INTRODUCTION TO GLOBAL FOREIGN EXCHANGE MARKET

The foreign exchange market is a highly decentralized medium of exchanging the currencies of different countries. The market is said to be highly decentralized because much of the transactions are done Over–The-Counter. Only about 4 percent of these transactions are done in some exchanges in the United States (Chicago mercantile exchange), the European Union and Asia (Tokyo stock exchange). The foreign exchange is an integration of markets from all over the world. It is a 24hours, 5 days a week operation, this implies that trading hours do overlap. As some financial markets prepares to close, other financial market opens. An example is the London market session which coincides with the closing hours of the Asian session and the opening hours of the United States sessions. The Bank of International Settlements (BIS), the mother of central banks all over the world , Stated that global currency transactions amount to around 4.2trillion dollars per day, a figure that leads the daily transaction size of asset classes such as Bonds, Equity etc. Generally, the three most traded pair in terms of daily volume are the EURUSD, USDJPY and GBPUSD with 32%, 13% and 13% respectively, as stated by the Bank of England .

In the course of introducing this market, focus would be streamlined to the reasons behind the existence of the market, and the general market structure (market instruments, participants, market connectivity and regulation).

Originally, the participants in the foreign exchange markets are importers and exporters of goods and services. Historically, they use this medium to facilitate trades, a sole reason for the existence of this market. But as other need emerges, this list has increased over the decades to include financial institutions, Central banks, and leveraged retail traders. Details of how these participants use the market are given below.

IMPORTERS AND EXPORTERS (CORPORATES)

This class of market players uses the foreign exchange market to support the treasury operations associated with the core of their business activities such as mining, shipping and manufacturing. As such, corporations primarily use foreign exchange market as a medium of exchange; they trade relatively small amounts and hold these positions only briefly. Most of these corporates chose not to do speculative trading. Given their institutional needs



, this seems logical. An example of the type of transaction they do, is hedging against downside currency and commodity risks. Another is say, a United States multinational needing EUR to pay tax in Germany can decide to sell its USD holding to buy the EUR for payment to the German government.



FINANCIAL INSTITUTION

Financial institutions are a diverse category that includes Hedge funds and other Asset managers, Commercial banks, Brokers, Dealers, Central banks etc. As compared to corporate participants, financial institutions trade larger amounts and hold positions for far longer period. They control about 80 percent of the daily transaction in the foreign exchange market. Their use of the market includes treasury management, proprietary trading, client’s asset management, risk hedging, arbitrage, open market operations etc. This class of participants can be divided into leveraged and unleveraged.

Leveraged institutional participants

Example of financial institutions that falls into this category are the Hedge funds managers. Usually they employ the use of well defined speculative strategies that are based on fundamental analysis, Technical analysis and Quantitative analysis, with the use of leverage to maximize profit.

Unleveraged institutional participants

This category includes Commercial banks, Pension fund managers, Insurance companies, Endowment funds and Mutual funds etc. Usually this group employ hedging strategies so as for them to contribute to the development of a country.

CENTRAL BANKS

Although, private financial institutions dominates the foreign exchange market but the central banks are noteworthy participants in this market. Central banks use the foreign exchange market for open market operations(OMO) and also trade foreign exchange as part of the regular procurement for government functioning.

RETAIL INVESTORS

This class of market participant uses the market for speculative reasons. Before the advent of the Internet, the foreign exchange market is restricted only for the financial institutions and multinational companies. The arrival of the internet resulted in a drastic reduction of spreads, trade execution time and trade requirements. It is gotten from history that the first retail foreign exchange margin trade was executed by CMC Markets, a foreign exchange dealer in the United States, in the year 1996.

It is important for us to have an idea about Derivatives in general. It`s a super set that contains currency tied financial instruments. Derivatives are financial instruments which derive value from the value of an underlying entity such as equities, interest rates, indexes, and commodities.

Obviously from the definition and the class of market participants (financial institutions) that uses these financial instruments, we observe the volume potential of the Derivative market. The Currency derivative segment of the global derivative market is 9.1 percents, a figure that is second to the Interest rate Derivatives which has 80.6 percent. The remainder is for debt, equity and commodity based Derivatives.

Due to our interest in the currencies market, much of our focus would be towards the Currencies derivatives.

Constituting the foreign exchange market (currencies derivative market) are several instruments which includes:

(i) Currency spot (37%of daily transaction)

(ii) Currency forwards (57%of daily transaction)

(iii) Currencies option (6% of daily transaction)

Currency spot

A currency spot transaction is a direct exchange between two currencies (involves cash within a 48 hours life span and zero interest rate). This instrument is widely used by market participants for several purposes.

Example of a spot transaction is;

Say, you bought 0.1lot size of pair EURUSD with a $25 margin at 1.3956. It implies you have just bought 10,000 Euros with a leverage of 400:1(10,000 ÷ 25 = 400). If at the end of the day the EURUSD has risen to 1.4066. You sell those 10,000 EURUSD units at the new rate and get $110 back.

Currency forwards

Currency forwards are indirect exchange of currencies at a particular price regardless of the exchange rates at that time. Because they are indirect (deposit not required) the need for a contract arose. This kind of transactions deals with a high risk of default by counter parties. The two types of currency Forwards are Currency forward swaps and Currency futures.

Currency forwards swap

This is the most common type of currency forward. A swap transaction involves two parties that exchange currencies for a certain length of time and agree to reverse the transaction at a later date. They are not traded through an exchange, and require deposits to hold the position open until the transactions are over.



Currency futures

Generally it is a standardized forwards contract, which implies that it is being traded in an exchange, majorly in the Chicago mercantile exchange (CME) and Tokyo stock exchange (TSE).The average life span of currency futures is three months.

Currency option

These are a currency derivative that gives the right but not the obligation to buy or sell currencies to the counter party during a particular period. Mostly, it is being traded in an exchange. Only a small fraction is traded over- the- counter.

As earlier stated, there is no unified or centrally clearing house for the majority of trades in the entire foreign exchange market. Due to the Over- The- Counter nature of this market, there are numbers of interconnected market places where different currency instruments are traded. This made the market open to the possibility of different exchange rates depending on the class of market players in that network. A better market platform will be the one that serves lots of financial and institutional players in its network. Because the huge volume pool, by these participants will bring spreads to minimal levels. Several efforts have been made to create a centralized system for all trade transactions, but success is yet to be recorded. Nevertheless, examples of existing platforms include Bloomberg terminal and Reuters platforms amongst others. Due to the geographical dominance of the city of London in the global trade, exchange rates from London are religiously followed by market participant and used as a benchmark for global foreign exchange movements.

In conclusion, it would be hard to over state the effect of foreign exchange to the world economy. They affect output and employment through real exchange rates. They affect inflation through the cost of import and commodity prices. And affect international capital flows based on risk and returns of different assets. These made Currency exchange rates justifiably the focus of policy makers and the entire public. We suggest a deeper regulation of the Over- The- Counter markets for more depth in operational efficiency.

The CBN, in a circular dated June 23, 2015, stated that the implementation of the policy would help to conserve foreign reserves and facilitate the resuscitation of domestic industries as well as generate employment.

The circular, which was signed by the Director, Trade and Exchange, CBN, Mr. Olakanmi Gbadamosi, stated that it was imperative to exclude importers of some goods and services from accessing foreign exchange at the Nigerian foreign exchange market in order to encourage local production of the items.