Currency Exchange Markets

Currency exchange markets began in the Middle Ages, when traveling traders used letters of credit as backing for transactions. At the time, the credit standard was gold. While there was no rate of exchange between currencies, the strength of a creditor added value to their transactions. For example, the backing of a king held more monetary power than that of a wealthy merchant. For centuries this led to volatility in currency markets. It was not until the Bretton Woods agreement was established in 1944 that the gold standard, which established gold as the underlying asset for all currency, helped the international market shift away from this volatile currency market. Under the agreement, all currencies could be pegged to gold in value and the U.S. dollar was viewed as a reserve currency. However, an overvaluation of the U.S. dollar began to raise concerns about the connection between exchange rates and the price of gold. As a result, U.S. President Richard Nixon called for a temporary suspension of the dollar’s convertibility. This provided countries the freedom to choose any exchange agreement, except the price of gold. In 1973, foreign governments let currencies float, which put an end to the Bretton Woods system in which countries could then back their currency with either gold or U.S. dollars. Thus, the Bretton Woods Agreement was dissolved and, respectively, in 1971 the United States stopped trading currency for gold, ending the gold standard within the U.S. and creating the foreign exchange market. The foreign exchange market (Forex) is a currency marketplace that is expressly used for trading currencies.

Similar to stock markets, in a currency exchange market, users can exchange, buy, and sell currency and can use derivatives to speculate on currency. Unlike stock markets, foreign exchange markets conduct their transactions electronically. The electronic network allows currency transactions to take place almost instantaneously. The currency exchange rate is generally set by the central bank of each nation. The central bank is the financial institution in a given nation tasked with the regulation of financial systems and the creation of money. The currency exchange rate is the relative ratio of the value of a foreign currency to that of a domestic currency. Similar to other trading markets, currency exchange may be packaged so that one fund will trade several different currencies. Doing this mitigates the currency exchange rate risk, the chance that the exchange rate between two currencies will change before a transaction is finalized. At the country level, central banks hold assets to cover the amount of currency that the country holds. This is called a foreign exchange reserve.

Approximately two-thirds of all currency transactions occur between large dealer banks. Because of the impact that foreign exchange markets have on the economy, the inability of one country to trade currency could severely affect the world economy. This is why currency exchange markets are decentralized and offer liquidity in trade. This helps to mitigate the risk of a rapid decline in currency exchange markets.

Forex markets are generally driven by the strength of the macroeconomics of the countries, as well as the custom of trading in that market. New York is one of the largest Forex markets because the United States has traditionally boasted a strong economy. Because New York has been a leading market for so long, it has become customary to trade through the New York market. Singapore is changing this tradition, as its healthy economy makes it a sought-after Forex market.

London is the largest of the currency exchange markets; approximately 30 percent of worldwide transactions happen through this market. The New York exchange comes in second with approximately 18 percent of transactions. The Tokyo exchange has approximately 9 percent of worldwide transactions. The Tokyo exchange has declined, with the Singapore exchange taking up the volume. The rise and fall of other Forex markets and the overlap between trading times is an important aspect for traders, as these overlaps are where volatility occurs. The London exchange sees its greatest volatility just before 4:00 p.m., before it closes.

It is common to pair and trade through the largest currency markets. Typical trading pairs are the euro and the U.S. dollar, the U.S. dollar and the Japanese yen, and the U.S. dollar and the British pound. About 23 percent of worldwide currency trades are exchanges between the U.S. dollar and the euro. It is with these trading pairs that most Forex transactions occur.