to formal and organized structures put in place by the monetary authority, such as the Central Bank, for conducting trading, transactions, and deals in foreign currencies. This market is referred to as either interbank foreign exchange market (IFEM), as in Nigeria, or official foreign exchange market. The Central Bank controls, monitors, and supervises this markets conduct of trading, transactions, and deals in most countries.
VI. How Did George Soros Break the Bank of England?
In Britain, Black Wednesday, which occurred on September 16, 1992, is now known as the day when speculators "broke the pound," which is an euphemism created to describe the moment in time when they came together to force the British government to pull the pound from the European Exchange Rate Mechanism (ERM).1 Joining the ERM was part of Britain's effort to help the unification of the European economies. However, in the imperialistic style of old, it became clear that Britain had tried to stack the deck. Black Wednesday is arguably a consequence of this effort.
Although it stood apart from European currencies, the British pound had shadowed the German mark in the period leading up to the 1990s, which unfortunately left Britain with low interest rates and high inflation.2 Britain entered the ERM with hopes of keeping its currency above 2.7 German marks to the pound. This was fundamentally unsound, mainly due to the fact that Britain's inflation rate was many times that of Germany's.3
The underlying problems inherent in the pound's inclusion into the ERM was compounded by significant economic strain resulting from Germany's reunification. This, in turn, put pressure on the mark as the core currency for the ERM. The drive for European unification also hit bumps along the road during the passage of the Maastricht Treaty, which was meant to bring about the Euro.4 Speculators began scrutinizing the ERM, causing them to start wondering how long fixed exchange rates could fight natural market forces.
The Maastricht Treaty was created as a follow up to earlier treaties establishing the European Communities (EC), which were the EU's first pillar.
Spotting the writing on the wall, Britain upped its interest rates to the teens in an effort to attract more people to the pound. Unfortunately, speculators such as George Soros began to heavily short the currency. Consequently, the British government gave in and withdrew from the ERM, once it became clear that it was losing billions of pounds, in its attempt to artificially buoy its currency to higher levels.5
Although this was a difficult situation, the pound came back stronger because excess interest and high inflation were subsequently forced out of the British economy.6 Soros pocketed $1 billion on the deal and cemented his reputation as the premier currency speculator in the world.5 (For more on Soros' feat against the British pound, check out The Greatest Currency Trades Ever Made.)
VII. Brief Biography of George Soros
George Soros, Hon FBA (born Schwartz György, August 12, 1930) is a Hungarian-American[b] billionaire investor and philanthropist. As of May 2020, he had a net worth of $8.3 billion, having donated more than $32 billion to the Open Society Foundations.
Born in Budapest, Soros survived Nazi Germany-occupied Hungary and moved to the United Kingdom in 1947. He attended the London School of Economics, graduating with a bachelor's, then obtaining a master's, and eventually a Doctor of Philosophy.
Soros began his business career by taking various jobs at merchant banks in the United Kingdom and then the United States, before starting his first hedge fund, Double Eagle, in 1969. Profits from his first fund furnished the seed money to start Soros Fund Management, his second hedge fund, in 1970. Double Eagle was renamed to Quantum Fund and was the principal firm Soros advised. At its founding, Quantum Fund had $12 million in assets under management, and as of 2011 it had $25 billion, the majority of Soros's overall net worth.
Soros is known as "The Man Who Broke the Bank of England" because of his short sale of US$10 billion worth of pounds sterling, which made him a profit of $1 billion during the 1992 Black Wednesday UK currency crisis. Based on his early studies of philosophy, Soros formulated an application of Karl Popper's General Theory of Reflexivity to capital markets, which he claims renders a clear picture of asset bubbles and fundamental/market value of securities, as well as value discrepancies used for shorting and swapping stocks.
Soros is a well-known supporter of progressive and liberal political causes, to which he dispenses donations through his foundation, the Open Society Foundations. Between 1979 and 2011, he donated more than $11 billion to various philanthropic causes; by 2017, his donations "on civil initiatives to reduce poverty and increase transparency, and on scholarships and universities around the world" totaled $12 billion. He influenced the collapse of communism in Eastern Europe in the late 1980s and early 1990s,and provided one of Europe's largest higher education endowments to the Central European University in his Hungarian hometown. His extensive funding of political causes has made him a "bugaboo of European nationalists".
Numerous American conservatives have promoted false claims that characterize Soros as a singularly dangerous "puppet master" behind a variety of alleged global plots, with The New York Times reporting that by 2018 these claims had "moved from the fringes to the mainstream" of Republican politics. Conspiracy theories targeting Soros, who is of Jewish descent, have often been described as antisemitic.
Foreign exchange markets can be considered as a linkage of banks, nonbank dealers, and forex dealers and brokers who all are connected via a network of telephones, computer terminals, and automated dealing systems. Electronic Broking Services and Reuters are the largest vendors of quote screen monitors used in trading currencies.
Foreign exchange market is a network for the trading of foreign currencies, including interactions of the traders and regulations of how, where and when they close deals. It is an arrangement for the buying, selling, and redeeming of obligations in foreign currency trading. There are two main foreign exchange markets—interbank and autonomous—in developing economies.
In Totality, Currency Trading in Forex Markets Plays a very vital role in smooth Transactions of International Businesses of both Products and Services etc.