Marketsforu Education - What is Forex


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Foreign Exchange (or "Forex", sometimes further abbreviated as "FX") refers to the trading of international currencies. Traditionally, currencies are traded via an interbank network of credit relationships with no centralised clearing.

Today, with the rise of liquidity aggregation systems and ECN technologies, a certain degree of centralisation exists (meaning is rare that the best bid price on one system crosses above the best ask price on another system on highly liquid pairs) but it remains an overall de-centralised over-the-counter (OTC) market.

To understand the Forex market, it's helpful to look at its history and how it became the market that exists today.

For most of recorded history, many of today's dominant governments originated from legal systems that used Gold as a standard for currency values. Even up until the early 1900's, the US Dollar was pegged to the value of Gold.

The US Dollar then gained the status of being the world's dominant reserve currency following the Allies' victory in World War II, taking over from the British Pound's long term reign on that throne.

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It all began with a meeting of the WWII victors, to which Russia and China were actually invited... but with their shared distrust of their western allies, they both decided against attending the meeting. Instead, 44 nations (excluding them) signed the Bretton Woods accord and agreed to tie all of their currencies to the US Dollar.

With Europe destroyed by the physical destruction of the 2nd World War, most of the other European nations had little to no argument against agreeing to Bretton Woods.

Considering the US would ultimate send USD grants to help western Europe rebuild

In the American-centric years that followed, Japan would grow into a major world power that adopted cultural elements that are essentially "Japanisations" of American culture (including Anime, despite its reputation as uniquely Japanese.) This trend didn't end with mainstream media and music, it included the country's Central Bank policies, which turned the Japanese Yen (JPY) into the US Dollar's primary peer as a "safe haven" currency.

(How can you see this effect? When stocks fall, the USD and JPY both gain strength against other currencies. It's remained to this day.)

Meanwhile, the US Dollar peg to Gold became a lot less attractive by the 1960's. With a rebuilt Europe and rejuvenated capitalist Japan, the formerly war-torn countries became far less happy with the USD as the world's reserve currency.

Plus, as the Vietnam War raged on, with massive flows of US Dollars flowing out of the country (creating higher supply, and consequently lower demand for it), the USD-to-Gold fixed rate became ridiculously over-valued. It was the FX equivalent of insisting that ice should be equal to Gold in Antarctica.

Giving in to natural market forces, the US ended the USD peg to Gold in the early 1970's. By 1973, almost all of the world currencies were free-floating fiat money with no intrinsic ties to any particular metal. (The Swiss Franc, CHF, kept a fractional peg to Gold for a few more decades but that ultimately was dropped too.)

Today, currencies are effectively "virtual" derivatives of their economies.

While a simple understand of this history leads some to believe that all fiat currencies are intrinsically worthless (which, in theory, isn't completely untrue), it's important to understand their current practical use within the context of interest rates. Read more about economic indicators to understand currencies' roles in relation to interest rates.

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The Structure of the Forex Market

The term "interbank" originates from the participation of the world's largest banks traded currencies with each other based on credit relationships. "Mutual trust between the inner circle of too-big-to-fails", one might call it in a post-Occupy Wall Street culture.

However, it's important to understand that many of the orders placed by the banks are actually for their clients.

These top tier banks, of course, would only accept business from extremely large clients such as larger hedge funds, major multi-national corporations (whose subsidiaries cross national boundaries), medium to small banks, and FX Prime Brokerage companies.

The Prime Brokerage companies then provide services to their own customers, which often include smaller hedge funds and many retail Forex brokers (who offer margin-based trading to individuals, and smaller companies and money managers.)

While the top banking institutions in the world are, in a literal sense, the only real "market movers" of the FX market, a large portion of their orders are a netting of orders originating from lower members of this Forex food chain.

The reason this is important is understand is that FX market movements are still the result on human decisions with a heavily influence from herd mentality.