The national central banks play an important role in the (FOREX) markets. Ultimately, central banks seek to control the money supply and often have official or unofficial target rates for their currencies. As many central banks have very substantial foreign exchange reserves, their intervention power is significant. Among the most important responsibilities of a central bank is the restoration of an orderly market in times of excessive exchange rate volatility and the control of the inflationary impact of a weakening currency. Frequently, the mere expectation of central bank intervention is sufficient to stabilize a currency, but in case of aggressive intervention the actual impact on the short-term supply/demand balance can lead to the desired moves in exchange rates.
If a central bank does not achieve its objectives, the market participants can take on a central bank. The combined resources of the market participants could easily overwhelm any central bank. Several scenarios of this nature were seen in the 1992-93 with the European Exchange Rate Mechanism (ERM) collapse and 1997 throughout South East Asia.
The Interbank market caters to both the majority of commercial turnover as well as enormous amounts of speculative trading. It is not uncommon for a large bank to trade billions of dollars daily. Some of this trading activity is undertaken on behalf of corporate customers, but a banks treasury room also conducts a large amount of trading, where bank dealers are taking their own positions to make the bank profits.
The Interbank market has become increasingly competitive in the last couple of years and the godlike status of top foreign exchange traders has suffered as equity traders are again back in charge. A large part of the banks’ trading with each other is taking place on electronic booking systems that have negatively affected traditional foreign exchange brokers.
Until recently, foreign exchange brokers were doing large amounts of business, facilitating Interbank trading and matching anonymous counterparts for comparatively small fees. With the increased use of the Internet, a lot of this business is moving onto more efficient electronic systems that are functioning as a closed circuit for banks only. The traditional broker box, which lets bank traders and brokers hear market prices, is still seen in most trading rooms, but turnover is noticeably smaller than just a few years ago due to increased use of electronic booking systems.
The commercial companies’ international trade exposure is the backbone of the foreign exchange markets. A multinational company has exposure in accounts receivables and payables denominated in foreign currencies. They can be protected against unfavorable moves with foreign exchange. That is why these markets are in existence. Commercial companies often trade in sizes that are insignificant to short term market moves, however, as the main currency markets can quite easily absorb hundreds of millions of dollars without any big impact. It is also clear that one of the decisive factors determining the long-term direction of a currency’s exchange rate is the overall trade flow. Some multinational companies, whose exposures are not commonly known to the majority of market, can have an unpredictable impact when very large positions are covered.
The arrival of the Internet has brought us a host of retail brokers. There is a numbered amount of these non-bank brokers offering foreign exchange dealing platforms, analysis, and strategic advice to retail customers. The fact is many banks do not undertake foreign exchange trading for retail customers at all, and do not have the necessary resources or inclination to support retail clients adequately. The services of such retail foreign exchange brokers are more similar in nature to stock and mutual fund brokers and typically provide a service-orientated approach to their clients.
Hedge funds have gained a reputation for aggressive currency speculation in recent years. There is no doubt that with the increasing amount of money some of these investment vehicles have under management, the size and liquidity of foreign exchange markets is very appealing. The leverage available in these markets also allows such a fund to speculate with tens of billions at a time. The herd instinct that is very apparent in hedge fund circles was seen in the early 1990’s with George Soros and others squeezing the GBP out of the European Monetary System.
It is unlikely, however, that such investments would be successful if the underlying investment strategy was not sound. It is also argued that hedge funds actually perform a beneficial service to foreign exchange markets. They are able to exploit economical weakness and to expose a countries unsustainable financial plight, thus forcing realignment to more realistic levels.
Investors and Speculators
In all efficient markets, the speculator has an important role taking over the risks that a commercial participant hedges. The boundaries of speculation in the foreign exchange market are unclear, because many of the above mentioned players also have speculative interests, even central banks. The foreign exchange market is popular with investors due to the large amount of leverage that can be obtained and the liquidity with which positions can be entered and exited. Taking advantage of two currencies interest rate differentials is another popular strategy that can be efficiently undertaken in a market with high leverage. We have all seen prices of 30 day forwards, 60 day forwards etc, that is the interest rate difference of the two currencies in exchange rate terms.