The Forex Market
Initially, banks, multinationals and commercial enterprises operating their businesses overseas, and therefore generating revenue in diverse currencies, traded on the forex markets purely to protect their profits against price fluctuations. With the increase in volume, it became necessary to ensure greater liquidity because while their transactions were taking place, the market was also open to speculators. The dynamics have since changed and we can now distinguish various market participants, each entering the market for different reasons and with different goals in mind.
There are hundreds of active banks in the markets, but the larger ones are responsible for the majority of transactions carried out. The table below shows the percentage of the total volume exchanged on the markets by each individual bank. These banks have the advantage of being able to understand the positions of their major customers and with this information can position themselves in the market knowing they have the support of large investments that give them the possibility to influence the forex market.
Top 10 Currency Traders
For this reason it is very important to know when and how professional traders enter the market because the best strategy for a retail trader is to trade in the same direction as the professional traders, aiming to seize moments within the trend that the banks have created with their transactions.
For now it is important to understand that the banks play a key role in the foreign exchange market due to having a multitude of interests: both speculative in the short term using the bank’s own money (proprietary desk), and long term for both their own
protection and that of their customers from variations in exchange rates (hedging).
MULTINATIONALS, COMMERCIAL ENTERPRISES AND INVESTORS
Every business that performs activities outside of national borders, including transactions executed in a different currency, have an interest in the foreign exchange market. Capital flows need to be estimated and the risk carefully balanced so that budgets and business forecasts can be devised.
Take for example an American multinational with offices in Europe that has to pay their European employees in Euro: an appreciation of the Euro against the Dollar could weigh significantly on the cost of salaries calculated in US dollars. Another example is a European company that imports products from Japan and sells them in Europe: a devaluation of the Euro against the Yen will render imports more expensive, squeezing profits. This is why currencies can have a significant impact on these international businesses.
These companies do not usually operate directly on the foreign exchange market but rely instead on banks to perform hedging.
If a European company needs to make a large purchase in Yen in 6 months, but fears an appreciation of the Yen, it could go short on the EUR/JPY.
This way if the Euro indeed weakens, the higher cost of the Japanese products will be balanced by gains in the forex market. If, on the other hand, the Euro were to appreciate, the company will save on the purchase of the goods but will suffer investment losses. Hence this process cancels out the risk to business of a negative impact due to variations in exchange rates. In conclusion, these companies, via the banks, aim primarily to protect themselves and not to earn on the forex market.
The task of Central Banks is to support the government’s monetary policy and to maintain the stability of the currency by striving to avoid excessive fluctuations.
The instruments used by central banks to intervene in the market are essentially the following:
- Purchasing or selling their currency in an attempt to strengthen or weaken it
- Cutting or raising interest rates
- Threatening to intervene in the market, which is often sufficient to obtain the desired effect without having to resort to an actual intervention.
Central Banks have a vast array of resources and their every move, or presumed move, is immediately perceived by speculators as a very strong signal and can cause huge swings in the market. The force of these interventions is extreme when prices deviate considerably from the market fundamentals and the Central Banks can help to restore balance.
When prices are in line with the fundamentals, however, even central bank interventions may not be sufficient to avoid the inevitable. Just think back to when the Bank of England failed to prevent the Sterling from being forced out of the ERM in 1992 or, more recently, when the world’s major Central Banks continued to cut interest rate cuts down to 0%, yet still failed to calm the subprime mortgage crisis in 2008.
SPECULATORS (Hedge Funds, CTAs, Proprietary Houses, etc)
This is quite a varied category and includes all of those who work the forex markets trading in the short term and trying to take advantage of their knowledge and skills in order to profit. In this category there are Hedge Funds which we have heard much talk of just lately. These Hedge Funds have been labelled as one of the causes of the crisis in the financial markets. In the same category there are also other financial institutions including, as mentioned earlier, banks with their Proprietary Desk.
The reason there are speculators is of course to generate profits from the forex market, but in doing so they perform the basic function of providing liquidity to the market.
If, for example, the expectation is that of a weakening Euro against the Dollar in the long term and the multinationals seek to protect themselves by going short on the EUR/USD with millions and millions of Dollars, who would take the other side of the trade? If there were no institutional speculators it would prove difficult to find a counterparty for the transactions.
BROKER AND DEALER
This category of market participants services clients by providing access to the markets to those who cannot afford to do so directly through a bank. They do not therefore operate on their own but work as intermediaries for third parties. Usually, brokers’ clients are private traders and small investors, but even institutional speculators can use them to take advantage of arbitrage opportunities or even in order to not access the forex market directly, thereby maintaining anonymity on their positions.
Central Banks and multinationals have a long-term outlook and do not have any interest in earning on the forex market.
Speculators and banks on the other hand, either in part or in full, make a business of pulling profits from the market and also have an interest in the short term.
As private traders, we are small fish in an ocean of sharks and so our task is to figure out the movement of capital flows in order to follow the current and position ourselves on the same side as the major forex market participants.