Since 2020, the world and its economy have been in a state of constant turmoil caused by the notorious global pandemic or geopolitical struggles in different parts of the globe. The concept of financial stability ensured by a steady job or a promising business is being ruined by quarantine restrictions, soaring inflation, and economic wars between global powerhouses.
In these uncertain conditions, more and more people are looking for alternative routes to financial freedom and find them in financial markets, whether in stocks or, like in our case, the Forex market. But those who want to learn Forex trading from scratch need to understand that taking any shortcuts in the learning path will most certainly lead to the disaster called the account blowup.
Trading might look uncomplicated on the outside, but in reality, it’s one of the toughest occupations, mastering which requires building the knowledge base from the ground up, from properly understanding the very meaning of the term “Forex” and the origins of this market. This is exactly what we intend to help you with through the following article - creating a foundation for profitable Forex trading in years to come.
What’s that colossus called Forex and how did it come to existence
The term Forex stands for foreign exchange - it’s also often abbreviated FX - it represents a worldwide network of buyers and sellers who speculate in the national currencies of numerous countries that are placed against each other into trading pairs. Individual traders aren’t the only participants in this market - banks, institutions, and businesses, basically, anyone who needs to purchase or sell an official currency for another one as quickly and as safely as possible.
Even though the history of money exchange dates back 2,500 years when the Greeks and Egyptians traded coins made of precious metals, the Forex market in its modern form emerged in Amsterdam approximately 500 years ago which led to the stabilization of exchange rates across Western Europe.
A brief history of foreign exchange
Starting from 1821, the world currency market saw the emergence of the gold standard era after Great Britain and the United States pegged the value of respective national currencies to their gold reserves in an attempt to raise the credibility of the forming monetary system. Even though the gold standard had a number of flaws, it existed until the breakout of World War I and contributed immensely to the formation of the contemporary foreign exchange market.
Two world wars and the Great Depression in between them resulted in the abolition of the gold standard and the adoption of the Bretton-Woods system of monetary management between the countries of North America, Western Europe, Australia, and Japan. It led to the acceptance of the USD as the standard unit of exchange and made it into the global reserve currency as the only currency convertible to gold as per the International Monetary System (IMS). Later, the International Monetary Fund (IMF) was established to oversee the said system, but eventually, the convertibility of dollars was abolished, which led to the implementation of the free-floating exchange system cemented in the Louver Accord, the agreement signed between the members of G7 in 1987.
With the spread of the Internet, Forex has truly become a global phenomenon that offers access to millions of people to currency markets along with the opportunity to become financially independent. Today, all that one needs to start trading foreign currency is a laptop, a decent broadband connection, an account with one of the top Forex brokers, and an installed trading platform, such as MetaTrader versions 4 or 5.
For years, the foreign exchange market retained the status of the biggest financial market in the world worth around $2.5 quadrillion, with a daily trading volume of $6.6 trillion. Due to the fact that exchange activities are taking place all over the world, the FX market is live for 24 hours during all five business days. During the weekend, the markets are closed, offering traders the time to analyze their strategies and prepare for the coming week.
The functional attributes of the foreign exchange market
The general answer here should be obvious by now - the main function of the FX market lies in the facilitation of currency exchange activities between buyers and sellers. However, the functional attributes of this financial market are much broader. Apart from the exchange itself, Forex also carries out the transfer function that lies in the transition of purchasing power from one individual, business entity, or state, to another through the conversion of corresponding currencies.
The market participants, listed below, can also exercise the credit function by offering short-term credits to importers that want to purchase foreign goods or services through the issuance of a bill of exchange with a certain maturity period, commonly the three-month period.
The foreign exchange market also exercises the hedging function to mitigate the risks associated with high market volatility. The hedging is usually carried out through forward contracts, which is the agreement to buy/sell a currency at a determined date in the future and at a specified price.
The decentralized nature and the list of participants in the FX markets
What’s also interesting about foreign exchange is that it’s fully decentralized, contrary to stock exchanges like NYSE or LSE. This decentralization is explained by the fact that FX is composed of a network of banks that communicate with each other electronically without a central control facility. The trading principle of this kind is characterized by the term Over-the-Counter (OTC) market. As for the structure of Forex, it’s very broad and includes many actors. Let’s review them one by one:
- Retail traders are individuals or small groups of people who trade from home with a relatively small capital - around $10,000 on average. This is the most numerous group of participants, but they are unable to exert any significant impact on the market. This group of actors also includes exporters/importers, small-scale investors, and tourists (exchanging one currency for another at a bureau de change in a foreign country also constitutes a Forex trade).
- Commercial banks, retail electronic communications (ECN) brokers, and hedge funds that operate with significantly larger capital and are given permission to provide financial services or facilitate transactions within the Forex market (ECN brokers).
- Next on the Forex hierarchy ladder are Electronic Broking Services (EBS) and Reuters Dealing 3000 Spot Matching - both are electronic trading platforms that deal with market-making banks that are also known as liquidity providers that profit on the difference between the buying and the selling prices (the bid-ask spread) and facilitate trades between retail traders by reducing the transaction cost.
- At the top of the Forex structure, there are central or national banks, the main financial institutions that operate in any given country that participate in the Forex market. These banks exercise the functions of lenders of last resort and central custodians of corresponding currencies. These establishments are regulating the Forex market in respective jurisdictions and carry out interventions aimed at stabilizing a national currency at times of violent price fluctuations.
The top currency pairs across all Forex markets
Since the US dollar, often called the “Greenback,” remains the global reserve currency, USD is the currency that is being traded against the most on the Forex market. According to the latest stats, over 84% of all trading volume on the foreign exchange market accrues to the pairs that include USD. Currencies such as Euro (EUR), British pound sterling (GBP), and Japanese yen (JPY) also generate plenty of volume on a daily basis - they are called majors.
- EUR/USD is the most widely traded FX pair since both these currencies circulate in the regions that boast the largest economies in the world. Because of the constantly elevated interest in this pair, this market provides the most liquidity and tends to be less volatile than most other markets. High liquidity means that even very large orders are executed seamlessly because there is enough money to fill all orders at any given moment. The lower volatility translates to a ‘calmer’ and more predictable price action that allows traders to follow the visible trends and notice changes in the market structure that might signal the trend reversal. GBP/USD, also known as the “Cable,” is the pair where the US dollar is traded against the British pound sterling. Experts claim that this particular trading pair is positively correlated with the one reviewed above, which is another term for interdependence, which points to the similarity in price movements in both pairs - where one goes, the other follows. This is due to the fact that both economies are considered the oldest among modern economies. They are also very intertwined since the U.S. and the U.K. have always had strong ties, both military and economic.
- USD/JPY is the third most popular Forex pair, with the yen being the fourth global reserve currency behind USD, EUR, and GBP, and Japan being the third-largest economy in the world with a GDP of over $5 trillion. It’s believed that this particular pair has always been in a close correlation with the price of the U.S. Treasury bonds - the government-issued debt instruments used as an alternative to taxation - and the interest rates established by corresponding national banks. If the rates go up, the price of bonds tends to decrease which, in turn, has a positive effect on the given FX pair. Traders call this pair the “Gopher” and say that it correlates nicely with USD/CHF and USD/CAD.
- USD/CHF is the pair where the U.S. dollar is traded against the Swiss franc, which is why this pair is nicknamed the “Swissie.” This pair is important because, as you surely know, Switzerland is the global center of banking and financial services. And since this beautiful mountainous country knows very little political and economic turmoil, the franc is widely regarded as a safe-haven currency because it practically always remains unaffected by inflation, and up to 40% of its mass is backed by gold. Traditionally, this pair is negatively correlated with EUR/USD and GBP/USD.
- Other Forex trading pairs that might attract your attention are AUD/USD, where the base currency is the Australian dollar, hence the nickname the “Aussie,” accompanied by the one where USD is paired against the Canadian dollar (CAD), called the “Loonie.” This pair is also one of the most popular on the foreign exchange due to the very strong economic ties between both nations, though CAD tends to be affected significantly by the prices of commodities like oil. Besides, the difference in interest rates imposed by the Federal Reserve (Fed) in the United States also exerts an impact on the behavior of this particular market.
- Last but not least is the FX pair where the USD is traded against the Chinese yuan (USD/CNY). The interest in this pair is dictated by the unceasing economic and geopolitical tensions between the two powerhouses ever since the beginning of the trade war initiated by the Trump administration. It isn’t a major trading pair in terms of trading volume, although it does constitute 4% of daily FX trades. However, the strained relationship between the countries, and China’s strive to steal the economic leadership from the U.S., offer a plethora of opportunities for speculation since the pair has proven to be quite volatile.
The principles of formation of foreign exchange rates
Before starting to learn the basics of technical and fundamental analysis necessary for Forex trading, it’s of immense importance to understand how the exchange rates are formed and what moves the price up, down, or sideways. The rate is formed primarily by the basic economic law of supply and demand, which in this case is translated to the bid (buy) and ask (sell) offers. The distance between the closest bid and the closest ask is called the spread. In the currency pair, for example, EUR/USD, the first one listed (EUR) is called the base currency, and the second (USD) is the quote currency.
The price movement on this market is expressed not in dollars or cents, like in commodities or shares, but in pips. With the exception of JPY, a pip value is 1/100th of a cent so $1 equals 10,000 pips. In the case of the Japanese currency, a pip is worth 1% of one JPY.
The main factors that cause the movement of FX rates are economic reports from governments and financial institutions; domestic and foreign political occurrences; the showings of the gross domestic product (GDP); the increase or decrease of interest rates by central banks; the prices of important commodities like oil and wheat.
Types of Forex markets, from spot to swaps
Rookie FX traders, for whom this article is intended, will surely enter the vast realm of foreign currencies through the spot market where most of the action takes place. This market is great for beginner traders because there are practically no intricacies to it as all actions here constitute the straightforward buying or selling operations at the current exchange rate that is determined by a number of factors, such as supply & demand, interest rates, etc., which will be described later in the article. Small deals are usually settled immediately whereas large transactions usually take up to two days to be settled. Retail traders will find the spot market to be the most flexible and active of all Forex markets, which is explained by its immense liquidity, huge variety of deals of different scale, and the constant presence of market participants of all calibers, from independent traders who trade from their homes to hedge funds that operate with millions if not billions of dollars.
While spot markets take care of exchange operations on the spot, hence the name, forward markets open their doors to the parties that want to settle a deal at the determined date in the future and at a predetermined price. Unlike the spot market, where the currencies exchange hands right away and the trades are executed as promptly as possible, the forward market sees the deal being concluded and transactions being made only at the date in the future - no such activity is done on the day when the contract is made. This market is most useful for hedging against price fluctuations - it also offers more sophisticated ways to make a profit used by more experienced Forex traders. However, forward markets present certain disadvantages such as considerably lower liquidity than on spot markets and different counterparty risks like a default.
Futures markets are conceptually very similar to forward markets but they are considered safer and more efficient. In those markets, the contracts are also delivered and settled at future dates, but this trading process is standardized since it's carried out on a centralized platform, whereas trades on forward markets are done Over-the-Counter, in other words, strictly between two parties without a controlling entity and outside the standard contractual framework. Moreover, futures markets tend to be significantly more liquid than forward ones because of the greater number of participants involved. Futures contracts also have a useful feature called transferability, which means that they can be sold to other traders or funds before the expiration date. Lastly, these contracts safeguard against one party defaulting on another before the expiration date because they have a provision that obliges all parties to have a sufficient amount of funds to match the contract value at all times before the expiration.
Forex swaps market is probably the most complicated and confusing for a nascent FX trader who has to stick to spot markets at the beginning of a trading journey, but it still needs to be mentioned. During the swap, commonly known as FX swap, the sides exchange a certain amount of money in respective currencies under the obligation to repay the specified sum at a predetermined date and at a fixed exchange rate. Therefore, through swap markets, the participants exercise the loan function described above, but only at more favorable interest rates than on the general market. FX swaps are usually done with vast sums of money by financial institutions or large funds, sometimes on behalf of corporations that aren’t directly involved in the financial sector.
Don’t underestimate the importance of Forex regulators
Now that you’ve discovered the origin of the Forex market, the principles of price formation, the types of markets, and the most popular trading pairs, it’s time to get some insight into the subject that might seem boring to most beginner FX traders but it’s nonetheless important. The subject in question is Forex regulation and the regulatory bodies that oversee foreign currency exchange operations in corresponding jurisdictions.
Perhaps there is no need to explain that despite its decentralized nature, Forex needs to be regulated because the volume of money that is pumped through these markets on a daily basis attracts crowds of fraudsters and other white-collar criminals who are more than willing to lure the hard-earned money from gullible traders and investors.
We won’t delve into the methods these criminals use to steal the money - perhaps we’ll do a separate article on this topic - but it’s important to understand that without regulators, the Forex market would have been no safer than the Wild West. Before getting down to reviewing the most important regulators, let’s have a quick rundown of their main functions.
The functions of FX regulators
Forex regulators execute the function of broker licensing and oversee that their operations comply with the corresponding legal framework. The licensing is necessary to ensure that the broker is fully capable of meeting the obligations given to investors and traders. If a dispute arises, the regulator must act as an arbitrator and offer legal protection, thorough investigation and inspection of suspicious brokers.
- Financial regulators conduct regular audits of all licensed brokers and revoke the license if any breach of law is discovered, such as imposing hidden fees or offering excessively high leverage. The results of said audits are always made available to both registered and potential customers, thus ensuring the transparency of brokers’ operations.
- The regulators oversee that brokers keep the clients’ funds in separate (segregated) bank accounts opened for this particular purpose and not in their operational accounts.
- Ensure that brokers submit operational reports in a timely fashion, along with trade data and reports of suspicious activities on the part of traders, funds, and other market participants.
- If an illicit activity is discovered, the regulators make sure that the broker imposes the necessary restrictive measures with regard to the suspect’s account.
Through their regulatory and punitive measures, FX regulators instill confidence in traders and investors that they are on an equal footing with other participants, and that non-compliant brokers are held responsible.
How to check the broker’s regulatory license - what if the broker doesn’t have a license?
Therefore, before you sign up with a Forex broker, always carry out due diligence on this provider, especially if you aren’t residing in the country where the broker is headquartered or has its offices. This process isn’t that complicated - copy the licensing number that the broker ought to provide on its website, and then search it in the database of that regulator, the access to which is usually given through its official website. Otherwise, contact the regulator through the available means such as email or phone. Some regulators publish the blacklists of scam brokers or brokers with suspended licenses - make sure to check this list before putting the money with an FX service provider.
The only instance when you can skip due diligence is when creating the account with one of the brokers included in our own list of top Forex brokers that we published earlier. But even in that case, you have to make sure that it is operating in the right jurisdiction. For instance, if you reside in the U.S., it would be unwise to sign up with a broker that is regulated by the financial authority of another country, especially if that governmental body doesn’t have regulatory cooperation agreements with the United States.
In that case, traders and investors won’t be able to plead for legal protection. However, some brokers carry licenses from several regulators that give them permission to operate across several jurisdictions - they are called multi-regulated brokers. Dealing with them constitutes the safest way to trade on the Forex market. Most brokers included in our list of the best Forex brokers are multi-regulated.
We must also mention that some jurisdictions don’t require Forex brokers to obtain a license from a regulatory body. The broker can operate in that country as a fully legal business entity that provides financial services - and by no means such a business can be called fraudulent - but its customers shouldn’t count on getting the same legal support and assurances of safety of funds in their trading accounts. Therefore, if you still decide to carry out trading through such a broker, you would be doing that at your own risk.
Top regulatory bodies that oversee the foreign exchange
Some experts tend to classify Forex regulators as highly reputable, reliable, and unreliable. However, we don’t adhere to this classification because it’s rather vague. We prefer to focus on the strictness of their requirements towards brokers. In our opinion, the toughest regulators are in the United States, the United Kingdom, and Japan, whereas regulators in offshore zones like Seychelles or Saint Vincent and the Grenadines have the laxest regulatory requirements towards Forex brokers.
The National Futures Association (NFA) is the chief regulatory body in the U.S. with regard to the foreign currency market. It conducts due diligence, issues licenses, counteracts fraud, and ensures orderliness. NFA protects individual traders and small business entities that put no more than $10 million into the FX market. All licenses issued by this regulator, and the results of audits, can be found in the online verification system dubbed the Background Affiliation Status Information Center (BASIC). NFA allows for the leverage of no more than 50:1.
In the United Kingdom, the foreign exchange market is regulated by the Financial Conduct Authority (FCA) which operates under the purview of the British Treasury and Parliament. What’s peculiar about the FCA is that it charges a certain fee to the brokers under its regulation, the number of which exceeds 59,000. The licenses and audit results of all underlying brokers can be found in the Financial Services Register.
Operations with foreign currencies in Japan are regulated by the Financial Services Agency (FSA) which reports directly to the Minister of State for Financial Services. The fact that the Forex market in Japan is literally controlled by the government, which is one of the least corrupt in the world, makes this regulator one of the strictest in the industry, hence the brokers that manage to obtain the license from the FSA are universally considered among the most reliable.
Brokers that don’t want to deal with strict regulators try to acquire a license from the Seychelles Financial Financial Services Authority (FSA). This regulator emerged in 2013 and took that function away from the Central Bank of Seychelles and the International Business Authority (SIBA). The FSA demands that the firm that seeks to obtain the Forex license must have a share capital of $50,000 and no less than two shareholders and directors. The reasons why Seychelles is a popular destination for FX brokers are the short waiting period (no more than 4 weeks) and relaxed capital requirements. But customers of Seychelles-based brokers must be aware of the regulator's reluctance when settling complex legal disputes related to foreign exchange, though standard disputes are being settled in a normal fashion.
The article turned out quite lengthy, yet it revealed only the very basics of foreign currency trading, the very foundation of the fortress called “financial freedom.” But one doesn’t have to be an architect to understand that without the proper foundation, no building will be able to withstand the winds of volatility and uncertainty that occur on the Forex market every so often.
But if you are prepared to handle the long learning curve that is often comprised of mistakes and even failures - no one is able to “get it right” all the time, even the gurus - then you will eventually learn to understand the ebbs and flows of this great ocean of money and steer your ship to the calm haven of financial security. Rest assured that we will help you to find the way there with this and many other insightful articles.