Trading foreign exchange is markedly different from trading other financial assets in the market. There are certain unique features of foreign exchange which make it so different. In this article, we have listed these features and explain how they influence an individual’s ability to trade the market.
Currencies Come in Pairs
The biggest difference between the stock market and other markets is that you do not have to choose whether you want to buy or sell. By default, you are always doing both simultaneously. In the Forex market whenever you make a trade, you are always buying one currency and selling the other. This is because currencies are always traded in pairs.
The reason behind this is very simple. In the stock market when you sell a stock you are exchanging it for money. In the Forex market, money itself is the commodity being traded. Therefore, you simply exchange one sort of money for another kind. The kind of money that you are giving away is considered to be sold by you and the kind of money that you are accepting in return is considered to be bought by you.
Most novice investors have a difficult time getting their head around the fact that a Forex market entails simultaneous buying and selling of currency.
No Centralized Exchange
Stock markets all over the world work because there is a centralized governing body. This body is often called the exchange. It regulates all the trades taking place in the market and also provides an effective risk prevention mechanism. An exchange ensures that all the parties entering into a trade honour their commitments. They do so via risk reduction mechanisms.
However, in a Forex market, there is no centralized exchange. This is because an exchange would find it impossible to function given the width and breadth of Forex trading that happens in the world. Not having an exchange has certain implications. For instance, anyone trading in the Forex market faces counterparty risks. This means that they have to ensure that they enter into trades with parties that will pay up in the end! There is no centralized body mitigating their risk for them.
Another important feature of the Forex market is that there are no brokers and therefore no commissions. Forex market is run by market makers who provide two-way quotes. The difference between their buy and sell price is called their spread and that is what intermediaries in the Forex market earn. The Forex market does not have any brokers charging fixed commissions. Even the intermediaries in the Forex market obtain a reward if they bear risks i.e. hold the volatile currency for a short period of time before they can find another buyer.
Dual Role of Central Banks
The Central Banks of all the nations are major participants in the Forex market. Firstly, these institutions have massive capital backing. They have financial might of entire nations behind them and can significantly dent the market if the need arises. Secondly, they can control the underlying commodity being traded. For instance, the Fed can buy or sell US dollars in the Forex market. Alternatively, the Fed is the only body in the world that has the power to create more US dollars and thereby influence the market.
These central banks, therefore, play a dual role in the market. On the one hand, they are participants in the market just like everyone else. On the other hand, they have an undue influence on the commodity being traded. Hence, the actions of central banks are closely watched by other market participants since these are the behemoths that can make or break the market at will.
Although, there have been cases where individuals or private banks have overpowered these Central Banks in the market. Billionaire currency trader George Soros stands out in this regard. His trades have once brought down the “Bank of England” and he is therefore known as the man who broke the Bank of England!
Another important fact regarding the Forex market is that there is no regulation in this market. Therefore if one were to obtain insider information about the currencies being traded and used it to make a huge sum of money, there would be no legal repercussions. There have been many suspected cases where private investors have supposedly used inside information from the markets to make a killing within a few trading sessions. Even when their names came out in the open, there was little to no action taken since the Forex market does not have any regulatory body.
Also since there are no regulatory bodies there are no limits to trading. This applies to the fact that there is no maximum amount of upside or downside that a particular currency can see in a given day. Also, there is no restriction on the amount of money that individuals can invest in the market at one go!
Forex market, therefore, provides the freedom for unrestricted trading. However, this freedom comes at a cost i.e. increased risk of counterparty default.