It is one in which purchase and sale transactions are made in currencies of different countries (currency).
The foreign exchange market is one of the main financial markets worldwide. The most traded currencies are the US dollar, the Japanese yen, the euro, the British pound, and the Swiss franc.
Most foreign currency operations are carried out through transfers between financial institutions. Physical currency banknote transactions constitute a small segment of the foreign exchange market and are linked to travel and tourism.
What is and how does the foreign exchange market work?
The foreign exchange market (Forex) is the largest financial market in the world. It is in the Forex where the exchange rates of the entire planet are negotiated through decentralized market mechanisms and, therefore, where the value of each currency is negotiated. But what is forex trading? what is a currency, and how is it different from a currency? How and why was Forex born? What gives ‘value’ to a currency today?
What is a currency, and what is the difference from a currency?
To understand the foreign exchange market, it is first essential to understand what a currency is. According to the RAE, the currency is a “foreign currency referring to the unit of the country in question.” In general terms, the term currency refers to any foreign currency other than the legal currency in a certain country. The currency is the currency of another region.
In Spain, the legal currency is the euro, the US dollar, the Chinese renminbi, or the British pound sterling are examples of currencies. However, for the United States, China, or the United Kingdom, the dollar, the renminbi, or the pound are local ‘currency.’ For these regions, the euro is a currency.
Every country has one or more official local currencies, sometimes linked to foreign currencies. This is known as a ‘fixed exchange rate,’ and it is the policy followed by countries such as the United Arab Emirates, with a dirham linked to the US dollar, or the Danish krone, which was linked to the German mark at the time and is now it is in euro.
What is the difference between currency exchange and currency exchange?
The Bank of Spain, in its banking customer portal, made a key division to understand the currency exchange against the currency exchange. While the currency exchange is any operation in which an asset goes from being expressed in one currency to another, the exchange supposes a change in the currency when a payment or deposit is made.
An example of the first. Going to an Exchange as soon as you land in London from Spain to exchange euros for pounds is a currency exchange. One currency is exchanged for another currency.
On the other hand, paying in a London restaurant with our European card (which is associated with an account in euros), but the restaurant receives pounds, makes a currency exchange. This is where the forex market comes into play.
This is how currency trading was born.
The first standardized exchange of capital in history was not between currencies but between currencies with the gold standard. Both silver and gold are rare metals in the world. That is why they were used as an exchange system by millennia. When the gold standard was defined in 1875, countries determined how much gold their currency was worth.
Thus, the first foreign exchange market was a market in which two currencies were related to each other based on the respective relationships that both had with gold. If one country’s coin was worth 0.001 ounces of gold and another country’s coin was worth 0.0005 ounces of gold, the first coin was worth twice as much as the second. Of course, this system was problematic for many reasons.
To begin with, gold did not have a stable value. In theory, it was going up, but opening a new mine could cause its value to fall temporarily, dragging down currencies and producing undesirable economic phenomena. In addition, central banks were required to have a certain reserve of metal to secure exchanges.
The banks began to take a bimetal standard to alleviate part of the problem. Instead of reflecting their currency as a set number of grams of gold, they assigned certain grams of gold plus certain grams of silver. This stabilized the currency’s value until the mid-20th century when the US dollar replaced gold and other metals.
This dollar standard, or Bretton Woods Agreement (first International Monetary System), helped regulate currency fluctuations and restore economic stability. However, the dollar began to lose value in the 1960s, and a new world economic pact was necessary for 1972: the floating exchange market.
This is how Forex was born: a space for exchange.
When in 1972, the Basel Agreement created the European Monetary Snake to “maintain stability in the cross-quotations of their currencies,” in the words of the Bank of Spain, the countries committed to stabilizing their currencies with this system. But it was a complete failure.
The dollar continued to depreciate, and countries quickly emerged from the ‘snake.’ The international monetary system of a floating exchange rate regime was then born. The idea was that the relative value of many currencies would be set by the market through the laws of supply and demand, while the intrinsic values were under the protection of the central banks of each country.
To give rise to these exchanges, the foreign exchange market or exchange market appeared, abbreviated as Forex by the term Foreign Exchange.
What is Forex?
The Forex is a decentralized and unregulated market that allows exchanging some currencies for others bilaterally.
The Forex completely changed the concept of currency and currency. As of 2019, it was trading about US$6.6 trillion per day from the US$0.005 trillion (500 billion, more than a thousand times less) it traded in 1988. Today, the foreign exchange market is the world’s largest financial market.
How does the currency market work?
The foreign exchange market works globally so that banks can buy and sell currencies based on the exchange rate.
For example, BBVA can acquire 5 million pounds sterling today by paying in euros and selling them weekly, obtaining a profit when the euro loses relative value.
All Forex currencies are identified with an ISO4217 code, and a six-letter combination represents each currency pair. They are continuing with the example of EUR/GBP. The ‘major currency pairs are those with the highest trading volume and are the US dollar (USD) paired with: the British pound (GBP), the euro (EUR), the Japanese yen, etc.
Also, there are several interesting exchange groups. The ‘energy pairs’ are those affected by commodities such as gold, oil, and silver, and among them are NZD/USD, CAD/USD, and AUD/USD. It is also usually divided between operations without intermediaries (direct participants) or individuals (indirect participants), so who makes the change is relevant.
In recent years, thanks to tools such as APIs, banks like BBVA, which have historically been direct participants, have given indirect banks (such as SMEs) the possibility of entering Forex simply, integrated into their ERP and automated. . The FX API is an example of the latter, as it allows companies to automate the buying and selling of currencies.