Forex: what is the foreign exchange market

What is Forex

The word "Forex" comes from the English terms "foreign exchange", which translates to "foreign currency" or "currency exchange".

Forex is an international currency market where traders and investors exchange one currency for another. It is one of the largest and most active financial markets in the world and operates 24 hours a day, five days a week.

History of the Forex market

Until the 19th century, there was no universal currency in the world economy, but there was the British pound, which had the strongest position. Due to this, many foreign banks established their branches in England, turning it into the first global financial center. In Europe, funds were most often exchanged in pounds sterling. Nevertheless, gold remained the most reliable means of preserving value.

At the time, converting currencies into gold was common practice. Each central bank had to guarantee that national currencies could be exchanged for gold reserves, which later became known as the Gold Standard. However, after World War I, countries were forced to suspend the exchange of currencies for gold due to the significant cost of financing the war. In 1925, Britain reverted back to the gold standard in order to bring the economy back to pre-war levels. However, the increase in the value of the pound led to deflation in the country's economy. Later, France also reintroduced the gold standard in 1928. But this system again showed its flaws when the economic crisis of 1929 collapsed due to the issuance of large amounts of money not backed by gold reserves.

In 1931 Britain, Germany and Japan abandoned the gold standard, and in 1933 the US took this step, reducing the value of the dollar against gold by 40%. France stopped converting francs into gold in 1936. So the world returned to the use of independent national currencies.

Modern Forex began its development in the run-up to the end of the Second World War. In July 1944, the Bretton Woods Agreement was signed - it led to the formation of the first international monetary system. Its main task was to control currency fluctuations and restore economic stability.

Under the agreement, only the US dollar could be exchanged for gold at a fixed price of $35 per ounce. At the time, the US owned 75% of the world's gold reserves. The dollar became the world's reserve currency to which the exchange rates of other currencies were pegged. To manage this system, the International Monetary Fund was founded in 1947.

However, the system led to a decline in U.S. gold reserves, which caused difficulty in maintaining the foreign exchange reserves of other countries. To solve this problem, on September 15, 1971, President Richard Nixon announced the abolition of the ability to exchange the dollar for gold.

These developments were formalized in the Smithsonian Treaty, which ushered in the modern era of the forex currency market.

In 1972, the Basel Accord led to the creation of the European Currency Snake, a mechanism for coordinating the European Economic Community countries to stabilize currency fluctuations among themselves.

By 1973, the world currency system switched to a floating exchange rate regime, which gradually formed Forex in its modern form.

After the collapse of the Bretton Woods system, in January 1976, agreements were concluded in Jamaica that established the foundations of the modern international monetary system. In this system, exchange rates are determined by market supply and demand rather than government regulation (the Jamaican Monetary System).

The foreign exchange market became freer and more liberalized, abolishing the rules that had previously established fixed exchange rates. Gold lost its importance as a reserve asset and countries moved to a system of floating exchange rates.

At this point, a new era for world currencies began. Since then, currencies could be freely exchanged between each other. Moreover, this is what paved the way for international currency trading. Since then, companies that trade internationally have become active participants in this new market.

With the advent of the internet, trading moved into the virtual space and the Forex platform came into existence. Today, it is available to all investors. This market was born in 1973, when the agreement fixing exchange rates ceased to operate. Every year the turnover grew, and by 2017 it reached more than 6 trillion dollars, and in 2022 a record of 7.5 trillion dollars per day was recorded.

How the Forex market works

Both large and central banks of different countries, investment and pension funds, large-scale corporations and private investors participate in the Forex market. The Forex market works 5 days a week, around the clock. At the same time, it is closed on international holidays (for example, Catholic Christmas).

Forex is a market where, instead of actually buying or selling currencies, bets are placed on changes in exchange rates. People trade in pairs, for example: dollar to euro.

Participants make trades to lower or raise prices with the help of forex brokers. Brokers allow ordinary people to participate in forex trading. Here, a person tries to predict the movement of the exchange rate of one currency relative to another and tells the broker what to do.

In addition, traders have the opportunity to use leverage: this feature gives you the opportunity to trade with a larger amount than you have. For example, you have an amount of $100, and when you use x10 leverage, it turns into $1,000. With this feature, the potential income increases, but the risks increase proportionally. If the trader's prediction is justified, he receives profit from the broker, otherwise - the funds are deducted from the client's account.

To start trading on Forex you do not need large capitals or special equipment. It is enough to have access to the Internet and use a trading terminal - a program on a computer or a mobile application (the most common terminal at the moment is MetaTrader 4/5).

It should be remembered that Forex trading is associated with high risks, and it is not easy to make money here. For this reason, it is extremely important to observe risk management and calculate your actions to avoid losses.

Market volumes and liquidity

Daily turnover in the Forex market exceeds 6.5 trillion dollars.

The overall liquidity of Forex is high, and trades take place on time and without delays.

Liquidity is an extremely important indicator, as it determines how quickly traders can open and close their positions. Thanks to high liquidity, there is almost always a counterparty ready to take the opposite side of a trade in Forex. However, there are also less liquid, unpopular trading pairs where liquidity can be low and volatility can be high. Such trading pairs are also called "exotic". Often (but not always), exotic pairs are pairs of currencies of emerging and developed economies.
For example, USD / BRL (American dollar / Brazilian real), USD / CZK (American dollar / Czech crown) are some of such pairs. In addition, there are certain periods of time when liquidity in the markets is reduced: for example, before Christmas, many market participants prefer to be away from trading, accordingly they take their assets with them and "pull" liquidity out of the market. Statistically, in the run-up to Christmas, changes in the daily range and daily pip swings of EUR/USD indicate a decrease in market activity.

Types of Forex markets

There are three main types of forex markets: spot, forward and futures. Their main difference is when the transaction takes place - immediately or in the future at a certain date.

Spot forex market

In the spot forex market, settlement takes place immediately after the transaction is concluded. For example, if you bought Euros at 15:00 today, those Euros will appear in your account immediately. In rare cases there may be a slight delay.

There are three types of settlements on this market:

1. TOD (Today) - payment of the transaction takes place during the current day. This option is the simplest.
2. TOM (tomorrow) - payment occurs the day after the transaction.
3. SPT (2 days later) - payment occurs two business days after the transaction.

If you choose deferred settlement, a small additional amount is added to the amount of the transaction. For example, with TOM it is for one day, and with SPT it is for two working days.

Forward and futures market for currencies

A forward contract is an agreement to buy or sell a currency in the future at a predetermined price. For example, if you enter into a forward contract for euros today at 3:00 pm, it means that at some point in the future you will be obliged to buy euros at an agreed rate and the seller will be obliged to sell. As a result, if the exchange rates rise, you will receive euros at a lower price, making you a profit. Contract terms in the forward forex market can be up to a year. The longer the term of the contract, the lower its liquidity.

A futures is a contract that settles ahead, in the future, just like in the forward market. The main difference with a forward contract is that a futures contract has an exact date when it should be executed.

People choose the futures market when both parties want to hedge against losses that may occur due to price changes in the future. The one who buys is protected against a fall in price, while the one who sells is protected against a rise in price.

What affects the Forex market

Various factors influence the formation of prices and movements of currency pairs. First of all, the actions of Central Banks and macroeconomic indicators have an impact.

Each state has a Central Bank, which plays a key role in controlling the value of the national currency. One of the main tasks of central banks is to keep currency prices stable. They influence the forex market by changing interest rates and conducting currency transactions.
One of the main tools of the central bank is to regulate the money supply through issuance and currency intervention. If the Central Bank issues too much national currency without a corresponding increase in production, this leads to an increase in the price of goods, including currency. In such a situation, the value of the national currency decreases against foreign currencies such as the US dollar.

This decline in the value of the national currency is called inflation. In countries with high inflation or hyperinflation, central banks often withdraw part of the money supply from circulation to stabilize the currency. Countries with deflation may use negative deposit rates to stimulate economic activity.
This suggests that such actions of the Central Bank to issue currency and intervene directly affect the exchange rate of the national currency against other currencies.

Another tool of central banks is the interest rate.

Interest rate is the interest rate at which the Central Bank provides loans to commercial banks. The interest rate of Central Banks and especially the US Federal Reserve plays a key role in influencing the financial markets, including forex. During periods when the US Federal Reserve (Fed) raises rates, the dollar can become a more attractive currency for investors. This is because an increase in interest rates often leads to a stronger dollar. In times of economic instability, such as a recession or crisis, people and businesses prefer to avoid risky investments and tend toward more secure ways to store funds, such as investing in dollars. During such periods, people often sell their assets, which drives down prices. By selling assets, they actually purchase dollars or other fiat currencies, thereby increasing demand for them and creating potential shortages.

This movement of funds also works in the opposite direction: when people actively buy, the demand for money decreases, increasing its supply.
A stronger dollar can have an impact on other currencies and currency pairs, putting pressure on them.

The balance of payments also plays an important role. It represents the ratio of a country's exports to imports, which directly affects the exchange rate. If a country imports more than it exports, it spends more foreign currency, which can lead to a depreciation of the local currency. To counterbalance this, foreign investment or loans can be attracted, or customs duties can be increased to stimulate domestic production. This helps to strengthen the exchange rate of the national currency.

Apart from such actions by Central Banks, the following macroeconomic statistics also affect the prices of the national currency:

• Employment and unemployment rate. The lower it is, the better it is for the stability of the national currency. In the U.S., for example, the Non-Farm Payrolls report (a report on the number of jobs outside the agricultural sector), which is analyzed together with the average level of wages, is of great importance.
• Data on GDP and GNP. Their growth usually indicates a favorable state of the economy, attracting investors, which leads to the strengthening of the national currency. However, if GDP growth slows down compared to previous periods, it is perceived as a negative signal.
• Balance of state budget revenues and expenditures. When the budget runs a deficit, which is covered by issuing additional money, it can lead to an increase in inflation and, consequently, to a fall in the value of the national currency.
• Public Debt. An increase in public debt is often perceived as a sign of a weakening national currency, as it creates additional demand for foreign currency to service it, which may increase its value. Moreover, the risk of debt default can discourage investors, reducing foreign currency inflows and causing shortages. However, there are exceptions to this rule, as in the case of the U.S., where government debt does not always negatively affect the currency.

During the release of such economic news, forex markets tend to experience increased volatility. Some proprietary firms even prohibit trading forex pairs for a certain period of time before and after such news.

In addition to macroeconomic data, the value of the national currency is also significantly influenced by geopolitics:

• Presidential elections. In 2016, after Trump won the US election, the dollar rose. Investors expected policy changes, which eventually proved to be true and strengthened the dollar.
• Trade wars also play a role. For example, during the trade war between the US and China, despite the general assumption that such conflicts should weaken the dollar, the US currency strengthened while the Chinese yuan fell. This is due to the perception that the US is the likely "winner" of these conflicts, able to protect its market and strengthen its economy.
• International sanctions also affect exchange rates, as shown by the example of ₚosia, where the ruble weakened significantly following the imposition of US and EU sanctions.
• In addition, armed conflicts, statements by state leaders, economic alliances and other such events are also important. An example is the results of the referendum on the UK's withdrawal from the European Union (Brexit). This event led to a sharp drop in the value of the British pound by 11%, reaching the lowest level since September 1985.

Yes, there are many indicators that you need to follow in order to trade forex, but only taking into account the whole list will allow you to understand the changes in currency quotes. Following the economic calendar and important world events is a must if you trade currency pairs.

Central Bank and Forex Market

One of the main tasks of central banks is to keep currency prices stable. They influence the forex market by changing interest rates and conducting currency transactions. The interest rate of Central Banks and especially the US Federal Reserve plays a key role in influencing the financial markets, including forex. During periods when the US Federal Reserve (Fed) raises rates, the dollar can become a more attractive currency for investors. This is because an increase in interest rates often leads to a stronger dollar. In times of economic instability, such as a recession or crisis, people and businesses prefer to avoid risky investments and tend toward more secure ways to store funds, such as investing in dollars. During such periods, people often sell their assets, which drives down prices. By selling assets, they actually purchase dollars or other fiat currencies, thereby increasing demand for them and creating potential shortages.

This movement of funds also works in the opposite direction: when people actively buy, the demand for money decreases, increasing its supply.

A stronger dollar can have an impact on other currencies and currency pairs, putting pressure on them.

There is also what is known as "currency intervention" - this means that the central bank buys or sells its national currency in the forex market. They do this in order to control the exchange rate of the currency and reach the desired values.

In addition, sometimes even rumors that the central bank may intervene already affect the exchange rates. This happens for the reason that market participants are ordinary people whose main goal is to secure their investments and benefit from the trades.

Forex legality and regulation

Forex trading is a legal activity and the foreign exchange market, as well as forex brokers, are subject to laws.

A broker does not have to have a license to operate in the interbank market, but licensed brokers are considered more reliable as they undergo regular inspections, keep records and have a special fund for compensation.

There are three main bodies that issue licenses to brokers:

1. The U.S. Futures Trading Commission (CFTC) and the U.S. National Futures Association (NFA).
2. The UK's Financial Services Authority (FSA) and the Australian Securities and Investments Commission (ASIC).
3. Cyprus Securities and Exchange Commission (CySEC) and Malta Financial Services Authority (MFSA).

What is traded on Forex?

Currency pairs are traded on Forex. This means that the price of one currency is stated in another currency. For example, the EURUSD pair says how many U.S. dollars is worth 1 euro.

Popular currencies

Major currencies, like the euro to the dollar (EUR/USD) or the dollar to the Japanese yen (USD/JPY), often move steadily. Less popular currencies, such as the dollar to the Polish zloty (USD/PLN) or the Singapore dollar (USD/SGD), can change value more quickly and sometimes less predictably.

How to start trading on Forex?

To start trading on Forex, you need to register and open a trading account with a broker, with the help of which you can open positions. To trade, you can use a special platform (the most popular ones are MetaTrader 4/5) or a trading terminal embedded in the website where you opened your account.

There are two types of trades:

1. Buying (up): when you think prices will rise.
2. Sell (down): when you think prices will fall.

Let's take a closer look at how this works:

You have selected the currency pair you want to open a position in. The currency pair reflects how many units of the second (quoted) currency are needed to buy one unit of the first (base) currency. For example, in the EUR/USD pair, if you expect the euro to rise against the dollar, you can buy this pair.

When you open a long position, you are actually selling dollars (the quote currency) to buy euros (the base currency), expecting to sell euros later at a higher price. Your profit will be equal to the difference in price.

If you anticipate that the euro will fall against the dollar, you sell EUR/USD, opening a short position. In this case, you are exchanging euros for dollars. If the euro falls, you make a profit. However, if the dollar strengthens and you bought the euro, counting on its growth, you will suffer losses.

For this reason, it is very important to remember that trading in the currency markets involves risks, so using stop orders is a must - it will help you protect your money.

Trading currency pairs at proprietary trading firms

Most of the proprietary trading firms were originally aimed at trading specifically currency pairs. A trader who participates in a Challenger and then trades on a fanded account can choose among the forex pairs available in the terminal directly on the prop firm's website or, if available, trade them through one of the terminals we discussed earlier. Many prop firms provide the opportunity to trade such pairs with 100x leverage.

Forex: final thoughts from Cryptology experts

Forex is a market where currencies of different countries are traded against each other. It is the largest and most liquid financial market in the world. At Forex, traders make money on the difference in the exchange rate by opening positions on the rise or fall of one currency against another. Trading on the currency markets is available to anyone who has a computer and an internet connection. Anyone can open an account with a broker and start earning on the difference of quotes. However, the availability of Forex does not mean that successful trading is guaranteed to everyone. Forex trading requires preparation and training. Successful traders have an in-depth knowledge of the financial markets, analyze the economy and political events that affect exchange rates. They also study various trading strategies and risk management techniques.
Forex trading is not about luck or chance. It is a field where skill and constant learning are critical. Without proper training, forex trading can easily turn into gambling, resulting in a loss of investment. For this reason, before you start trading real money, we recommend getting training and practicing on a demo account where your money will be safe. This will increase your chances of successful trading.