In our previous article, we made a brief summary of the Forex market. In this one, we delve into the functions, key players, and structure of the foreign exchange market (Forex). We shed light on how the Forex market structure enables it to help international trade in goods and services, as well as capital market transactions involving currency conversion for foreign asset investments. The Forex market has a broad range of actors with diverse motivations. The motivations include hedging risks, taking part in international transactions, driving for profits through speculative trading, and managing foreign exchange for various purposes. Understanding the Forex market structure is crucial to understanding its dynamics and its role in global financial activities.
What Are The Functions Of The Forex Market?
Within the forex market structure, various functions contribute to its importance in international trade and financial transactions. Firstly, currency exchange stands as a prime role. This allows perfect conversion between currencies for individuals and organizations engaged in international trade or travel. Moreover, the forex market’s liquidity and efficiency empower companies to easily conduct cross-border transactions, strengthening the fabric of international trade.
This dynamic market also determines exchange rates. It reflects the relative value of currencies, guided by the supply and demand dynamics within the forex market structure.
Furthermore, the forex market structure ensures liquidity, fostering an environment where numerous buyers and sellers actively participate in currency trading. This liquidity not only enables easy entry and exit from positions but also helps efficient price discovery within the forex market structure.
Risk management holds primary importance in the forex market, offering players an array of tools and instruments to effectively navigate foreign exchange risks. By using currency derivatives such as futures and options, companies can hedge against adverse currency movements, protecting their financial interests.
Speculation and investment activities thrive within the forex market, as traders and investors capitalize on their expectations of future currency movements, seeking profits through timely buy and sell decisions.
Moreover, as a facilitator of fund movement across borders, the forex market plays a pivotal role in financing international transactions, foreign investments, remittances, and other capital flows. It acts as a conduit for the efficient allocation of funds on a global scale, bolstering economic activity.
Central banks, operating within the forex market structure, wield influence over their respective currencies. They intervene strategically, aiming to manage currency value and influence exchange rates to stabilize economic conditions or achieve specific monetary objectives.
In conclusion, the forex market, including its specific structure, serves as a vital platform for currency exchange, international trade facilitation, risk management, and investment opportunities. With its liquidity, price discovery mechanisms, and role in fund movement, the forex market stands as a vital component of global financial activities.
Who are the Key Players in The Forex Market?
Many actors in the foreign exchange market have different goals and motives. We will place them into several categories to understand how the Forex Market works.
As we point out in our previous article about What Moves the Foreign Exchange Market, the foreign exchange (FX) market is the largest financial market in the world. Every day central banks, large commercial banks, hedge funds, retail traders, and many other players take part in it.
Let us review these key players in the forex market and their motivations to trade currencies.
Why Do Central Banks Take Part In The Fx Market?
These organizations sometimes intervene in FX markets to influence the level or trend in the domestic exchange rate. Central banks do this in two cases. The first is when they determine their domestic currency to be too weak. The second is when the exchange rate strays away from the equilibrium level (e.g., because of a speculative attack).
Alternatively, central banks also intervene when the FX market has become so erratic and dysfunctional that users such as corporations can no longer transact necessary FX business. Conversely, sometimes central banks intervene when they believe their domestic currency has become too strong, to the point that it worsens that country’s export competitiveness.
For instance, the Swiss National Bank intervened against the strength of the Swiss franc versus the Euro by selling the Swiss franc on the euro–Swiss (CHF/EUR) cross-rate in 2010, 2013, and again in 2015.
Why do Governments take part in the FX market?
The forex market structure accommodates the diverse foreign exchange needs of the public sector, including government and quasi-government organizations. These needs can range from relatively small and neutral goals such as helping the operations of embassies and consulates in foreign countries, to significant transactions like multi-billion military contracts or funding overseas military bases. The forex market structure provides the necessary frame for governments to engage in various foreign exchange activities, being in line with their specific goals and needs. This involvement includes trade support, reserve management, risk hedging, and even speculative purposes, and extends beyond the operations of central banks. Government forex transactions may involve different entities within the government, such as treasury departments or government wealth funds, further laying stress on the varied nature of their engagement within the forex market structure.
Why do SWFs (Sovereign Wealth Funds) take part in the FX market?
Another key player is Sovereign Wealth Funds or SWFs for short. SWFs are organizations closely related to the public sector. Very often, countries running current account surplus (a country exports more goods and services than it imports) through SWFs invest some of these funds in such financial assets as stocks, bonds, hedge funds, real estate, etc. Countries like China, Norway, the United Arab Emirates, and Kuwait are some of the largest SWFs in the world. Given their size, it is only natural they can significantly impact almost all exchange rates. Just imagine if such a fund makes changes to its portfolio or completely changes its strategy.
Why do Professional Trading Firms take part in the FX Market?
Almost any firm professionally managing foreign exchange risk for profit can fall into the category of Professional Trading Firms. For example, high-frequency algorithmic traders, hedge funds, prop firms, etc., can be counted as such. This bucket of key players accounts for a relatively large and growing volume of daily foreign exchange transactions.
Professional trading firms take an active role in the FX market for profit generation, liquidity provision, risk management, arbitrage opportunities, portfolio diversification, and advanced trading technologies. They capitalize on price movements, analyze trends, and employ advanced strategies. By providing liquidity, they enhance market efficiency. Hedging and managing risks, they protect portfolios. Seeking arbitrage opportunities, they exploit price inefficiencies. Diversifying portfolios, they access a wide range of markets. Leveraging advanced technologies, they execute trades swiftly. Overall, their involvement contributes to the functioning and liquidity of the forex market.
What are Retail FX Transactions?
The forex market structure contains retail traders, who are individual traders or small investors engaged in foreign exchange operations. These retail traders take part in currency trading for various purposes, including personal travel, online shopping, and speculative investments. Thanks to advances in electronic trading technology, retail traders now have the ability to speculate on exchange rate movements and even move their savings into foreign currencies using electronic trading platforms.
These online trading platforms, provided by brokers, grant retail traders access to the forex market. There is a wide range of currency pairs available. They include major currencies like the US dollar, euro, and Japanese yen, as well as exotic currency pairs. Therefore retail traders can actively trade currency pairs using these platforms from anywhere at any time.
Retail traders usually operate with a smaller capital. They may have limited knowledge and experience compared to professional investors or trading firms. However, they still contribute to the overall forex market structure. They make trading decisions based on technical analysis, fundamental analysis, or trading signals. It’s important to note that the volumes of retail FX transactions are generally smaller compared to institutional trades.
