Forex Trading and How It Determines the Dollar's Value
The Market That Trades $5.3 Trillion PER DAY
Forex, or foreign exchange, trading is an international market for buying and selling currencies. It is similar to the stock exchange, where you trade shares of a company. Like the stock market, you don't take possession of the money. It is a way to profit from the changing values of these currencies based on their exchange rates. In fact, the foreign exchange market is what sets the value of floating exchange rates.
How Much Money Trades Each Day
According to the Bank for International Settlements, average daily forex trading in April 2016 (most recent data available) was $5.1 trillion. Of this, spot trading made up $2.6 trillion. The rest was trading in foreign exchange derivatives.
April’s trading is down slightly from the record $5.4 trillion traded in April 2013. That’s a result of a slowdown in the spot trading market.
In 2010, forex trading was $4.4 trillion traded per day. In 2007, the pre-recession high hit $3.2 trillion traded per day. But forex trading kept growing right through the 2008 financial crisis. This was up 30 percent In 20014, only $2 trillion was traded per day traded.
How It Works
All currency trades are done in pairs. Every traveler who has gotten foreign currency has done forex trading. For example, when you go on vacation to Europe, you exchange dollars for euros at the going rate.
When you come back, you exchange your euros back into dollars.
About one-third of all exchanges are spot trades. It's similar to exchanging currency for a trip. It's a contract between the trader and the market maker, or dealer. The trader buys a particular currency at the buy price from the market maker and sells a different currency at the sell price.
The buy price is somewhat higher than the sell price. The difference is the spread. It’s the transaction cost to the trader, which in turn, is the profit earned by the market maker.
You paid this spread without realizing it when you exchanged your dollars for euros. You would notice it if you made the transaction, canceled your trip and then tried to exchange the euros back to dollars right away. You wouldn't get the same amount of dollars back.
The remaining two-thirds of exchanges are forward trades, short trades or other complex trades. A forward trade is like a spot trade, except the exchange occurs in the future. The trader pays a small fee to guarantee that he will receive an agreed upon rate at some point in the future. This protects him from the risk of his preferred currency’s value rising by the time he wants to claim it. (Source: "Forward Contract," U.S. Forex.com)
A short-sale is like a forward trade, except the trader sells the foreign currency first. He will buy them later. He hopes that the currency's value falls in the future. (Source: Intro to Currency Trading, OANDA. "Profit in Falling Markets (Short-Sale Selling Basics)," DailyFX.com, February 8, 2012)
The Most Traded Currencies
As of April 2016, most trading (88 percent) happened between the U.S. dollar and some other currency.
The euro is next at 31 percent. That’s down from 39 percent in April 2010. The yen carry trade returned with force. Its trading rose from 17 percent in 2007 to 22 percent in 2016. Trading in the Chinese yuan more than doubled from 2 percent in 2013 to 4 percent in 2016. Find out the Dollar's Value in Five Other Currencies.
The chart below shows the top 10 currencies and the percent of global currency trades in 2016. It also shows and percent traded among their primary currency pairs, where available.
|Currency||% of World Trade|
|USD (U.S. Dollar)||88|
|AUD (Australian Dollar)||7|
|CHF (Swiss Franc)||5|
|CAD (Canadian Dollar)||5|
|CNY (Chinese Yuan)||4|
|MXN (Mexican Peso)||2|
|NZD (New Zealand Dollar)||2|
(Source: “Triennial Central Bank Survey of Foreign Exchange and Derivatives Markets,” Bank for International Settlements, April 2016.)
The Biggest Traders
Banks are the biggest traders, accounting for 24 percent of the daily turnover. It is a source of revenue for these banks that saw their profits decline after the subprime mortgage crisis. Investment companies always look for new and profitable ways to invest. Currency trading is a perfect outlet for financial experts who have the quantitative skills to invest in complicated areas.
Hedge funds and proprietary trading firms come second and contribute 11 percent. Although they represent smaller proportion, their trading is increasing for the same reason as the banks.
Pension funds and insurance companies are responsible for another 11 percent of the total turnover.
Corporations contribute just 9 percent. Multinationals must trade foreign currencies to protect the value of their sales to other countries. Otherwise, if a particular country's currency’s value declines, the multinational's sales will too. This can happen even if the volume of products sold grows.
Why Forex Trading Is So Massive
Forex volatility is declining, reducing the risk for investors. In the late 1990s, volatility was often in the teens. It sometimes rose to as high as 20 percent with U.S. dollar versus yen trades. Today, volatility is below 10 percent. It includes historical volatility, or how much prices went up and down in the past. It also includes implied volatility. That's how much future prices are expected to vary, as measured by futures options.
Why is volatility lower? One, inflation has been low and stable in most economies. Central banks have learned how to measure, anticipate and adjust for inflation. Two, central bank policies are more transparent. They clearly signal what they intend to do. As a result, markets have a lower chance of overreacting. Three, many countries have also built up large foreign exchange reserves. They hold them either in their central banks or sovereign wealth funds. These funds discourage the currency speculation which creates volatility.
Four, better technology allows for faster response on the part of forex traders. It leads to smoother currency adjustments. The more traders there are, the more trades occur. This contributes to additional smoothing in the market.
Five, more countries are adopting flexible exchange rates, which allow for natural and gradual movements. Fixed exchange rates are more likely to let the pressure build up. When market forces overwhelm them in the end, it causes huge swings in exchange rates. This is true in particular for emerging market currencies, making them more important global economic players. The "BRIC" countries, Brazil, Russia, India and China, seemed impervious to the recession until recent times. Forex traders became more involved in their currencies. In 2013 though, these countries started to falter, leading to an exodus and fast depreciation of their currencies.
Why the Recession Didn't Reduce Trading
The BIS was surprised that the recession didn't affect the growth of forex trading as it did for so many other forms of financial investments. A BIS survey found that 85 percent of the increase was due to increased trading activity from "other financial institutions."
Just a few high-frequency traders do most of the trades. Many of them work for banks, who are now increasing this area of their business on behalf of the biggest dealers. Last but not least, is an increase in online trading by retail (or ordinary) investors. It has become much easier for all of these groups to trade electronically.
This shift is compounded by algorithmic trading (also called program trading). It means computer experts, or "quant jocks," set up programs that automatically conduct trades when certain parameters are met. These parameters can be central bank interest rate changes, an increase or decrease in a country's gross domestic product or a change in the value of the dollar itself. Once one of these parameters is met, the trade is automatically executed.
How It Affects the U.S. Economy
Overall, lower volatility in forex trading means less risk in the global economy than in past decades. Why? Central banks have become smarter. Also, the forex markets are now more sophisticated. It means that they are less likely to be manipulated. As a result, dramatic losses based on currency fluctuations alone (like we saw in Asia in 1998) are less likely to happen.
Traders still speculate in the forex market though. In May 2015, four banks (Citigroup, JPMorgan Chase, Barclays and Royal Bank of Scotland) admitted to rigging foreign exchange rates. They join UBS, Bank of America and HSBC, who have already admitted to price fixing and colluding with each other to manipulate foreign exchange rates. The investigation is related to the Libor investigation. (Source: "Banks Near Settlement in FX Probe," Wall Street Journal, May 7, 2015)
Even without outright price fixing, traders can create asset bubbles in foreign exchange rates. It may have happened with the U.S. dollar in 2014 and also in the last quarter of 2008. A strong dollar makes U.S. exports less competitive. It slows GDP growth. If traders bid the dollar down, then oil-producing countries will raise the price of oil as oil is sold in dollars. The impact of expanding forex trading needs to be better regulated in order to avoid potential bubbles and busts.