What Is Forex Trading? How It Determines the Dollar's Value

What Market Trades $5.3 Trillion PER DAY?

forex
Forex trading is a $5.3 trillion a day business. Credit: Chung Sung-Jun/Getty Images

Definition: 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 value 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 Bureau for International Settlements, average daily forex trading in April 2013 (most recent data available) was $5.3 trillion per day. That is greater than the $4.4 trillion traded in 2010,  and the pre-recession high of $3.2 trillion traded per day in 2007. Even this was up 30% from $2 trillion per day traded in 2004. That's because forex trading kept growing right on through the 2008 financial crisis

How Does Forex Trading Work?

All currency trades are necessarily done in pairs. Every traveler who has gotten foreign currency has done forex trading. You exchange your dollars for euros at the going rate. When you come back, you exchange your euros back into dollars. 

Roughly one-third of the trades 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 currency at the buy price from the market maker and sells a different currency at the sell price.

The buy price is slightly higher than the sell price. That difference is the spread. That's the transaction cost to the trader, which is the profit earned by the market maker.

You've paid this spread without realizing it when you exchange your dollars for euros. You would notice it if you made the transaction, canceled your trip, then tried to exchange the euros for dollars right away.

You wouldn't get the same amount of dollars back.

The remaining two-thirds 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 he will receive that rate. That protects him from the risk that the currency he wants will rise in value by the time he wants 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. "Short-Sale Basics," DailyFX.com)

What Are the Most Traded Currencies?

Most trading (87%) is between the U.S. dollar and some other currency. The euro is next, at 33%, down from 39% in April 2010. The yen carry trade returned in force, with trading in yen rising from 19% to 23% of the total. Trading in the Chinese yuan more than doubled, rising from 0.9% to 2.2% of global trading. Find out the Dollar's Value in 5 Other Currencies.

This chart shows the top ten currencies, the percent of global currency trades, and percent traded among their primary currency pairs, where available:

Currency% of World Trade% W/USD% W/EUR
USD (U.S. Dollar)87.0 24.1
EUR (Euro)33.424.1 
JPY (Yen)23.018.32.8
GBP (Pound)11.88.8 
AUD (Australian Dollar)8.66.8 
CHF (Swiss Franc)6.23.41.3
CAD (Canadian Dollar)4.63.7 
MXN (Mexican Peso)2.52.4 
CNY (Chinese Yuan)2.22.1 
NZD (New Zealand Dollar)2.01.5 

 (Source: Bureau for International Settlements, Triennial Central Bank Survey of Foreign Exchange and Derivatives Markets, April 2013, most recent report available)

Who Are the Biggest Traders?

Banks are the largest traders, accounting for 24% of the daily turnover. That is a source of revenue for these banks that saw their profits decline after the sub-prime mortgage crisis. These investment companies continuously look for new ways to invest profitably. 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 contribute another 11%. Although a smaller percent, their trading is increasing for the same reason they are for banks.

Pension funds and insurance companies are responsible for another 11% of the total.  

Corporations contributed just 9%. Multinationals must trade foreign currencies to protect the value of their sales to other countries. If not, then if that country's currency declines, the multinational's sales will, too -- even if the volume of products sold grows.

Why Is Forex Trading So Massive?

Forex volatility is declining, reducing the risk for investors. In the late 1990s, volatility was usually in the teens.  It sometimes rose as high as 20% with U.S. dollar vs. yen trades. Today, volatility is below 10%. That includes historical volatility, or how much prices went up and down. It also includes implied volatility. That's how much future prices are expected to vary, as measured by futures options

Why is volatility lower? First, inflation has been low and stable in most economies. Central banks have learned how to measure, anticipate, and adjust for inflation. Second, central bank policies are more transparent. That means they clearly signal what they intend to do. As a result, markets are less likely to overreact. Third, many countries have also built up large foreign exchange reserves. They hold them in either their central banks or sovereign wealth funds. These funds discourage the currency speculation that creates volatility.

Fourth, better technology allows for faster response on the part of forex traders. That leads to smoother currency adjustments. The more traders, the more trades, contributing to additional smoothing in the market.

Fifth, 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 finally overwhelm them, it causes huge swings in exchange rates. It'is especially true 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 recently. Forex traders became more involved in their currencies. However, in 2013, these countries started to falter, leading to an exodus and fast depreciation of their currencies. 

Why Didn't the Recession Reduce Forex 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 investing. The BIS survey found that 85% of the increase was because of increased trading activity of "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 portion of their business on behalf of the biggest dealers. Last but not least, is an increase of 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 known as program trading). That means computer experts, or "quant jocks," set up programs that automatically transact trades when certain parameters are met. These parameters can be central bank interest rate changes, an increase or decrease in a country's GDP, or a change in the value of the dollar itself. Once one of these parameters is met, the trade automatically executes.

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. That means 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.

However, traders still speculate in the forex market. In May 2015, four banks (Citigroup, J.P. Morgan Chase, Barclays, and Royal Bank of Scotland) admitted to rigging foreign exchange rates. They join UBS, Bank of America, and HSBC, who already admitted to price fixing and colluding with each other to manipulate foreign exchange rates. The investigation is related to the LIBOR investigation. (Source: Devlin Barrett, Aruna Viswanatha, Christopher Matthews, "Banks Near Settlement in FX Probe," WSJ, May 7, 2015)

Even without outright price fixing, traders can create asset bubbles in foreign exchange rates. That may have happened in the U.S. dollar in 2014, and also in the last quarter of 2008. A strong dollar makes U.S. exports less competitive, slowing GDP growth. If traders bid the dollar down, then oil-producing countries will raise the price of oil since oil is sold in dollars. The impact of expanding forex trading needs to be better regulated to avoid potential bubbles and busts.