Reference manual introduction to FX

The London Academy of Trading Level Diploma in Applied Financial Trading -Reference Manual Introduction to Foreign Exchange Contents The Global FX market trades more than $5 trillion each day Apart from the essential function of facilitating international trade, FX has become an asset class in its own right, traded actively by banks, funds, corporations and even individuals This course covers an overview of the FX market, including:  History of the FX Market  Financial Centres  Market size and liquidity o Central Bank Survey  Market Participants o Banks o Central Banks o Hedge Funds o Investment Management Firms o International Commercial Companies o FX Brokers o FX Real Money Brokers o Money Transfer Companies o Retails FX Brokers  Factors Affecting FX Rates o Economic Factors o Political Conditions o Market Psychology o Technical Trading  Trading Characteristics o Key Concepts Behind FX Trading  Retail Trading o Leverage o Transaction Costs and Market Makers  Speculation  Algorithmic Trading Foreign Exchange Market The FX market exists wherever one currency is traded for another It is by far the largest market in the world in terms of cash value traded and includes trading between large banks, central banks, currency speculators, multinational corporations, governments, other financial institutions and even retail traders The Creation of the Euro and the Role of the Dollar in International Markets During the nineteenth and the first half of the twentieth centuries, the British pound was the preeminent international currency It was used in both international trade and financial transactions and circulated throughout the British Empire With the decline of British economic power in the 20th century, the U.S dollar replaced the pound as the leading international currency For over 60 years the U.S dollar has been the leading currency used in international trade and debt contracts Primary commodities are generally priced in dollars on world exchanges Central banks and governments hold the bulk of their foreign exchange reserves in dollars In addition, in some countries dollars are accepted for making transactions as readily as (if not more so than) the domestic currency On January 1, 1999, a new currency—the euro— was created, culminating the progress toward economic and monetary union in Europe The euro replaced the currencies of 11 European countries: Austria, Belgium, Finland, France, Germany, Ireland, Italy, Luxembourg, the Netherlands, Portugal, and Spain Two years later Greece became the 12th member of the euro area Although the Japanese yen and particularly the German mark have been used internationally in the past several decades, neither currency approached the international use of the dollar With the creation of the euro, for the first time the dollar has a potential rival for the status as the primary international currency FUNCTIONS OF AN INTERNATIONAL CURRENCY Economists define money as anything that serves the following three functions:  a unit of account,  a store of value, and  a medium of exchange To operate as a unit of account, prices must be set in terms of the money To function as a store of value, the purchasing power of money must be maintained over time To function as a medium of exchange, the money must be used for purchasing goods and services For an international currency, one used as money outside its country of issue, these functions are generally divided by sector of use - private and official, as listed in Table 1.4 A currency serves as a unit of account for private international transactions if it is used as an invoice currency in international trade contracts It serves as a store of value if international financial assets are denominated in this currency It serves as a medium of exchange internationally if it is used as a vehicle currency through which two other currencies are traded, and as a substitute for a domestic currency History of the FX Market The forex market is a cash inter-bank or inter-dealer market, which was established in 1971 when floating exchange rates began to appear The FX market is huge in comparison to other markets For example, the average daily trading volume of US Treasury Bonds is $300 billion and the US Stock Market has an average daily volume of less than $10 billion Ten years ago the Wall Street Journal estimated the daily trading volume in the forex market to be in excess of $1 trillion By 2013 that figure had grown to exceed $5 trillion a day According to David Krutz from the Financial Times website: "The FX market will have doublcontinues to rapidly grow in size thanks to increased participation by fund managers and pension funds, as FX has become accepted as an asset class in its own right " Prior to 1971, an agreement called the Bretton Woods Agreement prevented speculation in the currency markets The Bretton Woods Agreement was set up in 1945 with the aim of stabilizing international currencies and preventing money fleeing across nations This agreement fixed all national currencies against the dollar and set the dollar at a rate of $35 per ounce of gold Prior to this agreement the gold exchange standard had been used since 1876 The gold standard used gold to back each currency and thus prevented kings and rulers from arbitrarily debasing money and triggering inflation Institutions like the Federal Reserve System of the United States have this kind of power The gold exchange standard had its own problems however As an economy grew it would import goods from overseas until it ran its gold reserves down As a result the country’s money supply would shrink resulting in interest rates rising and a slowing of economic activity to the extent that a recession would occur Eventually the recession would cause prices of goods to fall so low that they appeared attractive to other nations This in turn led to an inflow of gold back into the economy and the resulting increase in money supply saw interest rates fall and the economy strengthen These boom-bust patterns prevailed throughout the world during the gold exchange standard years until the outbreak of World War I which interrupted the free flow of trade and thus the movement of gold After the war the Bretton Woods Agreement was established, where participating countries agreed to try and maintain the value of their currency with a narrow margin against the US Dollar A rate was also used to value the dollar in relation to gold Countries were prohibited from devaluing their currency to improve their trade position by more than 10% Following World War II, international trade expanded rapidly due to post-war construction and this resulted in massive movements of capital which destabilized the foreign exchange rates that had been set-up by the Bretton Woods Agreement The agreement was finally abandoned in 1971, and the US dollar was no longer convertible to gold By 1973, currencies of the major industrialized nations became more freely floating, controlled mainly by the forces of supply and demand Prices were set, with volumes, speed and price volatility all increasing during the 1970’s This led to new financial instruments, market deregulation and open trade It also led to a rise in the power of speculators In the 1980’s the movement of money across borders accelerated with the advent of computers and the market became a continuum, trading through the Asian, European and American time zones Large banks created dealing rooms where hundreds of millions of dollars, pounds and yen were exchanged in a matter of minutes Today electronic brokers trade daily in the forex market with single trades for tens of millions of dollars being priced and executed in seconds The market has changed dramatically with most international financial transactions being carried out not to buy and sell goods but to speculate on the market with the aim of most dealers to make money out of money Financial Centres The main trading centers are in London, New York, Tokyo, Hong Kong and Singapore, but banks throughout the world participate Currency trading happens continuously throughout the day; as the Asian trading session ends, the European session begins, followed by the North American session and then back to the Asian session, excluding weekends London has grown to become the world’s leading international financial center and is the world’s largest forex market This arose not only due to its location, operating during the Asian and American markets, but also due to the creation of the Eurodollar market The Eurodollar market was created during the 1950’s when Russia’s’s oil revenue, all in US dollars, was deposited outside the US in fear of being frozen by US authorities This created a large pool of US dollars that were outside the control of the US These vast cash reserves were very attractive to foreign investors as they had far less regulations and offered higher yields Today London continues to dominate as American and European banks have come to the City to establish their regional headquarters The sizes dealt with in these markets are huge and the smaller banks, commercial hedgers and private investors hardly ever have direct access to this liquid and competitive market, either because they fail to meet credit criteria or because their transaction sizes are too small But today, market makers are allowed to break down the large inter-bank units and offer small traders the opportunity to buy or sell any number of these smaller units (lots) Market size and liquidity Since FX is an OTC market where brokers/dealers negotiate directly with one another, there is no central exchange or clearing house The top four centres account for more than 65% of global turnover The chart of FX volume by region (below) illustrates the dominance of London, but also highlights the increase in trading volumes across Asia between 2013 and 2016 45 40 35 30 25 20 15 10 2013 2016 Source - BIS Triennial Survey, 2016 (http://www.bis.org/publ/rpfx13fx.pdf) FX trading has increased dramatically since 2001, largely due to the growing importance of FX as an asset class and an increase in fund management assets, particularly of hedge funds and pension funds The diverse selection of execution venues such as internet trading platforms has also made it easier for retail traders to trade in the FX market The FX market is unique because of a number of factors:  its trading volume,  the extreme liquidity of the market,  the large number (and variety) of traders in the market,  its geographical dispersion,  its long trading hours - 24 hours a day (except on weekends)  the variety of factors that affect exchange rates  low profit margins (although high volumes compensate for this)  the use of leverage The most respected survey of FX market turnover is published every three years by the Bank for International Settlements (BIS) According to their latest Triennial Central Bank Survey the average daily turnover in traditional FX markets was more than ten times the size of the combined daily turnover on all the world’s equity markets Daily OTC FX Turnover ($ billions) 6,000 5,000 4,000 3,000 2,000 1,000 2001 2004 2007 2010 2013 2016 Source - BIS Triennial Survey, 2016 (http://www.bis.org/publ/rpfx13fx.pdf) Market Participants Unlike a stock market, where all participants have access to the same prices, the forex market is divided into levels of access At the top is the inter-bank market, which is made up of the largest investment banking firms Within the inter-bank market, spreads, which are the difference between the bid and ask prices, are razor sharp and usually unavailable, and not known to players outside the inner circle As you descend the levels of access, the difference between the bid and ask prices widens (from from 0-1 pip to 1-2 pips for major currencies such as the EUR) This is due to volume If a trader can guarantee large numbers of transactions for large amounts, they can demand a smaller difference between the bid and ask price, which is referred to as a better spread The levels of access that make up the forex market are determined by the size of the “line” (the amount of money with which they are trading) The top-tier inter-bank market accounts for more than half of all transactions After that there are usually smaller investment banks, followed by large multi-national corporations (which need to hedge risk and pay employees in different countries), large hedge funds, and even some of the retail forex market makers According to Galati and Melvin, “Pension funds, insurance companies, mutual funds, and other institutional investors have played an increasingly important role in financial markets in general, and in FX markets in particular, since the early 2000s.” In addition, he notes, “Hedge funds have grown markedly since the early 2000’s, both in terms of number and overall size” Central banks also participate in the forex market to align currencies to their economic needs Investment Banks The interbank market caters for the majority of commercial turnover and large banks may trade billions of dollars daily, mostly on behalf of customers and speculators According to the latest Euromoney rankings, the ten biggest FX trading banks by market share account for more than 75% of trading volume The table below shows the top ten rankings for 2015: Bank Citi Deutsche Bank Barclays JPMorgan UBS Bank of America Merrill Lynch HSBC BNP Paribas Goldman Sachs Royal Bank of Scotland (RBS) Ranking 10 Market Share 16.1% 14.5% 8.1% 7.7% 7.3% 6.2% 5.4% 3.7% 3.4% 3.4% These large international banks continually provide the market with both bid (buy) and ask (sell) prices The bid/ask spread is the difference between the price at which a bank or market maker will sell ("ask", or "offer") and the price at which a market-maker will buy ("bid") from a wholesale customer This spread is minimal for actively traded pairs of currencies, usually only 1-3 pips For example, the bid/ask quote of EUR/USD might be 1.3155/1.3156 Minimum trading size for most deals is usually $100,000, but $10,000,000 per trade is normal These spreads might not apply to retail customers at banks and exchange brokers, which will routinely mark up the difference to say 1.2500 / 1.4300 for banknotes or travelers' cheques Spot prices at market makers may vary, but on EUR/USD are usually no more than pips wide (i.e 0.0002) However, competition has greatly increased with pip spreads shrinking on the major pairs to less than pip, with Barclays being the first bank to reduce spreads to fractions of a pip for major currency pairs Central Banks National Central Banks (e.g Bank of England, US Federal Reserve, European Central Bank, Bank of Japan, etc.) play an important role in the FX markets They try to control the money supply, inflation and/or interest rates and often have official or unofficial target rates for their currencies They can use their often substantial foreign exchange reserves to stabilize the market Milton Friedman argued that the best stabilization strategy would be for central banks to buy when the exchange rate is too low, and to sell when the rate is too high — that is, to trade for a profit based on their more precise information Nevertheless, the effectiveness of central bank "stabilizing speculation" is doubtful because central banks not go bankrupt if they make large losses, like other traders would and there is no convincing evidence that they make a profit from trading The mere expectation or rumour of central bank intervention might be enough to stabilize a currency, but aggressive intervention might be used several times each year in countries with a dirty float currency regime (This is where but central banks attempt to influence their country’s own exchange rates by buying and selling in the market.) However, central banks not always achieve their objective since the combined resources of the market can easily overwhelm any central bank Several scenarios of this nature were seen in the 1992-93 Exchange Rate Mechanism (ERM) collapse, and in more recent times in Southeast Asia Hedge Funds Hedge Funds, such as George Soros’s Quantum Fund have gained a reputation for aggressive currency speculation since the 1990’s They control billions of dollars of equity and may borrow billions more, and thus may overwhelm intervention by central banks to support almost any currency, if the economic fundamentals are in the hedge fund’s favour The number of hedge funds has rocketed in recent years (although the number has declined in recent months), with over 10,000 now in existence It should be noted, however, that only a small proportion of these are dedicated to FX trading, while others may employ currency overlay strategies in an aim to increase returns Investment Management Firms Investment management firms (who typically manage large accounts on behalf of customers such as pension funds and endowments) use the FX market to facilitate transactions in foreign securities For example, an investment manager with an international equity portfolio will need to buy and sell foreign currencies in the spot market in order to pay for purchases of foreign equities Since the forex transactions are secondary to the actual investment decision, they are not seen as speculative or aimed at profitmaximization However, some investment management firms also have more speculative specialist “Currency Overlay” operations, which manage clients' currency exposures with the aim of generating additional profits as well as limiting risk Whilst the number of this type of specialist firms is quite small, many have a large value of assets under management (AUM), and hence can generate large trades International Commercial Companies An important part of this market comes from the financial activities of companies seeking foreign exchange to pay for goods or services Commercial companies often trade fairly small amounts compared to those of banks or speculators, and their trades often have little short term impact on market rates Nevertheless, trade flows are an important factor in the long-term direction of a currency's exchange rate Some multinational companies can have an unpredictable impact when very large positions are covered due to exposures that are not widely known by other market participants Foreign Exchange Brokers Until recently, FX brokers did large amounts of business, facilitating interbank trading and matching anonymous counterparts for small fees Today, however, much of this business has moved on to more efficient electronic systems, such as EBS, Reuters Dealing 3000 Matching (D2), the CME, Bloomberg and TradeBook The broker squawk box lets traders listen in on ongoing interbank trading and is heard in most trading rooms, but turnover is noticeably smaller than just a few years ago Foreign Exchange Real Money Brokers Non-bank FX companies offer currency exchange and international payments to private individuals and companies These are distinct from Retail Forex Brokers (see below) as they not offer speculative trading but currency exchange with payments i.e there is usually a physical delivery of currency to a bank account (e.g HiFX) It is estimated that in the UK around 15-20% of currency transfers/payments are made via Foreign Exchange Companies These companies' selling point is usually that they will offer better exchange rates or cheaper payments than the customer's bank These companies differ from Money Transfer/Remittance Companies in that they generally offer highervalue services Money Transfer/Remittance Companies Money Transfer/Remittance Companies perform high-volume low-value transfers generally by economic migrants back to their home country In 2007, the Aite Group estimated that there were $369 billion of remittances (an increase of 8% on the previous year) The four largest markets (India, China, Mexico and the Philippines) receive $95 billion The largest and best known provider is Western Union with 345,000 agents globally Retail Forex Brokers Retail forex brokers handle just a very small fraction of the total volume of the FX market According to CNN, one retail broker estimates retail volume at $25-50 billion daily, which is about 2% of the whole market Factors Affecting FX Rates Although exchange rates are affected by many factors, in the end, currency prices are a result of supply and demand forces The world's currency markets can be viewed as a huge melting pot: in a large and ever-changing mix of current events, supply and demand factors are constantly shifting and the price of one currency in relation to another shifts accordingly No other market encompasses (and distills) as much of what is going on in the world at any given time as foreign exchange Supply and demand for any given currency, and thus its value, are not influenced by any single element, but rather by several These elements generally fall into three categories: Economic factors, political conditions and market psychology These three influences can in turn be analysed by technical analysts who study the resulting price movements, which adds a 4th element to the list of market influences Economic Factors These include economic policy, disseminated by government agencies and central banks, economic conditions, generally revealed through economic reports, and other economic indicators Economic policy comprises government fiscal policy (budget/spending practices) and monetary policy (the means by which a government's central bank influences the supply and "cost" of money, which is reflected by the level of interest rates) Economic conditions include: Government budget deficits or surpluses: The market usually reacts negatively to widening government budget deficits and positively to narrowing budget deficits The impact is reflected in the value of a country's currency Balance of trade levels and trends: The trade flow between countries illustrates the demand for goods and services which in turn indicates demand for a country's currency to conduct trade Surpluses and deficits in trade of goods and services reflect the competitiveness of a nation's economy For example, trade deficits generally have a negative impact on a nation's currency Inflation levels and trends: Typically, a currency will lose value if there is a high level of inflation in the country or if inflation levels are perceived to be rising This is because inflation erodes purchasing power, thus demand, for that particular currency However, a currency may sometimes strengthen when inflation rises because of expectations that the central bank will raise short-term interest rates to combat rising inflation Economic growth and health: Reports such as gross domestic product (GDP), employment levels, retail sales, capacity utilisation and others, detail the levels of a country's economic growth and health Generally, the more healthy and robust a country's economy, the better its currency will perform, and the more demand for it there will be Political Conditions Internal, regional, and international political conditions and events can have a profound effect on currency markets For instance, political upheaval and instability can have a negative impact on a nation's economy The rise of a political faction that is perceived to be fiscally responsible can have the opposite effect Also, events in one country in a region may spur positive or negative interest in a neighboring country and in the process affect its currency Market Psychology Market psychology and trader perceptions influence the FX market in a variety of ways: Interest Rates: Carry trade Borrow money in low-yielding currency & sell this ccy against a high yielding ccy (e.g AUD-JPY) Flights to quality: Unsettling international events can lead to a "flight to quality" with investors seeking a safe haven There will be a greater demand, thus a higher price, for currencies perceived as stronger over their relatively weaker counterparts Long-term trends: Currency markets often move in visible long-term trends Although currencies not have an annual growing season like physical commodities, business cycles make themselves felt Cycle analysis looks at longer-term price trends that may rise from economic or political trends "Buy the rumor, sell the fact:" This market truism can apply to many currency situations It is the tendency for the price of a currency to reflect the impact of a particular action before it occurs and when the anticipated event comes to pass, react in exactly the opposite direction This may also be referred to as a market being "oversold" or "overbought" To buy the rumour or sell the fact can also be an example of the cognitive bias known as anchoring, when investors focus too much on the relevance of outside events to currency prices Economic numbers: While economic numbers can certainly reflect economic policy, some reports and numbers take on a talisman-like effect: the number itself becomes important to market psychology and may have an immediate impact on short-term market moves "What to watch" can change over time In recent years, for example, money supply, employment, trade balance figures and inflation numbers have all taken turns in the spotlight Technical Trading As in other markets, the accumulated price movements in a currency pair can form recognisable patterns that traders may attempt to use Many traders study price charts in order to identify such patterns Recognised as very popular since it incorporates fundamentals, economics, political issues and investor sentiment into the price Trading Characteristics There is no unified or centrally cleared market for the majority of FX trades and there is very little cross-border regulation Due to the OTC nature of currency markets, there are rather a number of interconnected marketplaces, where different currency instruments are traded This implies that there is no such thing as a single dollar rate - but rather a number of different rates (prices), depending on what each bank or market maker is quoting In practice the rates are often very close (and much of the time identical), otherwise they could be exploited by arbitrateurs Traders can react to news when it breaks, rather than waiting for the market to open There is little or no 'inside information' in the FX markets Exchange rate fluctuations are usually caused by actual monetary flows as well as by expectations of changes in monetary flows caused by changes in GDP growth, inflation, interest rates, budget and trade deficits or surpluses, and other macroeconomic conditions Major news is released publicly, often on scheduled dates, so many people have access to the same news at the same time However, the large banks have an important advantage; they can see their customers' order flow Rank Currency US Dollar ISO 4217 Code Symbol % Market Share USD $ 88.7%   European Euro EUR € 37.2%   Japanese Yen JPY ¥ 20.3%   British Pound GBP £ 16.9%   Swiss Franc CHF - 6.1%   Australian Dollar AUD $ 5.5%   Canadian Dollar CAD $ 4.2%   Swedish Krona SEK - 2.3%   HK Dollar HKD $ 1.9% 10   Norwegian Krone NOK - 1.4% Other Currencies 15.5% Currencies are traded against one another Each pair of currencies thus constitutes an individual product and is traditionally noted XXX/YYY, where YYY is the international ISO 4217 three-letter code of the currency into which the price of one unit of XXX is expressed For instance, EUR/USD is the price of the EURO expressed in US Dollars, as in euro = 1.3155 dollars The ten most traded currencies are listed above Note that all currencies have a standard code (ISO 4217), but not all have a symbol (e.g CHF) How the prices are quoted is also important, as quoting EUR/USD 1.3155 as “One point three one five five” would clearly illustrate ones ignorance of market convention! Each price is broken down into “Big Figures” (in this case 31) and “Pips” (in this case 55) The price is then quoted as “One, thirty one, fifty five” Also out of convention, the first currency in the pair, the base currency, was the stronger currency at the creation of the pair The second currency, counter currency, was the weaker currency at the creation of the pair On the spot market, according to the BIS study, the most heavily traded currency pairs are:  EUR/USD - 28 %  USD/JPY - 18 %  GBP/USD (also called sterling or cable) - 14 % Also, the US Dollar was involved in 89% of all transactions, followed by the euro (37%), the yen (20%) and sterling (17%) (Note that volume percentages should add up to 200% 100% for all the sellers, and 100% for all the buyers) Although trading in the euro has grown considerably since the currency's creation in January 1999, the FX market is thus far still largely dollar-centered For instance, trading the euro versus a non-European currency ZZZ will usually involve two trades: EUR/USD and USD/ZZZ The only exception to this is EUR/JPY, which is an established traded currency pair in the interbank spot market Key Concepts Behind FX Trades As previously mentioned, currencies fluctuate relative to other currencies and are traded against one another Each pair of currencies thus constitutes an individual product and is traditionally expressed as XXX/YYY, where XXX and YYY are the ISO 4217 codes of the currencies involved into which the price of one unit of XXX is expressed (called base currency) For instance, EUR/USD is the price of the euro expressed in US dollars, as in euro = 1.3155 dollars Out of convention, the first currency in the pair, the base currency, was the stronger currency at the creation of the pair The second currency, counter currency, was the weaker currency at the creation of the pair The factors affecting XXX will affect both XXX/YYY and XXX/ZZZ This causes positive currency correlation between XXX/YYY and XXX/ZZZ As an example, take two of the most common currency pairs, EUR/USD and GBP/USD If there is positive economic news in the Eurozone and negative economic news in the UK, it is conceivable that EUR/USD would go up in value, let’s say by 1% from 1.3000 to 1.3130, meaning it is now more expensive in US dollars to purchase one EUR - or a European would get 1% fewer dollars for each of their Euros if they were planning a trip to America Also, GBP/USD (also called “Cable”) would be expected to go down in value, let’s say by 1% from 1.4500 to 1.4355, meaning it is now cheaper to buy pounds with US dollars – or you would get 1% fewer dollars for each of your pounds if you were planning a trip to America Now, EUR/GBP is actually quoted in professional FX markets as “the number of GBP in each EUR”, so in April 2009 was trading at 0.8965 (or 89.65 pence per Euro) This is equivalent to Cable at 1.4500 and EUR/USD at 1.3000, calculated by dividing the EUR/USD rate by the Cable rate Now, if Cable and EUR/USD each move by 1% as above, then EUR/GBP would move 2%, from 0.8965 to 0.9097 In this scenario, the USD went up in value against one currency and down in relation to another It is important to understand this idea that currency pairs move mostly independently from one another although they are all interlinked Currency pairs with similar currencies on one side (like the USD in the previous example) can be similarly affected by news regarding the common currency, but the crucial concept is that they don’t have to be Retail Trading Retail trading is more structured than the Forex market as a whole While Forex has been traded since financial markets began, modern retail trading has only been around since the mid 1990’s Prior to this time, retail investors were limited in their options for entering the Forex market They could create multiple bank accounts, each one denominated in a different currency and transfer funds from one account to another in order to profit from fluctuating exchange rate This was troublesome, however, because the market spreads and other transaction costs incurred were large due to the small quantity of funds being converted relative to the size of the market This transaction type was at the very bottom of the Forex pyramid Another option was dabbling in the Futures market This was treacherous for an individual investor because there isn’t suitable structure for individual participation There is no market maker in the Futures market, which means there is no buyer of last resort This is important because it adds a level of risk to the market that many investors are not willing to take on In the stock market, there are people called “Specialists” on the floor of the NYSE who are required to buy (or sell) if no one else is willing They can determine what they will accept, but they must always offer a price This guarantees that you are always able to exit your current position, even in times of low liquidity In the Futures market, though, there is no equivalent of the Specialist Thus, traders can (and do) find themselves unable to unload a position and exit the market when liquidity dries up Consequently, a trader may be stuck in a position he does not want, which can lead to frustration and severe economic loss By 1996, new market makers took advantage of developments in web-based technology that made retail Forex trading practical These internet-based market makers would take the other side of retail trader’s trades The new companies felt that there was enough liquidity in the Forex market (and eventually within their own customer base) to guarantee markets under all but the most unusual market conditions These companies also created online trading platforms that provided a quick and easy way for individuals to buy and sell on the Forex Spot market In addition, the companies realized that by pooling many retail traders together, they had the size to enter the upper echelons of the Forex market, which reduced the size of the spread As the business grew, the market makers were given better prices, which they then passed on to the customer The final barrier these new market makers were able to revolutionize involves the lack of large-scale changes in the currency Unlike the more “sexy” world of equities, currencies tended to have an almost boring reputation Market makers got around this issue by allowing customers to inflate all movements many times over In the world of online currency exchange, no transaction actually leads to physical delivery to the client; all positions will eventually be closed The market makers are therefore able to offer high amounts of leverage While up to 4:1 leverage is available in equities and 20:1 in Futures, it is common to have 100:1 leverage in currencies; some Forex market makers offer up to 400:1 In the typical 100:1 scenario, the client absorbs all risks associated with controlling a position 100 times the capital they are putting up, and, given that the money is only being used for currency exchange and on the market makers’ books, the transaction can proceed Current spreads for the most common currency pair, EUR/USD, is typically pips (3/100th of a percent) An equivalent trade using a bank account would most likely be between 200 and 500 pips, while an equivalent trade using cash at an exchange institution would be around 1,500 – 2,000 pips! Retail Forex is usually highly leveraged The idea of margin (leverage) and floating loss is another important trading concept and is perhaps best understood using an example Most retail Forex market makers permit 100:1 leverage, but also, crucially, require you to have a certain amount of money in your account to protect against a critical loss point For example, if a $100,000 position is held in Eur/USD on 100:1 leverage, the trader has to put up $1,000 to control the position However, in the event of a declining value of your positions, Forex market makers, mindful of the fast nature of Forex price swings and the amplifying effect of leverage, typically not allow their traders to go negative and make up the difference at a later date In order to make sure the trader does not lose more money than is held in the account, Forex market makers typically employ automatic systems to close out positions when clients run out of margin (the amount of money in their account not tied to a position) If the trader has $2,000 in his account, and he is buying a $100,000 lot of EUR/USD, he has $1,000 of his $2,000 tied up in margin, with $1,000 left to allow his position to fluctuate downward without being closed out Typically a trader's trading platform will show him three important numbers associated with his account: his balance, his equity, and his margin remaining If trader X has two positions: $100,000 long (buy) in EUR/USD, and $100,000 short (sell) in GBP/USD, and he has $10,000 in his account, his positions would look as follows: Because of the 100:1 leverage, it took him $1,000 to control each position This means that he has used up $2,000 in his margin, out of a $10,000 account, and thus he has $8,000 of margin still available With this margin, he can either take more positions or keep the margin relatively high to allow his current positions to be maintained in the event of downturns If the client chooses to open a new position of $100,000, this will again take another $1,000 of his margin, leaving $7,000 He will have used up $3,000 in margin among the three positions The other way margin will decrease is if the positions he currently has open lose money If his positions of $100,000 decrease by $5,000 in value (not at all an unusual swing), he now has, of his original $7,000 in margin, only $2,000 left As discussed above, if you have a $10,000 account and only open one $100,000 position, this has committed only $1,000 of your money plus you must maintain $1,000 in margin While this leaves $9,000 free in your account, it is possible to lose almost all of it if the position dives On the other hand, if you have positions open in a $10,000 account, you can lose only $5,000 because the other $5,000 is held in margin However, this does not make it safer to hold more positions The Forex market fluctuates so rapidly, that with shallow margins, you are much more likely to be closed out of your position and lose it entirely when it might have recovered from a temporary fluctuation if you had had sufficient margin to cover the variation The more positions open at one time, the more risk the trader is exposed to Transaction costs and market makers Market makers are well compensated for allowing retail clients to enter the Forex market They take part of all of the spread in all currency pairs traded In a common example, EUR/USD, the spread is typically pips (3/100 of a percent) Thus prices are quoted with both a Buy and Sell price (e.g., Buy Eur/USD 1.2000, Sell Eur/USD 1.2003) That difference of pips is the spread and can amount to a significant amount of money (Note: the spread is only taken out at the beginning of the trade; this transaction cost is subtracted only upon entering the trade, not leaving it) Because the typical standard lot is 100,000 units of the base currency, those pips on EUR/USD translate to $30 paid by the client to the market maker However, a pip is not always $10 A pip is 1/100th of a percent, and the currency pairs are always purchased by buying 100,000 of the base currency, which is also known as the counter currency For the pair EUR/USD, the base currency is USD; thus, 1/100th of a percent on a pair with USD as the base currency will always have a pip of $10 If, on the other hand, your currency has Swiss Frank (CHF) as a base instead of USD, then 1/100th of a percent is now worth around $8, because you are buying 100,000 worth of Swiss Franks If a trader with a $10,000 account on 100:1 leverage felt, after reading reports on the economy, that the USD was going to go up in value against the EUR and the CHF, he would Sell EUR/USD (thus selling EUR and buying USD) and Buy USD/CHF (buying USD and selling CHF) The transaction is all electronic, so the trader doesn’t need to have Euros in his account On a large scale, the market maker can sell Euros on behalf of the trader, knowing that the position will eventually be closed and converted back to USD Assume that the client sold 100,000 EUR/USD at 1.2000 and bought 100,000 USD/CHF at 1.2500 Seconds after this transaction, his account would read: Balance: $10,000, Equity $9,946 The loss of $54 is due to the transaction cost taken only at the entry of a position of pips, which translates to $30 for the EUR/USD pair and $24 for the USD/CHF pair With equity of $9,946 on 100:1 leverage with positions opened, $2,000 is now held in margin, leaving the trader $7,946 in usable margin Suppose the EUR/USD (sold at 1.2003) starts to move against the trader and goes up in value to 1.2013, while the USD/CHF (bought at 1.2500) starts moving for the client and also goes up in value to 1.2515 His account information will have changed but his balance and margin will remain unchanged at $10,000 and $2,000 respectively His equity and his usable margin, however, will change to reflect the new market conditions While for the trader, the platform will calculate this all automatically, it is important to see it step by step Beginning Summary Client Account: XXX Balance $10,000 Equity: $ 10,000 Usable Margin: $10,000 Used Margin: $0 Step 1: Client XXX places two trades Sells standard lot EUR/USD (100,000 worth of the base currency USD) Buys standard lot of USD/CHF (100,000 worth of the base currency – CHF) Balance remains: $10,000 Equity: $9,946 (roughly, due to transaction costs of pips each $30 – EUR/USD transaction cost $24 USD/CHF transaction cost -the difference is due to difference in pip value) Usable Margin: $7,946 Used Margin $2,000 Step 2: Market Conditions Change, with EUR/USD going up 10 pips (a 10 pip decrease in value to the client, since he is short EUR/USD), while the USD/CHF has increased in value by 15 pips EUR/USD pair has lost 10 pips, with each pip $10 so it has lost $100 USD/CHF has gained 15 pips, with each pip around $8 so it gained $120 The difference is now +$20 Balance: $10,000 Equity: $9,966 Usable Margin: $7966 Used Margin: $2000 Step 3: Client closes both positions (by performing the opposite trade – Buying EUR/USD and Selling USD/CHF) He now has no positions in the market, and his money is no longer fluctuating with the market Balance: $9,966 Equity: $9,966 Usable Margin: $9,966 Used Margin: $0 Forex Scams The only way that retail traders (individuals) can participate in the FX market is indirectly through brokers or banks, increasingly using on-line systems to execute trades However, while most trading is legitimate and above board, these investors may be targets of forex scams A forex scam is any trading scheme used to defraud individual traders by convincing them that they can expect to profit by trading in the FX market These scams might include churning of customer accounts for the purpose of generating commissions, selling software that is supposed to guide the customer to large profits, improperly managed "managed accounts", false advertising, and outright fraud It also refers to any retail FX broker who indicates that trading foreign exchange is a low risk, high profit investment The U.S Commodity Futures Trading Commission (CFTC), which loosely regulates the FX market in the United States, has noted an increase in the amount of unscrupulous activity in the non-bank FX industry An official of the National Futures Association was quoted as saying, "Retail FX trading has increased dramatically over the past few years Unfortunately, the amount of forex fraud has also increased dramatically " Between 2001 and 2006 the CFTC has prosecuted more than 80 cases involving the defrauding of more than 23,000 customers who lost $300 million, mostly in managed accounts.” CNN also quoted Godfried De Vidts, President of the Financial Markets Association, a European body, as saying, "Banks have a duty to protect their customers and they should make sure customers understand what they are doing Now if people go online, on nonbank portals, how is this control being done?" The highly technical nature of the retail FX industry, the “Over-the-counter” (OTC) nature of the market, and the loose regulation of the market, leaves retail speculators vulnerable Defrauded traders and regulatory authorities, can find it very difficult to prove that market manipulation has occurred since there is no central currency exchange, but rather a number of more or less interconnected marketplaces provided by interbank market makers Speculation Controversy about currency speculators and their effect on currency devaluations and national economies recurs regularly Nevertheless, many economists argue that speculators perform the important function of providing a market for hedgers and of transferring risk from those people who don't wish to bear it to those who Other economists however, may consider this argument to be based more on politics and a free market philosophy than on economics Large hedge funds and other well capitalized "position traders" are the main professional speculators Currency speculation is considered a highly suspect activity in many countries While investment in traditional financial instruments like bonds or stocks often is considered to contribute positively to economic growth by providing capital, currency speculation does not, according to this view; it is simply gambling, that often interferes with economic policy For example, in 1992, currency speculation forced the Central Bank of Sweden to raise interest rates for a few days to 500% per annum, and later to devalue the Krona Former Malaysian Prime Minister Mahathir Mohamad is one well known proponent of this view He blamed the devaluation of the Malaysian ringgit in 1997 on George Soros and other speculators Gregory Millman reports on an opposing view, comparing speculators to "vigilantes" who simply help "enforce" international agreements and anticipate the effects of basic economic "laws" in order to profit In this view, countries may develop unsustainable financial bubbles or otherwise mishandle their national economies, and forex speculators only made the inevitable collapse happen sooner A relatively quick collapse might even be preferable to continued economic mishandling Mahathir Mohamad and other critics of speculation are viewed as trying to deflect the blame from themselves for having caused the unsustainable economic conditions Algorithmic Trading Electronic trading is growing in the FX market, and algorithmic trading is becoming much more common According to financial consultancy Celent estimates, in 2008 around 25% of all trades by volume are executed using algorithm, up from about 18% in 2005 Algorithmic trading or automated trading, also known as algo trading, black-box trading, or robo trading, is the use of computer programs for entering trading orders with the computer algorithm deciding on certain aspects of the order such as the timing, price or even the final quantity of the order It is widely used by hedge funds, pension funds mutual funds and other institutional traders to divide up a large trade into several smaller trades in order to manage market impact, opportunity cost and risk It is also used to make the decision to initiate orders based on information that is received electronically, before human traders are even aware of the information Algorithmic trading may be used in any investment strategy, including market making, inter-market spreading, arbitrage or pure speculation (including trend following) The investment decision and implementation may be augmented at any stage with algorithmic support or may operate completely automatically FX markets have active algo trading (about 18% of orders in 2005, about 25% of orders in 2006, rising to an estimated 38% in 2008)  ... attractive to foreign investors as they had far less regulations and offered higher yields Today London continues to dominate as American and European banks have come to the City to establish... reserves to stabilize the market Milton Friedman argued that the best stabilization strategy would be for central banks to buy when the exchange rate is too low, and to sell when the rate is too high... money in low-yielding currency & sell this ccy against a high yielding ccy (e.g AUD-JPY) Flights to quality: Unsettling international events can lead to a "flight to quality" with investors seeking