As the trade between the nations of the world flourish, the need to trade currency becomes important. Moreover, due to the terrific rise in the tourism industry, people need to secure the currency of the country that they will be visiting. Individuals are able to secure the currency of another nation through the foreign exchange market, where the trading of currencies occurs. As a financial market, this one is the largest in the world since it includes transactions between the central banks of various countries, speculators of currency, multinational corporations, other financial markets, governments even and large private banks. The average daily transaction in the worldwide foreign exchange market is over US$ 1.9 trillion (Cross, 1998).
The foreign currency market is a unique one because of the large volume of trading, the market’s liquidity, the great number of traders and participants in this market spread across various locations all over the world, its nonstop 24 hours trading excluding weekends and the number of factors that have impact on the exchange rates (“Triennial Central Bank Survey”, 2005). The daily turnover of this market reached US$2.7 trillion as of April 2006. The period between April 2005 and April 2006 saw the increase of the foreign exchange trading by as much as 38%. The reason behind this remarkable growth is because of the consideration of foreign exchanges as an asset that contributes to the growth of fund management assets such as hedge and pension funds. In addition, the World Wide Web has contributed to a better performance of the foreign exchange market (“Foreign Exchange”, 2006). The liquidity of this market is partly because there is no central clearing house owing to the fact that transactions are considered as over the counter, meaning traders and brokers deal with each other directly instead of going through whatever channels.
The largest trading center is located in London in the United Kingdom, which has been the host of the global turnover increase of 32.4% in April 2006. In addition to this, 73% of the volume of foreign exchange being traded is undertaken by the ten most active traders in the market. These traders are responsible in providing the market with the price that the bank will sell the currency or the price at which a market maker will buy such currency (Cross, 1998).
Participants in the Market
The Top Ten traders in the market include Deutsche Bank, UBS AG, Citigroup, Barclays Capital, Royal Bank of Scotland, Goldman Sachs, HSBC, Bank of America, JP Morgan Chase and Merill Lynch. This market, however, differs with the stock market. With the stock market, every participant has access to the same price. With the foreign exchange market, this is not the case. What happens is that there are inter-bank prices subdivided into the bid/ask price. This price, however, is almost insignificant for those at the top levels of the market. As the level descends, however, this difference widens and becomes more apparent (Murphy, 1999).
Banks are responsible for most of the speculations in the trading. They also bring billions of dollars in transactions on behalf of their clients on a daily basis. There are also commercial companies that participate in the trading. They trade in smaller amounts than banks and usually do so in order to pay for services and products. Because of this, they do bring a level of unpredictability in the foreign exchange market (Murphy, 1999).
In addition to this, Central banks also play an important role in the market since they are engaged in the process of regulating money supply, interest rates and inflation in their respective currencies. By buying or selling foreign currency, central banks are able to stabilize the economy of their country. There are also firms that manage investments that participate in the trading of foreign currency. Lastly, there are retail brokers of foreign currency that accounts for very minimal volume of the market (Murphy, 1999).
Foreign Exchange Reserves: Gold and the US Dollar
Central banks and other monetary institutions are holding foreign exchange reserves. This is usually referred to as international reserves and is considered assets of central banks. These are held in the most widely used currencies such as the US dollar, Euro and Japanese Yen. These reserves serve as backup to the liabilities of the government or monetary institutions (UK Reuters, 1999).
Foreign reserves used to be held in gold alone and not in currency. But when the Bretton Woods system was instituted by the end of World War II, the US dollar was pegged to gold, which means that the value of the dollar is the same as that of gold. It should be noted that at this time that the United States aided in the rebuilding of Europe and that its currency was the main currency used for this purpose. Not long afterwards, there was a shortage of dollars as it continued to flow to other countries in the form of grants and loans. It also underwent a balance of payments deficit, which helped make the present system liquid and working. By 1967, however, there have been great pressures on both the US dollar and the UK Pound sterling. This led to a difficult choice on the part of the United States to allow a “run on gold”. Because of this run on gold, the efforts to maintain the dollar peg to gold collapsed and the Bretton Woods needed to be reformed in order to deal with the challenges of the times (Helleiner, 1996).
Based on these trends, it appears that using a gold standard is no longer workable in today’s world. Since gold is a precious commodity and could be readily traded, it is better to use a more mobile and more liquid asset to conduct various transactions. In this regard, the Bretton Woods system, on the whole, started out well, during the time that the United States still had great influence in both the political and financial realms in the world. Given the decline of the US dollar and the rise of foreign exchange markets, the governments of the countries all over the world are not holding foreign currency reserves in multiple currencies that are being used extensively.
One of the benefits of the gold standard, however, is that the possibility of speculations is reduced. Speculation in today’s currency system is very much in operation in foreign exchange markets. If such a system goes unchecked, then it has the power to bring down economies. This has been seen in the Asian financial crisis in the late 1990s.
Foreign exchange markets are doing an important role in the financial performance of almost every country in the world today. Likewise, this trading aids the economic development of a lot of countries today. It is now no longer a question of whether or not such foreign currencies are backed by gold. It is more important to look at the factors affecting the foreign exchange market together with the various political and economic issues affecting the market such as the political and economic issues in various countries. Through this way, the traders and participants will have a better understanding of what is waiting for them in participating at the foreign exchange market.
Cross, S. Y. (1998). All About the Foreign Exchange Market in the United States. New York: Federal Reserve Bank of New York.
Foreign Exchange. (2006). International Financial Services, London. Retrieved 25 July 2007 from http://www.ifsl.org.uk/pdf_handler.cfm?file=CBS_Foreign_Exchange_2006&CFID=737984&CFToken=58532009.
Helleiner, E. (1996). States and the Reemergence of Global Finance: From Bretton Woods to the 1990s. New York: Cornell University Pres.
Murphy, J. J. (1999). Technical Analysis of the Financial Markets. New York: New York Institute of Finance.
Triennial Central Bank Survey. (2005). Bank for International Settlements. Retrieved 25 July from http://www.bis.org/publ/rpfx05t.pdf
UK Reuters. (1999). An Introduction to Foreign Exchange and Money Markets. New York: John Wiley and Sons.