What Is The Forex Market?
We just have a quick question here from Lauren asking, what exactly is the forex market, wanting to just understand that a little bit better and who are the various participants? So firstly, thanks for the question Lauren.
Jumping into the question, the forex market is basically just the market where currencies are exchanged, right. So it’s basically, forex is just short for foreign exchange. It’s the biggest financial market in the world according to the Bank of International Settlements.
The average market cap is about $5 trillion per day, which is just massive compared to something like the equity market as a whole, which only does about 84 billion per day, so really big market in terms of liquidity and volatility.
Now, the forex market is also decentralized, which is great. So it’s an over-the-counter market, which means that you can access it from any way, from the comfort of your own home as long as you have an internet access. What’s also great from a retail trader point of view is the immense market saturation in terms of brokers, means that there’s lots of competition out there for clients.
So retail traders can really get away with pretty good deals in terms of spreads and commissions if you just shop around a bit. Now, coming to your question about the participants, we can basically divide it into two groups.
You have non-speculative participants and then speculative participants. So the non specs makes up about 20% of all transactions and that’s purely transactional in nature. So you buying a book from the U.S. from the UK, you obviously need to exchange your pounds for dollars and that equates about 20% of all transactions. 80% of the transactions is all speculative. So the sole intention, making a profit from it.
So the five main key players or participants, firstly is central banks, obviously the most important player from a trader point of view. They’re responsible for monetary policy, like adjusting interest rates, controlling the money supply, doing quantitative easing, doing quantitative tightening. So one of the biggest drivers of the currency values in the short and the medium-term.
Apart from all of the normal functions we just mentioned, some banks also actively or deliberately intervene in the FX markets to try and weaken and strengthen their currency, so also something to keep in mind from a participation point of view.
Then the second group will be commercial banks. Now, that’ll be commercial banks, investment banks, think like Barclays Bank or HSBC et cetera. They operate in what is called the interbank market and these guys are important because about half of all forex transactions are made by them. So the transactions that they do can either be part of transactions they do on behalf of their clients or their own speculative trades by the own traders. So they make money by charging their own spread by acting as a dealer for their clients and they also make money by actually trading the forex market from a speculative nature as well.
Another cool service that these guys normally provide, especially the investment banks, is advisory and research services. So they often release valuable research notes and articles, you would have seen some of their information that we share in the terminal as well. So, great for us from a retail trading point of view.
The third group will be your hedge funds, fund managers and prop firms. Now, these guys will basically normally have portfolios with various foreign assets inside. So if you are running a portfolio from Europe, for example and you wanna buy U.S. equities, you’re obviously gonna need to exchange your euros for U.S. dollars. So there’s obviously those type of transactions that they need in terms of every exchange from a trade execution point of view, but of course, they also do take speculative positions in the market as well, maybe as part of their investment strategy.
Then the fourth one would be companies and corporations. So it’s a very smaller group compared to the other three, of course, but also big in size compared to retail traders. Now, what companies and corporations most likely will use for an exchange for obviously, from also a transactional point of view, so imagine that you’re a company in the U.S. and you wanna buy raw materials from Europe, for example, you’re obviously gonna need some currency exchange there.
What companies can also do, is they might be very active participants in the Futures market because they might want to hedge some currency exposure that they have. So if they are a company in the EU, they might want to hedge some exposure towards the U.S. dollar or if they are a airliner, they might want to hedge their risk against oil or something like that.
So they can, if they are very exposed to certain currency exchange rates, they can obviously enter a currency forward contract to lock in exchange rates over longer periods of time. So they’re also a very important participant in the market and then number five will be the retail traders. So it’s definitely last and the least in terms of size and significance for the overall market, which will be the retail traders and the private investor community.
Now, even though we might be the smallest part of the market, the real trading and private investor community does play an important role in the overall global financial system by basically providing much higher levels of liquidity in the market. Sadly though, as most retail traders try and tackle the financial markets without any fundamental knowledge of why prices are moving or how they should trade it, they often end up just giving away all their hard-earned money to the other market participants, who are all too happy to take that money off their hand.
So it’s one of the important points why it’s important to approach the market in the same way that professional traders do, so that you’re always trying to stay on the right side of the smart money, so to speak. So trying to trade in line with those investment banks, trying to trade in line with those fund managers but for that, of course, you do need a more fundamental approach towards the market to be able to understand how they place their trades and how they value or look for value, in particular asset classes.
So Lauren, I hope that helps. Any other questions, of course, don’t hesitate to let us know.