Trading characteristics

There is no unified or centrally cleared market for the majority of FX trades, and there is very little cross-border

regulation. Due to the over-the-counter (OTC) nature of currency markets, there are rather a number of interconnected

marketplaces, where different currency instruments are traded. This implies that there is not a single dollar rate but rather

a number of different rates (prices), depending on what bank or market maker is trading. In practice the rates are often very

close, otherwise they could be exploited by arbitrageurs instantaneously. A joint venture of the Chicago Mercantile Exchange

and Reuters, called FxMarketSpace opened in 2007 and aspires to the role of a central market clearing mechanism.

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.

There is little or no 'inside information' in the foreign exchange markets. Exchange rate fluctuations are usually caused by

actual monetary flows as well as by expectations of changes in monetary flows caused by changes in GDP growth, inflation,

interest rates, budget and trade deficits or surpluses, large cross-border M&A deals and other macroeconomic conditions.

Major news is released publicly, often on scheduled dates, so many people have access to the same news at the same time.

However, the large banks have an important advantage; they can see their customers' order flow.

Currencies are traded against one another. Each pair of currencies thus constitutes an individual product and is

traditionally noted XXX/YYY, where YYY is the ISO 4217 international three-letter code of the currency into which the price

of one unit of XXX is expressed (called base currency). For instance, EUR/USD is the price of the euro expressed in US

dollars, as in 1 euro = 1.3045 dollar. Out of convention, the first currency in the pair, the base currency, was the stronger

currency at the creation of the pair. The second currency, counter currency, was the weaker currency at the creation of the

pair.

The factors affecting XXX will affect both XXX/YYY and XXX/ZZZ. This causes positive currency correlation between XXX/YYY and

XXX/ZZZ.

On the spot market, according to the BIS study, the most heavily traded products were:

* EUR/USD: 28 %
* USD/JPY: 18 %
* GBP/USD (also called sterling or cable): 14 %

and the US currency was involved in 88.7% of transactions, followed by the euro (37.2%), the yen (20.3%), and the sterling

(16.9%) (see table). Note that volume percentages should add up to 200%: 100% for all the sellers and 100% for all the

buyers.

Although trading in the euro has grown considerably since the currency's creation in January 1999, the foreign exchange

market is thus far still largely dollar-centered. For instance, trading the euro versus a non-European currency ZZZ will

usually involve two trades: EUR/USD and USD/ZZZ. The exception to this is EUR/JPY, which is an established traded currency

pair in the interbank spot market.

Market participants

Financial markets

Unlike a stock market, where all participants have access to the same prices, the forex market is divided into levels of

access. At the top is the inter-bank market, which is made up of the largest investment banking firms. Within the inter-bank

market, spreads, which are the difference between the bid and ask prices, are razor sharp and usually unavailable, and not

known to players outside the inner circle. As you descend the levels of access, the difference between the bid and ask prices

widens (from 0-1 pip to 1-2 pips for some 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 53% 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.” (2004)

In addition, he notes, “Hedge funds have grown markedly over the 2001–2004 period in terms of both number and overall size”

Central banks also participate in the forex market to align currencies to their economic needs.

Banks

The interbank market caters for both the majority of commercial turnover and large amounts of speculative trading every day.

A large bank may trade billions of dollars daily. Some of this trading is undertaken on behalf of customers, but much is

conducted by proprietary desks, trading for the bank's own account.

Until recently, foreign exchange 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. 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.

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.

Central banks

National central banks play an important role in the foreign exchange 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 trading.

The mere expectation or rumor 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. Central banks do not

always achieve their objectives. The combined resources of the market can easily overwhelm any central bank.[4] Several

scenarios of this nature were seen in the 1992–93 ERM collapse, and in more recent times in Southeast Asia.

Investment management firms

Investment management firms (who typically manage large accounts on behalf of customers such as pension funds and endowments)

use the foreign exchange 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 profit-maximization.

Some investment management firms also have more speculative specialist currency overlay operations, which manage clients'

currency exposures with the aim of generating 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.

Hedge funds

Hedge funds have gained a reputation for aggressive currency speculation since 1996. 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 funds' favor.

Retail forex brokers

There are two types of retail broker: brokers offering speculative trading and brokers offering physical delivery i.e. the

bought currency is delivered to a bank account.

Retail forex brokers or market makers handle a minute fraction of the total volume of the foreign exchange market. According

to CNN, one retail broker estimates retail volume at $25–50 billion daily, which is about 2% of the whole market. Retail

traders (individuals) are a small fraction of this market and may only participate indirectly through brokers or banks, and

might be subject to forex scams