Foreign exchange market

The foreign exchange market (also in English "Forex", "Foreign Exchange", sometimes "FX") is a system of stable economical and organizational relations arising in the course of transactions on purchase or sale of foreign exchange, payment instruments in foreign currencies, as well as transactions on capital movement of foreign investors.

In the foreign exchange market, the interests of investors, sellers and buyers of currency assets are aligned. Western economists characterize the foreign exchange market from the organizational and technical point of view as a complex network of modern means of communication connecting national and foreign banks and brokerage firms.

Exchange transactions existed as far back as the ancient world and the Middle Ages. However, modern foreign exchange markets emerged in the 19th century. The main prerequisites that contributed to the creation of the foreign exchange market in the modern sense were the following:

• extensive development of various international economic relations;
• creation of a world monetary system based on arranging and regulating currency relations, formalized in interstate agreements;
• widespread use of credit facilities for international settlements and payments;
• consolidation and centralization of banking capital, extensive development of correspondent relations between banks of different countries, including the management of correspondent accounts in foreign currency;
• development of information technologies and means of communication: telegraph, telephone, telex, which simplified contacts between foreign exchange markets and reduced the time for obtaining information on transactions.

Developing national foreign exchange markets and their interaction shaped a single world foreign exchange market, where the leading currencies in the world's financial centers began to circulate freely.

Importers, exporters and the banking structures serving them were forced to become regular participants in the foreign exchange market, as changes in exchange rates can affect their financial results both positively and negatively.

Central banks were able to influence the exchange rates of the national currency and influence the economic situation in the country by market methods, not only by administrative ones.

The exchange rates of the most liquid national currencies are formed based on the market's search for an equilibrium point between current demand and available supply, and changes in supply and demand in the market cause a shift in the exchange rate in one direction or another.

Modern world foreign exchange markets are characterized by the following main features.

International nature of foreign exchange markets based on globalization of world economic relations, widespread use of electronic means of communication for transactions and settlements.

The continuous, non-stop nature of transactions throughout the day alternately in all parts of the world.

Uniform nature of exchange transactions.

Use of foreign exchange market transactions for the purpose of protection against currency and credit risks through hedging.

A huge share of speculative and arbitrage transactions, which are many times higher than exchange transactions related to commercial deals. The number of currency speculators has increased dramatically and includes not only banks and financial-industrial groups, TNCs, but also many other participants, including individuals and legal entities.

Volatility in exchange rates, which is not always dependent on fundamental economic aspects.

Ensuring the timeliness of international settlements.

Creating opportunities for protection against currency and credit risks.

Ensuring the interconnection of the world's foreign exchange, credit and financial markets.

Creating opportunities for diversification of currency reserves of the state, banks, and enterprises.

Market regulation of exchange rates based on the interaction of demand and supply of currencies.

Possibility to realize the currency policy as a part of the state economic policy. Possibility to implement coordinated actions of different states in order to realize the goals of macroeconomic policy within the framework of interstate agreements.

Providing opportunities for foreign exchange market participants to make speculative profits through arbitrage transactions.

In the modern foreign exchange market, the following types of transactions can be distinguished.

Spot transactions are transactions on purchase and sale of currency on conditions of its immediate delivery by banks-counterparties within the term not later than the second working day from the day of conclusion of the transaction, during which the sale/purchase rate is fixed.

Exchange transactions with immediate delivery are the most mobile element of the currency position and involve a certain amount of risk. Using the "spot" transaction, banks meet the needs of their clients in foreign currency, transfer capital, including "hot" money, from one currency to another, carry out arbitrage and speculative transactions.

Forward exchange transactions include forward, futures and options transactions, as well as currency swaps.

Forward transactions include currency purchase and sale transactions, where the price (purchase and sale rate) is determined at the time of conclusion of the transaction, and delivery of currency, i.e. fulfillment of obligations by the parties, is envisaged in the future.

Forward transactions are made under contracts, the terms and conditions of which (volume of purchase/sale, term and place of fulfillment of obligations) are individual and not standard.

Futures transactions include standard contracts for purchasing and selling currencies that are traded on an exchange. Such transactions are made on terms and conditions that are developed by the exchange and that are binding on all those who transact in futures. Futures have standardized maturity terms. The three-month futures are the most common.

The leading exchanges for trading futures contracts are the Chicago Mercantile Exchange (CME), New York Mercantile Exchange (NYMEX), London (LIFFE), Singapore (SGX), Eurex, Paris (MATIF) exchanges. In April 1998, the Chicago Mercantile Exchange (CME), with the technological support of MICEX, began to conclude ruble futures contracts for the first time (with a par value of 500 thousand rubles and a term of six months). The ruble-dollar exchange rate formed on MICEX is used to assess the trading positions of offsetting participants. Rubles are not physically exported. The winner is the one who correctly predicts the exchange rate. Futures trading is done through a clearing house, which is a seller for each buyer and a buyer for each seller [2].

An option (from Latin optio, optionis – choice) is a derivative financial instrument, a contract under which the buyer of an option acquires the right, but not the obligation, to buy or sell a certain amount of currency in the future at a fixed price (strike price). The buyer of option, upon payment of the option premium to the seller, which is essentially the option price, acquires the right to either buy (call option) or sell (put option) on any day, if it is an American option; or on a specific date once a month, if it is a European option).

Currency option contracts are traded on the following exchanges: Chicago Board Options Exchange (the world's largest options exchange), European Options Exchange in Amsterdam (EOE), Austrian Dated Options Exchange in Vienna (ОсТОВ (Oesterreichische Termin Optionsboerse) [2].

A currency swap is a transaction combining the purchase and sale of two currencies on terms of immediate delivery with a simultaneous counter transaction for a certain period of time with the same currencies. Each party is simultaneously a seller and a buyer of a certain amount of currency. A currency swap is not a standard exchange contract.

In "swap" transactions, the cash transaction is carried out at the spot rate, which in the counter transaction (future transaction) is adjusted with a premium or discount depending on the exchange rate dynamics. In doing so, the client saves on margin – the difference between the seller's and buyer's exchange rates on a cash transaction. "Swap" transactions are useful for banks: they do not create an open position (the purchase is covered by the sale), temporarily provide the necessary currency without the risk associated with changes in its exchange rate.

Volume of transactions in the foreign exchange market, bln USD

It is believed that the daily turnover in the forex market was as follows:

in 1977 – 5 bln USD
in 1987 – 600 bln USD
at the end of 1992 – 1 trln USD
in 1997 — 1.2 trln USD
in 2000 — 1.5 trln USD
in 2005–2006, the daily turnover volume on the FOREX market fluctuated, according to various estimates, from 2 to 4.5 trln USD.
in 2010 — 4 trln USD
in 2013 — 5.3 trln USD
in 2016 — 5.1 trln USD
in 2019 — 6.6 trln USD
in 2022 — 7.5 trln USD

Participants in the foreign exchange market are as follows: central banks, commercial banks, firms, forex exchanges, foreign exchange brokers and, indirectly, other economic agents.

Central banks – their function is to manage the government's foreign exchange reserves and ensure exchange rate stability. To realize these tasks, both direct currency interventions and indirect influence – through regulation of the refinancing rate, reserve ratios, etc. – can be carried out.

Commercial banks – they conduct the base volume of exchange transactions. Other market participants hold accounts with banks. They use them to carry out transactions on conversion, deposit and credit necessary for their purposes. Banks concentrate the combined exchange and fund raising/allocation needs of commodity and stock markets. Besides meeting clients' requests, banks can also carry out transactions on their own using their own funds. Ultimately, the international foreign exchange market (forex) is a market for interbank transactions.

The biggest influence comes from large international banks with daily volume of transactions reaching billions of dollars. The volume of one interbank contract with actual delivery of currency on the second business day (spot market) is usually about 5 mln USD or its equivalent. The cost per conversion payment ranges from 60 to 300 dollars. In addition, one has to bear expenses up to 6 thousand dollars per month for an interbank information and trade desk. These conditions are the reason why there are no conversions of small amounts in Forex. For this purpose, it is cheaper to turn to financial intermediaries (bank or foreign exchange broker), who will carry out the conversion for a certain percentage of the transaction amount. With a large number of clients and multi-directional orders, an internal clearing situation regularly arises where the intermediary does not need to contact a third-party counterparty (no real Forex conversion is needed). However, intermediaries always get their commission from their clients. The fact that not all client orders get to Forex, intermediaries can offer their clients commissions that are significantly lower than the cost of direct transactions on Forex. At the same time, if intermediaries are eliminated, the cost of conversion for the end client will inevitably increase.

Currency exchanges – in a number of countries there are national currency exchanges, whose functions include exchanging currencies for legal entities and setting market exchange rates. The government usually actively regulates the exchange rate level, taking advantage of the compactness of the local exchange market.

Foreign exchange brokers – their function is to bring together a buyer and a seller of foreign currency and conduct a conversion or loan and deposit transaction between them. Brokerage firms charge a brokerage commission for their brokering in the form of a percentage of the transaction amount. However, the amount of this commission is often less than the difference between the bank's loan interest and the bank deposit rate. Banks can also perform this function. In this case, they do not provide a loan and do not bear the associated risks.

Firms engaged in foreign trade operations: total requests from importers form a stable demand for foreign currency, and those from exporters form its supply, including in the form of foreign currency deposits (temporarily free balances on foreign currency accounts). As a rule, firms do not have direct access to the foreign exchange market and conduct conversion and deposit operations through commercial banks.

International investment companies, pension and hedge funds, insurance companies, whose main task is diversified asset portfolio management, which is achieved by placing funds in securities issued by governments and corporations of different countries. In dealer slang, they are simply called funds. This type can also include large transnational corporations that carry out foreign production investments: the establishment of branches, joint ventures, etc.

Individuals - citizens conduct a wide range of transactions, each of which is small, but in the sum can form a significant additional demand or supply: payment for foreign tourism; money transfers of wages, pensions, fees; purchases/sales of cash currency as a means of saving; speculative currency transactions.