The foreign exchange (Forex) market is the world’s largest financial market. This market trades in the exchange rates of the entire planet through decentralized market mechanisms; this is where the value of each currency is traded. But what is a foreign currency and how is it different from a domestic currency? How and why was Forex created? What adds “value” to a domestic currency today?
What is a foreign currency and what differentiates it from a domestic currency?
To understand the foreign exchange market it is first essential to understand what a foreign currency is. According to Spanish Royal Academy (RAE), foreign currency is a “foreign currency referring to the unity of the country in question.” Broadly speaking, the term “foreign currency” is used to refer to any foreign currency other than the legal tender in a certain country. Foreign currency is the currency of another region.
In Spain, where the legal tender is the euro, the U.S. dollar, the Chinese renminbi or the UK pound sterling are examples of foreign currencies. However, for the United States, China or the United Kingdom, the dollar, the renminbi or the pound are considered simply local “currency”. For these regions, the euro is a foreign currency.
Every country in the world has one or more official local currencies, sometimes pegged to foreign currencies. This is known as the “fixed exchange rate,” and it is the policy followed by countries such as the United Arab Emirates, with the dirham pegged to the US dollar, or the Danish krone, which was linked to the German mark at the time and is now linked to the euro.
What differentiates currency exchange from foreign currency exchange?
In its banking customer portal, the Bank of Spain made a key division to understand currency exchange versus foreign currency exchange. While currency exchange is any transaction in which an asset goes from expressing itself in one currency to doing so in another, foreign currency exchange entails a change in currency when a payment or credit is made.
An example of the former. Going to an exchange desk as soon as you land in London from Spain to exchange euros for pounds is a currency exchange. One currency is exchanged for another currency.
On the other hand, when you pay in a London restaurant using your European card (which is associated with an account in euros) and the establishment receives the payment in pounds, we talk about a foreign currency exchange. This is where the foreign exchange market comes into play.
This is how currency exchange was born
The first standardized exchange of capital in history was not between currencies, but between currencies with the gold standard. Both silver and gold are scarce metals. That is why for millennia they were used as a system of exchange by themselves. When the gold standard was defined in 1875, countries determined how much gold their currency was worth.
A such, the first foreign exchange market was a market in which two currencies were related to each other according to their relationships to gold. If one country’s currency was worth 0.001 ounces of gold and another country’s currency was worth 0.0005 ounces of gold, the first currency was worth twice as much as the second. Of course, this system was problematic for many reasons.
For starters, gold did not have a stable value. In theory, it went up, but the opening of a new mine could cause its value to fall temporarily, dragging down currencies and producing unwanted economic phenomena. In addition, central banks were required to have some reserve in metal in order to secure exchanges.
To alleviate part of the problem, banks began to take a bimetallic standard. Instead of reflecting their currency as a certain number of grams of gold, they assigned it certain grams of gold plus certain grams of silver. This stabilized the value of the currency until the mid-twentieth century, when the U.S. dollar replaced gold and other metals.
This dollar standard, or Bretton Woods Agreement (first International Monetary System), helped regulate currency fluctuations and restore economic stability. However, the dollar began to lose value in the 1960s, and a new world economic agreement was needed in 1972: the floating exchange market.
This is how Forex was born: a space for exchange
In 1972, the Basel Agreement created the European “snake in the tunnel’ mechanism to “maintain stability in the cross-quotes of their currencies”, in the words of the Bank of Spain, and countries committed to stabilizing their currencies with this system. But it was a complete failure.
The dollar continued to devalue, and countries quickly exited the “snake.” That is when the international monetary system of floating exchange rates was born. The idea was that the relative value of many currencies would be fixed by the market through laws of supply and demand; while the intrinsic values were under the protection of the central banks of each country.
The foreign exchange market or exchange market, abbreviated as Forex, was created to facilitate these exchanges.
What is Forex?
Forex is the decentralized and unregulated market that enables the bilateral exchange of currencies for others.
Forex completely changed the concept of domestic currency and foreign currency. In 2019, it traded about 6.6 trillion U.S. dollars per day up from the 0.005 trillion (500 billion, more than a thousand times less) traded in 1988. At present, the foreign exchange market is the largest financial market in the world.
How does the forex market work?
The foreign exchange market operates globally so that banks may be able to buy and sell different currencies depending on the exchange rate.
For example, BBVA can buy 5 million pounds sterling today by paying in euros, and sell them within a week making a profit when the euro loses relative value.
All Forex currencies are identified with an ISO4217 code, and each currency pair is represented with a combination of six letters. For example, EUR/GBP. The “major currency” pairs are the ones with the highest exchange volume, and they are the U.S. dollar (USD) paired with: the pound sterling (GBP), the euro (EUR), the Japanese yen, etc.
In addition, there are several interesting exchange groups. “Energy pairs” are those affected by commodities such as gold, oil, silver; these include NZD/USD, CAD/USD and AUD/USD. The market is also usually divided between transactions without brokers (direct participants) or individual transactions (indirect participations); as a consequence, the party involved is important.
In recent years, thanks to tools such as APIs, banks such as BBVA (historically, direct participants) have given indirect participants (such as SMEs) the possibility of entering Forex in a simple way, automated manner with integration into their ERP. The FX API is an example of the latter, as it allows companies to automate the buying and selling of currencies.
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