The market for Foreign Exchange is vast. Over US$5trillion per day.
To put things into context, that’s US$220billion per hour. It is more than the entire quarterly volume of world trade. In five days it is more than the total annual US GDP (US$20.4trillion est. in 2018).
Only about 10% of this money is being used for “real” purposes – to buy goods or services. The rest is speculation by institutional and individual investors.
The Bank for International Settlements (“BIS”) is an international company owned by the world’s central banks and which “fosters international monetary and financial cooperation and serves as a bank for central banks”. In effect, it is the boss of the foreign exchange market.
The latest BIS report on Foreign Exchange (PDF download) (2016: it is only produced every three years) shows the market size and, interestingly, shows that it has recently contracted for the first time in a long time.
You will see that less than half of the total amount traded is by way of Spot Contracts, where one currency is immediately converted into another.
Some 87.6% of all transactions involve the US$ as one of the currencies in the Pair. It’s 31.4% for the euro – down from the last report, where it was closer to 40%.
Given the huge size of the market, it is surprising that it is almost totally unregulated – though in many countries the brokers dealing with the consumer must be registered and regulated.
“Foreign Exchange” is, for our purposes, the System of trading in and converting the currency of one country into that of another.
“Forex”, “ForEx” and “FX” have the same meaning as Foreign Exchange.
“The Foreign Exchange Market” is the global market in which foreign exchange is traded.
“Pairs” are the two currencies being traded in any transaction – e.g. buying US Dollars and selling Euro.
The “Exchange Rate” is the amount you pay in one currency to buy another currency. It is usually measured to four decimal points, e.g. if you pay US$1.15 to buy €1, the exchange rate is 1.1500.
“Pip” is the amount represented by the last digit in the exchange rate. This is, typically, 1/100th of 1% (0.01%). Currency margins are often measured in Pips. If you are paying 10 Pips above interbank rate you are paying about 1/10th of 1% (0.1%) of the price you are paying to the broker you are dealing with. See below.
“Spot Contracts” are contracts where currencies are bought and sold immediately, at the current rate.
“Future Contracts” are contracts when currencies are bought and sold for future delivery at an agreed exchange rate
How does the market work?
Almost all of that money changes hands electronically on the Foreign Exchange Market. As it is a market, there is a price for each currency and that price varies all of the time: literally, by the second.
There are various levels of access to the FX markets.
At the top level, deals are done between huge international banks. The exchange rate they use between each other – which chages constantly – is the “Interbank Rate”.
Below them banks are various levels of broker. The biggest are themselves large commercial banks. The smallest are very small indeed.
The big brokers sell large amounts of currency to the midsize brokers and the midsize brokers trade smaller amounts with the small ones. Generally, the smaller the broker you are using the more your currency will cost.
The brokers sell foreign exchange to end users (or “investors”) at varying prices but usually related to the Interbank Rate.
How does an individual transaction work?
In most countries, unless you are buying cash – for example, at an airport (usually not a good idea) you will have to register with a broker. The broker will open an account for you. This process is usually very fast.
This is so whether you are a private individual or a business.
When you want to buy or sell some currency you tell the broker. Most brokers have a minimum amount for a transfer. This varies a lot. These amounts are coming down all the time as more and more technology is used. For example, for Moneycorp it used to be £1,000 (US$1,310). Now it is £50.
You pay for the currency at the time of the transaction, either by putting funds into your account or by debit card.
The broker then transfers your funds to the bank account you specify – in your own country or overseas.
This is all very simple.
Some brokers deal with all or almost all currencies, most don’t. Some stick to just a small number of pairs.
Some brokers offer other facilities such as an online transaction service, a special plan for cheaper regular payments or taking conditional orders, which they will only execute once the currency paid has reached the exchange rate that you have specified.
How to “forward contracts” work?
From the buyer’s point of view, they are quite simple.
If your broker offers this facility – most do – you agree that you will buy a certain amount of currency on or before a certain date and at an agreed rate. You will then, typically, pay a 10% deposit.
The date you choose can, usually be up to 18 months or two years ahead.
When the time comes, you pay the rest of the price and take delivery of the currency.
There are two main reasons for wanting to make a forward contract.
You think the exchange rate is going to change in your favour
If you do this you are second guessing the banks. You may win or you may lose but this is pure speculation.
You want certainty
This is, in my opinion, a much better reason for entering into a forward contract.
Imagine that you have agreed to buy a consignment of cars for €10million. That is (now) US$11.7million (a rate of 1.1700). They are due for delivery in three months. You want to sell them on but you will be pricing them in dollars. You want to make sure that you make a profit, whatever happens to the euro-dollar exchange rate in the meantime. So you forward buy the euro. Let’s say at a rate of 1.1900.
Alternatively, you could be buying a house still under construction and you know that you are going to have to pay €200,000 in three months and then a further US$600,000 at closing in, say, one year. You want the certainty of knowing what these payments are going to cost you and so enter two forward contracts.
Is it better to use a bank or a broker?
Generally, you will get a much more favourable exchange rate if you use a currency broker.
This may seem strange, bearing in mind what I said earlier about generally paying more if you use smaller brokers. However, going against that, it the fact that most banks – and, dare I say it, in particular most US banks – are completely hopeless when it comes to foreign currency. They don’t really understand it. It is not their core business. Often, they don’t even have access to up to the minute exchange rates. They also have high overheads, which many brokers don’t.
The end result is that the cost of sending the money via a bank can be a lot higher than if you had sent it through a broker.
Of course, if you are going to use a currency broker you need to use a good one. Moneycorp, who I keep mentioning because they’re who I use, have been in business for 35 years and I and my companies have been using them for over 25. They make 9million transfers each year and have 900 employees worldwide.
On top of the better rate, a good broker can offer you advice and a personalised service you are unlikely to receive from your bank.
What fee do the brokers charge?
In most cases, there is no fee. They make their profit from the difference between the rate they pay for the currency and the price they charge you for it.
There will also usually be a charge to cover the bank charges involved in sending your money to its destination. This is usually small.
How long do transfers take?
It depends on the countries involved. Mine often arrive within a couple of hours but can take days, particularly if you are transferring large amounts to remote places.
Despite the fact that the funds usually arrive quickly, where there is a deadline involved – such as a closing (completion) of a property deal – I always send them at least a week in advance.