The FX market: functions and participants

What the FX market does

A Korean carmaker paid in euros, a Canadian pension fund buying Japanese bonds, a tourist in Lisbon paying with dollars: each needs to swap one currency for another. The foreign exchange (FX) market is where that happens. It has no single building or exchange; dealers and clients in every time zone are linked electronically, so it trades 24 hours a day on business days.

Its daily turnover dwarfs bond and equity trading combined. The reason is simple: international trade in goods and services, and every cross-border investment, has to go through it. Without it, global trade and global capital markets could not function.

That is why FX matters even to a 'domestic' investor. Large domestic companies earn part of their profits abroad, face foreign competitors and sell assets to foreign buyers. When you hold foreign assets, the exchange rate directly sets what they are worth in your home currency, so it becomes a key driver of portfolio returns.

• Trade: paying for imports and converting export revenue.
• Capital flows: buying and selling foreign stocks, bonds, property and companies; borrowing in foreign currency.
• Hedging: locking in a future exchange rate to reduce currency risk.
• Speculation: taking a currency position to profit from expected moves.

Buy side and sell side

The market divides participants into the sell side, which is the FX dealing banks that quote prices and sell FX products, and the buy side, which is everyone who uses those banks to transact.

Corporate accounts trade for cross-border purchases and sales, but also for M&A deals, foreign investments and foreign-currency borrowing. Real money accounts are institutional investors such as insurers, mutual funds, pension funds, endowments and ETFs; the name signals that they are usually restricted in using leverage or derivatives. Leveraged accounts, the professional trading community, include hedge funds, proprietary trading firms, commodity trading advisers, high-frequency algorithmic traders and banks' own trading desks. Styles range from macro funds holding positions for months to algorithms trading in milliseconds.

Retail accounts range from a tourist at an airport kiosk to individuals speculating through online platforms and households moving savings into foreign currencies; cheaper electronic trading has made retail a growing share of spot volume. Governments need FX for embassies, military purchases and foreign-currency debt, and public pension or insurance schemes can act much like investment funds, sometimes with a policy mandate as well.

Central banks trade for two reasons. They sometimes intervene to push the exchange rate, for example when a currency has overshot after a speculative attack, when markets have become disorderly, or when a currency is so strong it hurts exporters. And their reserve managers invest the country's FX reserves, behaving like cautious real money funds. Sovereign wealth funds, often fed by trade surpluses or oil revenue, are mostly investment-oriented but government-owned; their flows can move major currency pairs.

Inside the sell side

A growing share of volume is handled by a handful of very large global banks. Competing in FX requires heavy investment in electronic trading systems and a broad worldwide client base, so only these first-tier dealers can quote competitively across many currencies and products. Much of their business is crossed internally: one client's sale is matched with another client's purchase without ever reaching the outside market.

Every other bank is second or third tier. Regional and local banks, often in emerging markets, have client relationships but lack the scale, technology or credit lines to price competitively on their own, so they typically outsource FX execution to tier-one banks.

The labels describe typical roles, not fixed ones. A large hedge fund can access the professional market on equal terms with dealers and effectively make markets itself.

The FX market is not regulated by a single authority like a stock exchange. Market participants, central banks included, created a voluntary FX Global Code of best practice covering ethics, governance, execution, information sharing, settlement and risk management.

What gets traded, and by whom

Spot trades settle almost immediately. Forwards fix an exchange rate today for settlement at an agreed future date, which makes them the basic hedging tool. An FX swap combines a spot trade with an offsetting forward; participants use swaps to roll hedges forward and to raise foreign currency cheaply. FX swaps account for the largest share of daily turnover, ahead of spot; outright forwards and options are smaller.

By counterparty, trading between banks and financial clients (real money, leveraged accounts, central banks, SWFs) is now larger than pure interbank trading, and both far exceed trading with non-financial clients such as corporates, governments and retail. In other words, only a small part of daily FX volume is people buying and selling goods and services; investment and speculation dominate.

The most traded currency pairs all involve the US dollar, with euro–dollar the single largest. London is the biggest trading centre, followed by New York, then Tokyo, so liquidity peaks in the hours when London and New York are both open.