Foreign exchange trading (forex or FX) is the global market for buying and selling currencies. It’s the world’s biggest financial market by far. At £5.2 trillion, it dwarfs the world’s combined stock markets by a factor of 25.
For flexible-rate currencies like the Pound, Forex has a direct impact on exchange rates, meaning they fluctuate constantly. Other flex-rate currencies include the Euro, Japanese Yen, and the Canadian dollar.
Forex is primarily an over-the-counter (OTC)1 market, where trades happen via electronic platforms or over the phone rather than in a physical location like a stock exchange. Trades execute in specific currency pairs. When a currency is sold, payment happens in a different currency.
Anyone who’s travelled abroad has engaged in basic foreign currency trading. If you’ve been on a business trip on holiday in Europe, you swapped Pounds for Euros at whatever the going exchange rate was that day. When you left, you sold Pounds and bought Euros. When you returned, you sold your remaining Euros and purchased Pounds.
Forex trading happens using four financial instruments: swaps, spot contracts, options, and forward trades. Swaps take up the majority of trades at just above fifty per cent. Thirty per cent are spot trades with fifteen per cent going to forward contracts.
Options are favoured mainly by banks and large institutions, accounting for ca. five per cent of FX trades.
Here is a deeper look at each forex trading instrument and what it involves.
Half of all currency trades are foreign exchange swaps.3 Two parties agree to borrow currencies from each other at the spot rate. They agree to swap the currencies back on a specific date at the future exchange rate. Most swaps are short-maturity, between one to seven days.4
Central banks use these swaps to keep foreign currencies available for their member banks. The banks use it for overnight and short-term lending only. Most swap lines are bilateral, which means they are only between two countries’ banks. Importers, exporters, and traders also engage in swaps.
The most straightforward FX instrument is the spot trade. Similar to exchanging cash when you travel abroad, one currency is purchased using another. The purchased currency is acquired immediately.
Spot trades take the form of contracts between two counterparties in the transaction. The trader purchases currency at the ‘buy’ price from a dealer or ‘market maker.’ He or she then sells another, different currency at the ‘sell’ price. Usually, the buy price is higher than the sell price, with the difference between them referred to as the ‘spread’. The spread is what the trader pays in terms of transaction costs. For the market maker, the spread is where they turn a profit.
With FX options, you obtain the right to buy foreign currency on a fixed date for a fixed price. However, there is no obligation to exercise the option and make a purchase. As a trader, the only upfront cost is the premium paid to purchase the contract.
Because they have the means to de-risk themselves from currency price volatility, options are mainly used by banks and large multinational corporations.
Forward trades are often used by businesses. They operate much like spot trades, but the actual exchange of currencies occurs at a fixed date in the future. The trader pays a fee to guarantee an agreed-upon rate. The majority of forward trades execute on timeliness between one week and three months in duration.
Because they can act as a hedge against currency risk, businesses often use them to protect against the possibility that their currency’s value will rise when they need to exchange it.
According to the Bank for International Settlements, the average daily trading volume in forex was £5.2 trillion as of April 2020. The forex market grew steadily throughout the 2008 financial crisis. Analysts have suggested the crisis drove many people to see new ways to earn income and kick-started the trend to maintain a ‘side hustle’ to supplement employment income.
The world’s largest FX traders are central banks and large private banks. They account for nearly forty per cent of daily forex turnover, with smaller banks taking up another 13 per cent of total trading volume.
Corporations come in next at seven per cent of total trades. Then come insurance companies and pension funds with the next seven per cent. Hedge funds engage in five per cent of currency trading.
Forex trading affects the Pound’s value directly. When traders demonstrate more demand for pounds, the value of the Pound rises. This is often triggered when demand for UK goods and services rises. Greater demand for British products means more foreign companies need to transact in pounds and keep a store of them to hand. The value of the Pound also goes up happens when other currencies are seen as riskier. In this case, the Pound becomes a ‘safe haven’ for forex traders and investors.
If UK interest rates rise, that can also drive up Sterling’s value. Traders with Pounds in their trading accounts might be able to make more money by putting it in the bank and receiving interest. If another trader wants to buy Pounds, they have to beat the returns offered by bank interest.
When the Pound is pricier against other currencies, it makes British exports more expensive to buy. If British products cost a foreign buyer more of their local currency to purchase, the overall effect can slow down GDP growth.
Similarly, a strong pound can push down UK stock market values. Outside investors will assess UK stocks priced in Pounds as more expensive versus the shares available in their local or national markets.
Conversely, a strong Pound makes imports cheaper, that lowers the cost of consumer goods and can have a positive impact on standard of living.