Basics of Foreign Exchange Markets – How Currencies Are Traded

The Foreign Exchange Market (Forex or FX) is a global decentralized market where participants trade currencies. It facilitates the exchange of one currency for another, enabling international trade, investments, and financial transactions. The market operates 24/7, with participants including banks, corporations, central banks, and investors. Exchange rates in the forex market are determined by supply and demand dynamics, reflecting economic, political, and market factors. It offers spot, forward, swap, and derivative trading, making it a critical component of the global financial system.

Table of Contents

1. Brief History of Foreign Exchange Markets
2. Major Currencies and Currency Pairs
3. Basics of Currency Markets and Peculiarities in India

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1. Brief History of Foreign Exchange Markets

The current currency rate mechanism has evolved over thousands of years of the world community trying with various mechanism of facilitating the trade of goods and services. Initially, the trading of goods and services was by barter system where in goods were exchanged for each other. For example, a farmer would exchange wheat grown on his farmland with cotton with another farmer. Such system had its difficulties primarily because of non-divisibility of certain goods, cost in transporting such goods for trading and difficulty in valuing of services. For example, how does a dairy farmer exchange his cattle for few liters of edible oil or one kilogram of salt? The farmer has no way to divide the cattle! Similarly, suppose wheat is grown in one part of a country and sugar is grown in another part of the country, the farmer has to travel long distances every time he has to exchange wheat for sugar. Therefore, the need to have a common medium of exchange resulted in the innovation of money.

People tried various commodities as the medium of exchange ranging from food items to metals. Gradually metals became more prominent medium of exchange because of their ease of transportation, divisibility, certainty of quality and universal acceptance. People started using metal coins as medium of exchange. Amongst metals, gold and silver coins were most prominent and finally gold coins became the standard means of exchange. The process of evolution of medium of exchange further progressed into development of paper currency. People would deposit gold/silver coins with bank and get a paper promising that value of that paper at any point of time would be equal to certain number of gold coins. This system of book entry of coins against paper was the start of paper currency.

With time, countries started trading across borders as they realized that everything cannot be produced in each country or cost of production of certain goods is cheaper in certain countries than others. The growth in international trade resulted in evolution of foreign exchange (FX) i.e., value of one currency of one country versus value of currency of other country. Each country has its own “brand” alongside its flag. When money is branded, it is called “currency”. Whenever there is a cross-border trade, there is need to exchange one brand of money for another, and this exchange of two currencies is called “foreign exchange” or simply “forex” (FX).

The smooth functioning of international trade required a universally accepted foreign currency to settle the internal trade and a way to balance the trade imbalances amongst countries. This led to the question of determining relative value of two currencies. Different systems were tried in past to arrive at relative value of two currencies. The documented history suggests that sometime in 1870 countries agreed to value their currencies against value of currency of other country using gold as the benchmark for valuation. As per this process, central banks issue paper currency and hold equivalent amount of gold in their reserve. The value of each currency against another currency was derived from gold exchange rate. For example, if one unit of gold is valued at Indian Rupees (INR) 10,000 and US dollar (USD) 500 than the exchange rate of INR versus USD would be 1 USD = INR 20. This mechanism of valuing currency was called as gold standard.

With further growth in international trade, changing political situations (world wars, civil wars, etc.) and situations of deficit/surplus on trade account forced countries to shift from gold standard to floating exchange rates. In the floating exchange regime, central bank’s intervention was a popular tool to manage the value of currency to maintain the trade competitiveness of the country. Central bank would either buy or sell the local currency depending on the desired direction and value of local currency.

Fiat money is a government-issued currency that is not backed by a physical commodity, such as gold or silver, but rather by the government that issued it. The value of fiat money is derived from the relationship between supply and demand and the stability of the issuing government, rather than the worth of a commodity backing it. Most modern paper currencies are fiat currencies, including the U.S. dollar, the euro, and other major global currencies. The gold standard is not currently used by any government. Britain stopped using the gold standard in 1931 and the U.S. followed suit in 1933 and abandoned the remnants of the system in 1973. The gold standard was completely replaced by fiat money, a term to describe currency that is used because of a government’s order, or fiat, that the currency must be accepted as a means of payment. In the U.S., for instance, the US dollar is fiat money, and for India, it is the Indian rupee.

During 1944-1971, countries adopted a system called Bretton Woods System. This system was a blend of gold standard system and floating rate system. As part of the system, all currencies were pegged to USD at a fixed rate and USD value was pegged to gold. The US guaranteed to other central banks that they can convert their currency into USD at any time and USD value will be pegged to value of gold. Countries also agreed to maintain the exchange rate in the range of plus or minus 1% of the fixed parity with US dollar. With adoption of this system, USD became the dominant currency of the world. The Bretton Woods Agreement remains a significant event in world financial history. The two Bretton Woods Institutions it created in the International Monetary Fund and the World Bank played an important part in helping to rebuild Europe in the aftermath of World War II.

By 1973 the Bretton Woods System had collapsed. Countries were then free to choose any exchange arrangement for their currency, except pegging its value to the price of gold. They could, for example, link its value to another country’s currency, or a basket of currencies, or simply let it float freely and allow market forces to determine its value relative to other countries’ currencies. Hence, there was the need of a market where the exchange rates will be determined on a real time basis based on the information flowing through the markets. Since the Forex market was where currencies have always been exchanged, it was well poised to take up this role. The Forex market therefore came into prominence when the world went off the gold standard. This is because during the gold standard, there were no exchange rates to determine! It is only after gold was removed as the common denominator between currencies that all of them became freely floating and there was a need to value them against one another. Developed countries gradually moved to a market determined exchange rate (For e.g. USD, EUR, JPY etc.) and developing countries adopted either a system of pegged currency or a system of managed rate. In pegged system, the value of currency is pegged to another currency or a basket of currencies. The benefit of pegged currency is that it creates an environment of stability for foreign investors as they know the value of their investment in the country at any point of time would be fixed. Although in long run it is difficult to maintain the peg and ultimately the central bank may change the value of peg or move to a managed float or free float. In managed float, countries have controls on flow of capital and central bank intervention is a common tool to contain sharp volatility and direction of currency movement.

A clean float, also known as a pure exchange rate, occurs when the value of a currency, or its exchange rate, is determined purely by supply and demand in the market. A clean float is the opposite of a dirty float (also known as managed float), which occurs when government rules or laws affect the pricing of currency. A dirty float (managed float) is an exchange rate regime in which the exchange rate is neither entirely free (or floating) nor fixed. Most countries intervene from time to time to influence the price of their currency in what is known as a managed float system. For example, a central bank might let its currency float between an upper and lower price boundary. If the price moves beyond these limits, the central bank may buy or sell large lots of currency in an attempt to rein in the price. For e.g. If domestic currency quickly depreciates against USD, central bank may sell dollar and buy local currency.

2. Major Currencies and Currency Pairs

A currency pair is the dynamic quotation of the relative value of a currency unit against the unit of another currency in the foreign exchange market. Currency quotations use the abbreviations for currencies that are prescribed by the International Organization for Standardization (ISO) in standard ISO 4217. ISO currency codes are the three-letter alphabetic codes that represent the various currencies used throughout the world. When combined in pairs, they make up the symbols and cross rates used in currency trading.

The most traded currency pairs in the world are called the Majors. The list includes following currencies: Euro (EUR), US Dollar (USD), Japanese Yen (JPY), Pound Sterling (GBP), Australian Dollar (AUD), Canadian Dollar (CAD), and the Swiss Franc (CHF). These currencies follow free floating method of valuation. Amongst these currencies the most active currency pairs are: EURUSD, USDJPY, GBPUSD, AUDUSD, USDCAD, USDCNY and USDCHF. According to Bank for International Settlement (BIS) survey of April 2019, the share of different currency pairs in global average daily foreign exchange market turnover is as given below:

Source: BIS Triennial Central Bank Survey 2022

*Net-net basis, daily averages in April 2022, in percent

Currency pairs that are not associated with the U.S. dollar are referred to as minor currencies or crosses. These are usually derived from major non-USD currencies like EUR, GBP, and JPY. These pairs have slightly wider spreads and are not as liquid as the majors, but they are sufficiently liquid markets, nonetheless. For instance, Euro crosses include EUR/GBP, EUR/JPY, and EUR/CHF. Exotic Pairs stand out from these pairs because they contain a major currency (usually USD) and a currency from a developing or emerging market. This exposes traders to currencies from Asia, Africa, the Middle East, and more. An example of an exotic currency pairs are USD/TRY (U.S. dollar/Turkish Lira), USD/SEK (US Dollar/Swedish Krona), EUR/TRY (Euro/Turkish Lira) etc.

2.1 Major Currencies

US Dollar (USD)

U.S. Dollar (USD) is the home denomination of the world’s largest economy, the United States. U.S. banknotes are issued in the form of Federal Reserve Notes, popularly called greenbacks due to their predominantly green colour. The monetary policy of the United States is conducted by the Federal Reserve System, which acts as the nation’s central bank. It was founded in 1913 under the Federal Reserve Act in order to furnish an elastic currency for the United States and to supervise its banking system. As with any currency, the dollar is supported by economic fundamentals, including Gross Domestic Product (GDP), manufacturing and employment reports.

The US Dollar is by far the most widely traded currency. In part, the widespread use of the US Dollar reflects its substantial international role as “investment” currency in many capital markets, “reserve” currency held by many central banks, “transaction” currency in many international commodity markets, “invoice” currency in many contracts, and “intervention” currency employed by monetary authorities in market operations to influence their own exchange rates.

In addition, the widespread trading of the US Dollar reflects its use as a “vehicle” currency in foreign exchange transactions, a use that reinforces its international role in trade and finance. For most pairs of currencies, the market practice is to trade each of the two currencies against a common third currency as a vehicle, rather than to trade the two currencies directly against each other. The vehicle currency used most often is the US Dollar, although very recently EUR also has become an important vehicle currency.

Thus, a trader who wants to shift funds from one currency to another, say from Indian Rupees to Philippine Pesos, will probably sell INR for US Dollars and then sell the US Dollars for Pesos. Although this approach results in two transactions rather than one, it may be the preferred way, since the US Dollar/INR market and the US Dollar/Philippine Peso market are much more active and liquid and have much better information than a bilateral market for the two currencies directly against each other. By using the US Dollar or some other currency as a vehicle, banks and other foreign exchange market participants can limit more of their working balances to the vehicle currency, rather than holding and managing many currencies, and can concentrate their research and information sources on the vehicle currency.

Use of a vehicle currency greatly reduces the number of exchange rates that must be dealt with in a multilateral system. In a system of 10 currencies, if one currency is selected as the vehicle currency and used for all transactions, there would be a total of nine currency pairs or exchange rates to be dealt with (i.e. one exchange rate for the vehicle currency against each of the others), whereas if no vehicle currency were used, there would be 45 exchange rates to be dealt with. In a system of 100 currencies with no vehicle currencies, potentially there would be 4,950 currency pairs or exchange rates [the formula is: n(n-1)/2]. Thus, using a vehicle currency can yield the advantages of fewer, larger, and more liquid markets with fewer currency balances, reduced informational needs, and simpler operations.

Euro (EUR)

Euro is the official currency of 20 of the 27 member states of the European Union. Like the US Dollar, the Euro has a strong international presence and is the second-largest and second-most traded currency in the international markets for different types of transactions after the United States dollar. The euro is managed and administered by the Frankfurt-based European Central Bank (ECB) and the Eurosystem (composed of the central banks of the eurozone countries). As an independent central bank, the ECB has sole authority to set monetary policy. The Eurosystem participates in the printing, minting and distribution of notes and coins in all member states, and the operation of the eurozone payment systems.

Japanese Yen (JPY)

The Japanese Yen is the third most traded currency in the world. It has a much smaller international presence than the US Dollar or the Euro. The Yen is very liquid around the world, practically around the clock. It is also widely used as a third reserve currency after the US dollar and the Euro. The Yen is preferred as a funding currency for “carry trades1” by hedge funds.

British Pound/Pound Sterling (GBP)

Until the end of World War II, the Pound was the currency of reference. The nickname Cable is derived from the telegrams used to update the GBPUSD rates across the Atlantic. Sterling is the fourth most-traded currency in the foreign exchange market, after the United States Dollar, the Euro, and the Japanese Yen. The currency is heavily traded against the Euro and the US Dollar, but less presence against other currencies. It is also the fourth most-held reserve currency in global reserves.

Swiss Franc (CHF)

The Swiss Franc is the currency of Switzerland and is represented with the symbol CHF. The Swiss franc is considered a safe-haven currency. Given the stability of the Swiss government and its financial system, the Swiss franc usually faces a strong upward pressure stemming from increased foreign demand. Switzerland’s independence from the European Union also makes it somewhat immune to any negative political and economic events that occur in the region.

Indian Rupee (INR)

The Indian rupee is the official currency of India. The rupee is sub-divided into 100 paise. The issuance of the currency is controlled by the Reserve Bank of India. The Reserve Bank manages currency in India and derives its role in currency management on the basis of the Reserve Bank of India Act, 1934. The Indian rupee has a market-determined exchange rate. However, the Reserve Bank of India trades actively in the USD/INR currency market to impact effective exchange rates. Thus, the currency regime in place for the Indian rupee with respect to the US dollar is a de facto controlled exchange rate. This is sometimes called a “managed float”. Other rates (such as the EUR/INR and JPY/INR) have the volatility typical of floating exchange rates. Unlike China, India has not followed a policy of pegging the INR to a specific foreign currency at a particular exchange rate. RBI intervention in currency markets is solely to ensure low volatility in exchange rates, and not to influence the rate (or direction) of the Indian rupee in relation to other currencies.

According to Bank for International Settlement (BIS) survey of April 2019, the percentage share of various currencies in the global average daily foreign exchange market turnover is as follows:

* As two currencies are involved in each transaction, the sum of shares in individual currencies will total to 200%.

*Net-net basis, daily averages in April 2022, in percent

Source: BIS Triennial Central Bank Survey 2022

2.2 Overview of International Currency Markets

The international currency markets is a market in which participants from around the world buy and sell different currencies. Participants include banks, corporations, central banks, investment management firms, hedge funds, retail forex brokers, and investors. The international currency markets is important because it helps to facilitate global transactions, including loans, investments, corporate acquisitions, and global trade.

Foreign Exchange Market (Forex) is an inter-bank market that took shape in 1971 when global trade shifted from fixed exchange rates to floating rate regimes. Forex transactions are a set of transactions among forex market agents involving exchange of specified sums of money in a currency unit of any given nation for currency of another nation at an agreed rate as of any specified date. During exchange, the exchange rate of one currency to another currency is determined by supply and demand. Moreover, a corporate willing to hedge his currency exposure may also take appropriate positions in the market.

For the currency market, the concept of a 24-hour market has become a reality. In financial centers around the world, business hours overlap; as some centers close, others open and begin to trade. For example, UK and Europe open during the afternoon (as per India time) followed by US, Australia and Japan and then India. The market is most active when both US and Europe are open. In the New York market, nearly two-thirds of the day’s activity typically takes place in the morning hours. Activity normally becomes very slow in New York in the mid-to late afternoon, after European markets have closed and before the Tokyo, Hong Kong, and Singapore markets have opened.

Given this uneven flow of business around the clock, market participants often will respond less aggressively to an exchange rate development that occurs at a relatively inactive time of day and will wait to see whether the development is confirmed when the major markets open. Some institutions pay little attention to developments in less active markets. Nonetheless, the 24-hour market does provide a continuous “real-time” market assessment of the currency price and flow of influences and attitudes with respect to the traded currencies, and an opportunity for a quick judgment of unexpected events. With many traders carrying pocket monitors, it has become relatively easy to stay in touch with market developments at all times.

The Forex market is a worldwide decentralized over-the-counter¹ financial market for the trading of currencies. The scope of transactions in the global currency markets is constantly growing, with development of international trade and abolition of currency restrictions in many nations. With access to all of the foreign exchange markets generally open to participants from all countries, and with vast amounts of market information transmitted simultaneously and almost instantly to dealers throughout the world, there is an enormous amount of cross-border foreign exchange trading among dealers as well as between dealers and their customers. As per Triennial Central Bank Survey of Foreign Exchange and Over-The-Counter (OTC) Derivatives Markets in 2019, average daily turnover of OTC foreign exchange is approximately USD 6.6 trillion. Growth of FX derivatives trading, especially in FX swaps, outpaced that of spot trading.

OTC Foreign Exchange Turnover by Instrument

*Daily averages, in billions of US Dollars

Source: BIS Triennial Central Bank Survey 2022.

At any moment, the exchange rates of major currencies tend to be virtually identical in all the financial centers where there is active trading. Rarely are there such substantial price differences among major centers as to provide major opportunities for arbitrage. In pricing, the various financial centers that are open for business and active at any one time are effectively integrated into a single market.

3. Basics of Currency Markets and Peculiarities in India

3.1 Currency pair

Unlike any other traded asset class, the most significant part of currency markets is the concept of currency pairs. In currency markets, while initiating a trade you buy one currency and sell another currency. Therefore, same currency will have very different value against every other currency. For example, same USD is valued at say 78 against INR and say 115 against JPY. This peculiarity makes currency markets interesting and relatively complex. For major currency pairs, economic development in each of the underlying country would impact value of each of the currency, although in varying degree. The currency dealers have to keep abreast with latest happening in each of the country.

3.2 Base Currency/Quotation Currency

Every trade in FX market is a currency pair: one currency is bought with or sold for another currency. We need to identify the two currencies in a trade by giving them a name. The names cannot be “foreign currency” and “domestic currency” because what is foreign currency in one country is the domestic currency in the other. The two currencies are called “Base Currency” (BC) and “Quoting Currency” (QC). The BC is the currency that is priced, and its amount is fixed generally at one unit. The other currency is the QC, which prices the BC, and its amount varies as the price of BC varies in the market. What is quoted throughout the FX market anywhere in the world is the price of BC expressed in QC.

For the currency pair, the standard practice is to write the BC code first followed by the QC code. For example, in USDINR, USD is the base currency and INR is the quoted currency; and what is quoted in the market is the price of one USD expressed in INR. If you want the price of INR expressed in USD, then you must specify the currency pair as INRUSD. Therefore, if a dealer quotes a price of USDINR as 75, it means that one unit of USD has a value of 75 INR. Similarly, GBPUSD = 1.34 means that one unit of GBP is valued at 1.34 USD. Please note that in case of USDINR, USD is base currency and INR is quotation currency while in case of GBPUSD, USD is quotation currency and GBP is base currency.

In the interbank market, USD is the universal base currency other than quoted against Euro (EUR), Sterling Pound (GBP), Australian Dollar (AUD).

Currency pairs are quoted based on their bid (buy) and ask prices (sell). The bid price is the price that the forex broker will buy the base currency from you in exchange for the quote or counter currency. The ask-also called the offer-is the price that the broker will sell you the base currency in exchange for the quote or counter currency. When trading currencies, you’re selling one currency to buy another. Conversely, when trading commodities or stocks, you’re using cash to buy a unit of that commodity or a number of shares of a particular stock.

Currency pairs can also be separated into two types, direct and indirect. In a direct quote, the foreign currency is the base currency, while the local currency is the quote currency. An indirect quote is just the opposite: the domestic currency is the base currency, and the foreign currency is the quote currency. The way currency pairs are quoted can vary depending on the country in which the trader lives-most countries use direct quotes, while some countries prefer indirect quotes. Most pairs using the
U.S. Dollar are direct quotes.

3.3 Forex Market

Generally there are two distinct segment of OTC foreign exchange market. The foreign exchange market in India may be broadly divided into two segment. One segment is called as “interbank” market and the other is called as “merchant/retail” market. The participants in the interbank segment are banks holding Authorised Dealer (AD) licenses under the Foreign Exchange Management Act (FEMA), 1999. Transactions in this segment are conducted through trading platforms provide by Clearing Corporation of India Limited (CCIL), Refinitiv (formerly Thomson Reuters) etc. before being settled by CCIL (for Cash, Tom, Spot and Forward USD-INR transactions) through a process of multilateral netting. Interbank FX market has a network of banks and institutions who trade in currencies among themselves. These transactions are generally of very high volume and make up for the bulk of the global forex market volume. The currency desks of different trading banks transact continuously, which keeps the currency exchange rate uniform. The retail forex market, on the other hand, has a large number of traders. The trading volume is, however, less than the interbank market as the value per transaction is low.

The mechanism of quoting price for both buying and selling is called as market making. For example, your close by vegetable vendor will quote prices only for selling and he will not quote prices for buying it. While in a wholesale market, the vegetable wholesaler will quote prices for buying vegetable from farmer and will also quote prices for selling to vegetable retailer. Thus, the wholesaler is a market maker as he is quoting two way prices (for both buying and selling). Similarly, dealers in interbank market quote prices for both buying and selling i.e., offer two way quotes.

Retail Customers in India with a need to buy/sell foreign exchange can have multiple avenues. They can do so over the phone with an AD Bank or through proprietary electronic dealing platforms of individual banks and Multi-Bank Portals (MBPs). In one-to-one negotiated dealing over the phone, customers with large order size command more negotiating power compared to the ones having smaller forex requirement. Banks also follow the practice of fixing “card rates” for the various forex pairs at the beginning of the day at which purchases and sales from/to retail customers would be made regardless of the intraday movement of the currency. To provide transparent and fair pricing in the retail forex market RBI in 2019, has introduced an electronic trading platform for buying/selling foreign exchange by retail customers of banks. The platform, FX-Retail, is rollout by the Clearing Corporation of India Limited (CCIL) in August 2019.

Forex trading in India typically takes place over-the-counter (including Electronic trading platform) for spot, forward and swaps (major trading venues for interbank spot market are Refinitiv D2 and FX Clear while forex swaps are largely transacted outside platform on a bilateral basis), futures are traded on exchanges, i.e., National Stock Exchange (NSE), Bombay Stock Exchange (BSE) and Metropolitan Stock Exchange of India Ltd. (MSEI). Options are traded both OTC as well as on Exchanges.

In majority of the “merchant” market, merchants are price takers and banks are price givers. Although few large merchants or corporates may ask banks to quote two way prices as such merchants may have both side interest i.e., interest to sell or buy or both.