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How the foreign exchange market operates

In this week’s episode, we’re going to talk about the structure of the FX market: how it operates, its size and composition, and the role of liquidity providers in foreign exchange. 

Let’s start with how the foreign exchange market operates. The FX market is what is known as an over-the-counter (or OTC) market. Now, an OTC market involves the exchange of securities, whether that be currencies, bonds or derivatives for instance, that are not listed on an exchange (such as the New York or London Stock Exchanges). 

In FX, there is no one physical trading location. Currency trades are decentralised, and are instead facilitated by banks and brokers. Dealers act as market-makers by providing another party with quoted prices to buy and sell a currency. 

Unlike in centralised stock markets, there is no one prevailing price for all market participants, ensuring a lack of price transparency, with exchange rates instead negotiated between two parties. This means that trades are executed between two participants in the FX market, without other market participants being aware of the price at which the exchange was made.

Over-the-counter markets are generally less heavily regulated than centralised markets, can sometimes lack liquidity and leave participants open to counterparty risk, where one side of the party defaults prior to completion. This usually makes them riskier to invest in than traditional stock exchanges. 

The foreign exchange market is truly vast in terms of its size, and is, indeed, the largest financial market of any kind. As of 2022, the daily turnover in the global FX market was $7.5 trillion, which is roughly double the size that it was in 2010, and more than five times the size than in 2001. 

To put this into context, the global equity market turnover is only around $200 billion a day (that’s less than one-thirtieth of the size), while the US has a total economic output of around $23 trillion a year – that’s the equivalent of the volume of only 3 days currency trading. 

Spot transactions now only make up around 30% of the daily turnover in the FX market. Spot transactions being trades that are agreed upon at today’s rate, and completed within two days, referred to as the settlement period. 

Swaps, options, forwards and other derivatives are now increasingly important in global FX trading volume. FX swaps now account for 51% of the daily trading volume, that’s according to the 2022 Triennial Central Bank Survey from BIS. An FX swap is an agreement to borrow one currency, and lend another, at an initial date, before exchanging the amounts at the date of maturity. 

Forward contracts, which allow participants to agree a rate today for exchange at a future date, have also grown in importance over the years. As of 2022, forwards accounted for 15% of the world’s daily FX trading volume.  

We then have options at 4%. FX options (as the name suggests) provide the buyer with the right, rather than the obligation, to buy or sell a currency at a specified rate, on a specific date in the future. 

Market Dynamics and participants

But who is accounting for this turnover? Well the vast majority of trading volume, approximately 90%, is driven by speculators. Speculators will enter into the FX market in the hopes of profiting from changes in the exchange rate. These investors will aim to identify currencies that they believe are misvalued. They’ll long (or buy) currencies that they think are undervalued, in the hope that they’ll appreciate in value, and short (or sell) currencies that they think are overvalued, in the hope that they’ll depreciate. 

The remaining 10% of the trading volume in the FX market is made up by deliverable trading, i.e. the exchange of currencies in order to facilitate international trade. 

When does trading take place? Well, the FX market is open 24 hours a day during the week, and is closed on weekends. This is due to the overlap inherent in trading hours across the various time zones. So when the London trading hours close at 4pm GMT, the New York hours are open. And when New York trading closes at 10pm GMT, the Sydney market is open, and so forth. 

The most active trading period takes place during the London hours (around one-third of all trades take place during this time), with around 17% occurring during New York trading. Unsurprisingly, the US dollar is the most popular trading currency in the world (about 86% of all trades include the greenback), followed by the euro (at around 27%). Again, unsurprisingly, EUR/USD is the most popular trading currency pair in global FX, accounting for just over a quarter of total trading volume. 

Role of liquidity providers

We now move onto the role of liquidity providers in the FX market. Liquidity, in the form of bid and offer rates (i.e. the rates to buy and sell the foreign currency), are provided to the foreign exchange market by entities that are known as money centre banks. 

These money centre banks are the large financial institutions that have operations in key financial centres around the world (whether that be New York, Tokyo or London for instance), and have borrowing and lending activities with governments, large corporations and standard banks. Rather than raising funds through relying on depositors, these money centre banks raise funds through domestic and international money markets. Examples of money centre banks would be Citigroup, JP Morgan Chase, HSBC or the Bank of America. 

These liquidity providers (or LPs) are incredibly important for FX, as they trade large amounts of currency on a daily basis, providing both stability and depth to the market, acting to limit volatility. Their role in the market is to connect market participants and enable both efficiency and timely execution of trades. The competition inherent due to the presence of multiple LPs also makes for a more efficient market, as this reduces costs for traders due to tighter bid/ask spreads.

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