What is the FX market all about?

In past blogs, I’ve focused on FX risks, market moves, and regulations. I think it would valuable to take a step back and review FX basics, to discuss key terms and phrases used in the markets, and review the basics of trading FX.

So what exactly is the FX market?

The foreign exchange market, also known as the FX market, currency market, and forex market, is the single-largest market in the world. It operates 24 hours a day from the beginning of the work week on Monday morning in New Zealand until 5 p.m. New York time on Friday afternoon.

The currency market is unlike any other market. Unlike stocks that you can buy or sell based on your view, when you buy or sell a currency, you are simultaneously selling or buying another currency, creating the need for a view in two currencies.

Roughly $5 trillion is traded daily.

Historically there were two sides to the market:

• A sell side, made up of large financial institutions and brokers.

• A buy side, made of up of clients in need of foreign currency, or speculating on foreign currency movement.

The buy side was generally made up of asset managers, hedge funds, and corporations. The buy side client would call their sell side bank or broker to transact their foreign currency business.

Today, however, those lines have grayed.

Due to advancing technology, and regulations limiting a bank’s ability to take currency risk, the buy side has become a provider of currency market liquidity as well.

Electronic trading platforms now allow for all currency prices to be posted in a commingled environment, so that buy and sell side, given some restrictions, can participate in the same pools of currency market liquidity together.

The asset managers, hedge funds, banks, brokers or electronic platforms are now called Liquidity Providers or LPs.

The Market

Today’s market has two basic components, spot and forward, although there are many more variations that I will discuss at another time.

• Spot FX is the buying or selling of a currency at a specific rate (the spot rate), for delivery in two business days. People buy and sell currency in the spot market for a variety of reasons. Most often this is so they can buy something in that currency, like a foreign bond or stock.

Spot FX can be transacted through your banker or broker, or over an electronic trading platform. Over the last ten years, electronic trading has become much more common.

•The forward market is the second major component of FX.

Unlike spot, which settles in two days, a forward trade is anything that settles in longer than two business days. That could be three days, all the way out to multiple years.

These transactions are performed in the same way as spot, but with a slightly different purpose. Forward FX is used to lock in an FX rate today for some time in the future.

For example, you are a U.S. investor and plan to buy a building in Canada in six months. You are concerned that over the next six months the Canadian Dollar will strengthen relative to the U.S. Dollar. If that happens, the U.S. based investor will need more U.S. Dollars to cover his cost. To eliminate that risk, the investor can buy the Canadian Dollars today in the forward FX market at a set market rate for settlement or delivery in six months

What else is there to know

Currencies don't trade like stocks, in one penny incremental moves. Most currencies move at one hundredth of a cent increments.

That may seem like a very small increment. But considering the trades are mostly done in large amounts, those differences add up quickly.

A penny move for most currencies is considered large.

“Dollar up in overnight markets”

So what is the most-traded currency? And what's it worth?

The answer to the first part of that question is simple—the U.S. Dollar is the most actively traded currency.

The second part of that question is a bit more complicated.

The answer is, it depends on what you are buying and selling the U.S. Dollar against. It trades at one price against the Euro and at another price against the Mexican Peso, and those prices vary constantly.

When you open the paper in the morning (sorry, dating myself) or go online and see a story that says the “Dollar was up overnight,” what exactly does that mean?

It generally means that the U.S. Dollar is trading higher against some of the other major currencies in the world, like the Euro, British Pound, or Japanese Yen. It does not mean it has moved higher against all currencies.

Think of it similar to stock headlines. When the headline says “Stocks are up,” it usually means the Dow Jones Industrial Average, or the S&P. One quick check of your own stock portfolio often reminds you that a headline like that does not mean all stocks.

When to trade

A key term and topic of discussion in today’s market is “The Fix.”

It is a specific time of day where investors around the globe can transact foreign currency trades at a set, documented price. At all other times of the day, the price varies from moment to moment and lacks any regulatory oversight.

The Fix has come into question over the last few years due to possible manipulation by large financial institutions. However for many asset managers that don't want to trade FX all day, executing all of their FX trades at a single price at a single time of day is very appealing.

I hope this covers some of the basics of the FX market. In upcoming blogs, I will discuss where currency risk may arise and whether or not to hedge. As always, questions and comments are welcome.