Forex is short for the foreign exchange, also known as the FX market, which is the global market for currency trading. Since it is a global market, it is only closed on weekends. Trading starts on Sunday evening (20:15 GMT) and continues until Friday evening (22:00 GMT). The daily turnover is enormous, about four trillions dollars per day.
The modern Forex market was created in 1971, following the collapse of the Bretton Woods system. But foreign exchange markets have been around since ancient times. Travellers and international trade are dependent on foreign exchange markets. Money changers become were important for the growing trade between countries in the medieval Europe. The Templars developed an international banking system which made them very rich. But that became also their downfall when the King of France preferred to confiscate their money rather than pay his debts.
Northern Italy became a centre for banking, including foreign exchange, during the 15th century. Later on Holland and England would become dominant countries in foreign exchange. With the creation of the gold standard in the 19th century, foreign exchange markets were stable since each currency was pegged to gold. The exchange rates were fixed so speculating in currencies did not make sense. The First World War ended the gold standard and it was first after the Second World War that a new system with fixed exchange rates was established, the Bretton Woods system.
The Bretton Woods system lasted until August 1971, after that many of the major currencies have been floating freely. Governments and central banks have from time to time intervened to prevent currencies to appreciate or deprecate too much. Especially smaller currencies have often been pegged to either a large currency, such as the US dollar, or to a basket of currencies, typically weighted so that it represents the country’s trade partners.
With currencies floating more or less freely, trading in currencies has become interesting. Obviously, the Forex market is not just about speculating in currencies but the traditional part of foreign exchange markets has decreased and is estimated nowadays to just make up about 20% of the daily turnover. This also explains the rapid growth of the Forex turnover, a lot of players, from large hedge funds to small investors, have started to trade on the Forex market.
The structure of the Forex markets is more complicated than the stock market. It is not a centralized market, such as the New York Stock Exchange for US shares. Instead dealers are located almost all over the world, connected together into a global foreign exchange market. London is the largest Forex market with about a third of the daily turnover.
Not only is the Forex market decentralized, the participants have different levels of access. At the top is the Interbank market where large banks trade currencies with each other. The spread is lowest at the Interbank level. Obviously, the volumes are large. The levels are determined by the size of the trades. The Interbank market is estimated to make up almost 40% of the daily turnover. The level below the Interbank level is made up of smaller banks, hedge funds and large multinational corporations. Further down, on the retail level, the spread is larger, that is how the dealers make their money. The largest currency trader at the moment is Deutsche Bank, with about 15% of the daily turnover.
On the FX market, currencies are trade in pairs, the most popular are US Dollar and Euro, known as EURUSD, the US Dollar and Yen (USDJPY) and US Dollar and British Pound (GBPUSD). The US Dollar is involved in about 85% of the transactions followed by the Euro (about 40%) and the Japanese Yen (almost 20%). Note that since currencies are traded in pairs, the total of all currencies adds up to 200%. In each trade, one currency is sold and another is bought. For example, if you think that the US Dollar will increase in value against the Euro, you buy Dollars and sell Euros. If you instead believe that the US Dollar will decrease in value against the Euro, you buy Euros and sell Dollars.
The traditional spot market is just one of the financial instruments on the Forex market. The financial instruments on the FX market are spot, forwards, futures, swaps and options. Each instrument has its own advantages and disadvantages. For small traders the spot market generally offers the most advantages.