[Fegu]

The Foreign Exchange (FX) market is the largest “Over-the-Counter” market in the world. “Over-the-Counter” (OTC) means that there is no organized or prescribed exchange on which trading must occur. Another important feature of the FX market is that market makers always act as principals, and are under no obligation to pass any price on to their clients. Because they act as principals on every transaction, FX market makers are generally not allowed to charge commissions to their clients for trading. Unlike an agency-based equity market maker, an FX market maker can earn or lose money on any transaction. The competitive nature of the professional FX market ensures small spreads.

Market Participants, Brokers and E-Trading

Banks and Investment Houses

Commercial banks and investment banks are generally the market makers in foreign exchange. Traditionally, commercial banks served corporations who needed access to currency markets to conduct their international business. Currency transactions that cover imports, exports, remittances, transfers and tourist activities are considered current account transactions and, in some countries, are subject to a different set of rules than capital market transactions.

Investment houses, on the other hand, have traditionally been in the FX market to facilitate international investment flows, cross-border M&A activities and cross-border financing. FX transactions arising from this business are considered capital account transactions. These are, again in some countries, subject to different and in general more restrictive rules than current account transactions.

Today, the delineation between commercial and investment banks has blurred, and therefore the market activities of the two types of institutions are no longer clearly characterized by the above distinctions.

Central Banks & Governments

Central banks are primarily the guardians of the national currencies, and are usually responsible for setting monetary policy, and in some instances, exchange rate policy. Very often, exchange rate policy is regarded as the outcome of monetary policy. Some countries, like Japan, will take a very active role in managing the exchange rate, while others, like the U.S., will take a more “at arms” length attitude. In many countries, including the U.S., the finance ministry (Treasury) sets exchange rate policy.

Central banks, whether they set FX policy on their own or follow orders of the finance minister, are the executing agency to implement that policy through a variety of tools, the most direct of which is buying or selling currency. This is called direct intervention in the currency market.

When governments get involved in currency markets, they can either do so through their central bank or directly through market-making institutions. Genially, governments will only get involved directly in the market because of an economic need, such as establishing hedges on foreign funding, debt conversion, defense contracts, etc.

Corporations

Corporations use the FX market predominantly to facilitate their international business activities. Hedging currency exposure arising from the day-to-day or core business is known as transaction exposure management, while the hedging of balance sheet items, such as a manufacturing plant abroad, is known as managing translation exposure. Not all companies will manage their translation exposure, but prefer to establish funding in the same currency or simply absorb the currency fluctuations.

Some corporations may trade currencies actively for profit, besides trading them for hedging purposes.

Money Managers

Money managers are under increasing pressure to diversify beyond their own borders, to lessen the impact of domestic swings in the business cycle. International investors depend on FX market to acquire the foreign currency needed to pay for investments abroad. Frequently, these investments are hedged back into the home currency of the investor. During the life of the investment, coupon and dividend payments may need to be repatriated, and at the end of an investment, part of all of the sales proceeds may be repatriated into the investor’s home currency.

Some money managers will treat currencies as a separate asset class and take a more active role by establishing and lifting currency hedges as they deem appropriate.

Others will delegate their currency dealings to a “currency overlay manager” because they may feel that they lack the expertise and/or the infrastructure to do it themselves.

Hedge Funds

Hedge funds, despite their name, have very little to do with hedging. The naming is a consequence of how hedge funds are used: because a hedge fund, unlike a mutual fund, can be either long or short equities, bonds, currencies or any number of other assets, its performance is considered to be independent of other asset market. This “independent return” characteristic will add to the diversification of an overall portfolio. Therefore, an investor may want to have such an asset in the portfolio, providing a “diversification hedge”.

A possible characteristic of a hedge fund’s “macro bet” approach to investing is that it may carry significant positions with a concentration of risks based on a specific market view. Yet, other hedge funds may trade on purely technical models, rather than macro views.

Voice Brokers

Voice brokers still exist for certain families of products, ranging from forwards to options – in short, those products that are not yet traded on an electronic network.

FX-brokers do not act as principals; they merely connect buyers and sellers and charge a fee for the brokerage service. The emergence of electronic trading has, at least in the FX spot market, displaced the voice broker. It is likely that the same thing will happen with many of the other products that are still covered by voice brokers.

Individual Investors

A word about FX trading for individuals seems appropriate at this point. Currencies are much less volatile than stocks, as a general rule. Therefore, participants in the currency market tend to trade very large sums, in order to make profits that amount to something. For example, a 1 Yen move on a single day is about what can be expected in normal circumstances. This is roughly 0.8%. Compare this to a typical stock that moves 3-10% in a single day. In order to make $1,000 on a currency transaction, I have to trade over $1 million, while in a stock transaction, I can obtain the same Dollar result by trading an amount somewhere in the $10,000 - $50,000 range.

The point is that individuals who want to trade currencies for profit will need to be very highly leveraged, in order to equate the profit opportunities typically found in the equity markets. Higher leverage is directly associated with higher risk, while the returns do not have a linear relation to the leverage. For example, I can leverage my money 20 times and trade $2 million with a capital of $100,000. If the market moves 5% in my favor, I’ll double my money. If it moves 5% against me, my capital is wiped out, and I am done trading.

The moral is: trading is a very risky business when capital is being highly leveraged. FX trading for speculative profits is only worthwhile when trading in a highly leveraged fashion.

E-Trading

In addition to private network electronic trading (Reuters, EBS), a number of internet trading venues have emerged. The benefit of having access to FX via the internet is that FX becomes a much more ubiquitous product that is easily bought and sold. The fact that trading can be done on a standard platform may help straight through processing (STP) to become a reality. This is an important consideration for large users of FX, because it will lower transaction cost dramatically – a benefit that has a direct and immediate impact on the bottom-line.