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Understanding How The Foreign Exchange Market Works

The idea of exchanging one currency for another seems simple enough. But understanding who and what is actually involved can be somewhat more complicated.

So, we thought we’d try and explain it for you.

First off, a glossary. There can be a lot of jargon and slang to decipher when it comes to first understanding the foreign exchange market. So, to help, this:

 

  Foreign Exchange Market Glossary
Foreign Exchange An institution or system for dealing in the currencies of other countries.
Forex Shorthand for Foreign Exchange
FX Shorterhand for Foreign Exchange
The stock markets The stock markets are the collection of markets and exchanges (think Wall Street, the London Stock Exchange) where, amongst other things, the trading of equities or stocks of publicly held companies or bonds, take place.
Commodity market A commodity market is like a stock market, but it trades primarily in one sector or type of goods. I.e. gold, coffee or wheat.
Decentralised market The New York Stock Exchange or the London Stock Exchange are centralised to those cities, making them centralised, individual markets. Financial markets without a centre, such as the FX market, are decentralised.
Mid-market rate Also known as the true exchange or the interbank rate, the mid-market rate is the mid-point between the buy and the sell prices of two currencies in the FX market. I.e. the average rate a currency is being bought and then sold at. This tends to be the ‘real’ rate before banks or bureaux add their fee
A spread Banks and brokers often apply a “spread” to the mid-market rate, this tends to be a fee that is factored into the rate. which amends the quoted rate to factor in their charges. For WeSwap, we include a spread of no more than 2% (and nothing else, might we add). You can see the real exchange rate before any of these fees at XE.com
Central Bank  A central bank is the institution that manages a country or state’s currency and finances. Amongst other things, they set interest rates, manage the commercial banks in a country, print more money (and manage any fallout from this).

 

Now, to the tricky stuff.

WHAT IS THE FOREIGN EXCHANGE MARKET?  

The foreign exchange market is, by quite a way, the largest financial market in the world.  On average over $5 trillion is exchanged daily by banks, financial institutions, corporations and individuals.

BUT HOW DOES IT WORK?

Unlike other financial markets, such as the stock market or specific commodity markets, currencies are not traded on a central exchange. Instead, it’s a highly decentralised market, which allows a huge number and variety of people to access it, to buy currencies or swap one currency against another.

The currencies are always traded in pairs and these are always written in a certain way. For example, if you’re trading British pounds against US dollars, you would write GBP/USD.

The trades are always done between two parties. At the highest level this is done between banks and other ‘Big Players’ (see next point for more on these guys) with one party buying one lot of currency with another, e.g. buying an amount of dollars with an amount of pounds.

WHAT AFFECTS A CURRENCY’S VALUE?

Moves in the market are caused by vast amounts of currency being bought or sold. Specialists in the market pay attention to many different areas and ultimately make speculations over what is about to happen.

For the most part, these split into two categories:

  1. News and economic releases that hint at moving interest rates (Central Bank rate decisions, inflation reports, unemployment reports, GDP numbers, oil prices).
  2. Changing risk environment (elections, geopolitics, terrorist threats, economic agreements).

DO YOU HAVE AN EXAMPLE?

The day before Trump’s election, for example, Japanese Yen was stronger than the US Dollar because of the unpredictability around who would win the election and the potential for an economic shake-up if ‘the Donald’ was to win. Yen also improved vs the Pound throughout Brexit because investors identified Japan as a safe haven in contrast to the UK.

WHO ARE THE BIG PLAYERS?

The Big Players, as we’re calling them, sit at the top of the Foreign Exchange pyramid and are comprised mostly of banks, hedge funds, pension funds and big businesses with a lot of money (or capital). How they behave in the markets ultimately determines the exchange rates.

HOW DO THEY MAKE MONEY?

They buy currencies on a much larger scale than your regular, humble traveller. That’s because they are trying to manage their own portfolios by making more money and by avoiding losing any money.

The Big Players may decide that one currency has greater value or carries less risk than another asset they already own. That asset could be anything from another currency, to stocks & shares, to physical commodities – like gold.

The higher a currency’s interest rate is, the more money they’ll will get. So it’s beneficial for the Big Players to deposit 100 in currency X that will earn 10%, than in currency Y that pays 1%. As long as they don’t expect X to lose significant value by the time they collect their money back.

WHERE DO TRAVELLERS COME INTO THIS?

At the very bottom of the currency pyramid is the individual traveller looking to get a relatively small amount of foreign currency for a trip abroad.

That means that the customer will usually receive the worst rate in the market. Meaning, sadly, that you have less spending money for your trip.

BUT WHY CAN’T WE GET THE SAME RATE AS THE BANKS?

Mostly because banks and bureaux need to cover their costs and aim to make a profit. They need to have an office nearby, staff and a stock of multiple currencies that they might have bought at a lower price a few days ago: this means heavy costs, logistics and high risk.

As a result, we end up paying more.

IS THERE ANOTHER WAY?

We like to think so. In fact, we’ve dedicated almost all our time to it. At WeSwap, we’ve built a community of travellers who exchange and swap currencies between each other (with a helping hand from our algorithms, of course). We skip most intermediaries and the fees you pay narrow down to our real costs, with a small amount allowing us to operate sustainably.

Got some more questions? Ask below and we’ll consult our in-house FX experts and get back to you.  

 

   

One Comment

  1. Well Done!!! well presented and very informative , Direct and systematic

    Well Done!! Direct , Systematic , very informative and Well presented. It came out to be very helpfull for me. Thank You! And wish you All The Best !

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