Definition, How It Works, Types, Trading Risks

What Is the Forex Market?

The forex market allows participants, such as banks and individuals, to buy, sell or exchange currencies for both hedging and speculative purposes. The foreign exchange (forex) market is the largest financial market in the world and is made up of banks, commercial companies, central banks, investment management firms, hedge funds, retail forex brokers, and investors.

Understanding the Forex Market

The forex market is not dominated by a single market exchange, but a global network of computers and brokers from around the world. Forex brokers act as market makers as well and may post bid and ask prices for a currency pair that differs from the most competitive bid in the market.

The forex market is made up of two levels—the interbank market and the over-the-counter (OTC) market. The interbank market is where large banks trade currencies for purposes such as hedging, balance sheet adjustments, and on behalf of clients. The OTC market, on the other hand, is where individuals trade through online platforms and brokers.

From Monday morning in Asia to Friday afternoon in New York, the forex market is a 24-hour market, meaning it does not close overnight. The forex market opens from Sunday at 5 p.m. EST to Friday at 4 p.m. EST.

This differs from markets such as equities, bonds, and commodities, which all close for a period of time, generally in the late afternoon EST. However, as with most things, there are exceptions. Some emerging market currencies close for a period of time during the trading day.

History of the Forex Market

Up until World War I, currencies were pegged to precious metals, such as gold and silver. Then, after the Second World War, the system collapsed and was replaced by the Bretton Woods agreement. That agreement resulted in the creation of three international organizations to facilitate economic activity across the globe. They were the following:

1. International Monetary Fund (IMF)
2. General Agreement on Tariffs and Trade (GATT)
3. International Bank for Reconstruction and Development (IBRD)

The new system also replaced gold with the U.S. dollar as a peg for international currencies. The U.S. government promised to back up dollar supplies with equivalent gold reserves. But the Bretton Woods system became redundant in 1971 when U.S. President Richard Nixon announced a “temporary” suspension of the dollar’s convertibility into gold.

Currencies are now free to choose their own peg and their value is determined by supply and demand in international markets.

Type of Forex Markets

Three are three key types of forex markets: spot, forward, and futures.

Spot Forex Market

The spot market is the immediate exchange of currency between buyers and sellers at the current exchange rate. The spot market makes up much of the currency trading. 

The key participants in the spot market include commercial, investment, and central banks, as well as dealers, brokers, and speculators. Large commercial and investment banks make up a major portion of spot trades, trading not only for themselves but also for their customers.

Forward Forex Market

In the forward markets, two parties agree to trade a currency for a set price and quantity at some future date. No currency is exchanged when the trade is initiated. The two parties can be companies, individuals, governments, or the like. Forward markets are useful for hedging. 

On the downside, forward markets lack centralized trading and are relatively illiquid (since there are just the two parties). As well, there is counterparty risk, which is that the other part will default.

Futures Forex Market

Future markets are similar to forward markets in terms of basic function. However, the big difference is that future markets use centralized exchanges. Thanks to centralized exchanges, there are no counterparty risks for either party. This helps ensure future markets are highly liquid, especially compared to forward markets.

Big Players in the Forex Market

The U.S. dollar is by far the most-traded currency. The second is the euro and the third is the Japanese yen. JPMorgan Chase is the largest trader in the forex market. Chase has 10.8% of the global forex market share. They have been the market leader for three years now. UBS is in second, with 8.1% of the market share. XTX Markets, Deutsche Bank, and Citigroup make up the remaining places in the top five.

Advantages and Disadvantages of Forex Trading

Forex markets have key advantages, but this type of trading doesn’t come without disadvantages. 

Advantages

One of the biggest advantages of forex trading is the lack of restrictions and inherent flexibility. There’s a very large amount of trading volume and markets are open almost 24/7. With that, people who work nine-to-five jobs can also partake in trading at night or on the weekends (unlike the stock market). 

There’s a large amount of optionality when it comes to available trading options. There are hundreds of currency pairs, and there are various types of agreements, such as a future or spot agreement. The costs for transactions are generally very low versus other markets and the allowed leverage is among the highest of all financial markets, which can magnify gains (as well as losses).

Disadvantages

With forex markets, there are leverage risks—the same leverage that offers advantages. Forex trading allows for large amounts of leverage. The leverage allowed is 20-30 times and can offer outsized returns, but can also mean large losses quickly. 

Although the fact that it operates nearly 24 hours a day can be a positive for some, it also means that some traders will have to use algorithms or trading programs to protect their investments while they are away. This adds to operational risks and can increase costs. 

The other major disadvantage is counterparty risk, where regulating Forex markets can be difficult, given it’s an international market that trades almost constantly. There is no central exchange that guarantees a trade, which means there could be default risk.

Forex Market FAQs

The Bottom Line

Forex trading offers several advantages over other markets, such as flexibility with types of contracts and near 24/7 trading. It also allows investors to leverage their trades by 20 to 30 times, which can magnify gains. On the downside, this leverage can also lead to major losses fast.