In the foreign exchange market, there are different levels of access that determine who participates. The highest level is the interbank market, which consists of large commercial banks and securities dealers. Spreads, which are the difference between bid and ask prices, are very narrow in the interbank market, known only to those within the inner circle. As you move down the levels of access, the spreads widen, indicating a greater difference between bid and ask prices. This is due to the volume of transactions.
The size of the trading line, or the amount of money used for trading, determines the access level in the forex market. The top-tier interbank market represents 39% of all transactions. Below that, smaller banks, large multinational corporations, hedge funds, and even some retail market makers participate in forex trading.
In recent years, institutional investors like pension funds, insurance companies, and mutual funds, along with hedge funds, have become increasingly important players in the forex market. Central banks also participate to align currencies with their economic needs.
Commercial companies play a significant role in the forex market when seeking foreign exchange to pay for goods or services. Although their trade volumes are smaller compared to banks or speculators, their long-term direction can influence currency exchange rates. Multinational corporations, in particular, can have an unpredictable impact on the market due to their large positions and exposures.
Central banks hold a crucial role in the forex market as they attempt to control money supply, inflation, and interest rates. They may have official or unofficial target rates for their currencies and utilize their foreign exchange reserves to stabilize the market. However, the effectiveness of central bank interventions in trading remains debatable.
Foreign exchange fixing refers to the daily exchange rate fixed by national banks. Fixing exchange rates provide a benchmark for banks, dealers, and traders to evaluate market trends. Central banks may use fixing rates to assess the behavior of their currencies. Although the expectation or rumor of central bank intervention can stabilize a currency, the combined resources of the market can easily overwhelm central banks, as seen in historical events.
Speculation makes up a significant portion (70-90%) of forex transactions. Speculators engage in trading based on the movement of a currency without intending to take physical delivery of the currency. Hedge funds, in particular, are known for their aggressive currency speculation. With their substantial resources and ability to borrow even more, they can potentially overpower central bank interventions if economic conditions align in their favor.
Investment management firms, such as pension funds and endowments, participate in the forex market to facilitate transactions in foreign securities. They may need to purchase and sell foreign currencies to pay for their foreign securities purchases. Some investment management firms also have specialist currency overlay operations that manage clients' currency exposures to generate profits and limit risk.
Retail Foreign Exchange Traders:
Retail traders are individual speculative traders who participate in the forex market indirectly through brokers or banks. They are a growing segment of the market and engage in retail foreign exchange trading. Retail brokers, regulated in the US by the Commodity Futures Trading Commission (CFTC) and National Futures Association (NFA), help retail traders access the market. However, there have been instances of foreign exchange fraud, leading to increased regulations for retail brokers. Retail traders can trade with brokers or market makers who act as intermediaries, either acting as an agent or principal in the transaction.
Non-bank foreign exchange companies offer currency exchange and international payment services to individuals and companies. These companies, also known as foreign exchange brokers, focus on currency exchange with physical delivery to bank accounts. They do not offer speculative trading. Non-bank foreign exchange companies often provide better exchange rates or cheaper payments compared to traditional banks. In the UK, it is estimated that 14% of currency transfers/payments are made via these companies.
Money transfer/remittance companies specialize in high-volume, low-value transfers, often made by economic migrants sending money back to their home country. These companies, such as Western Union, facilitate a significant amount of remittances globally. Bureaux de change, on the other hand, offer foreign exchange services for travelers, typically found at airports, tourist locations, and transportation hubs. These services allow physical currency notes to be exchanged between different currencies.
Understanding the different participants in the forex market highlights the diverse range of actors and roles they play in driving market liquidity and the movement of currency exchange rates.
