Over-the-Counter Foreign Exchange (FX)

Over-the-Counter Foreign Exchange (FX): An Introduction The basics of understanding how currency trade works. By Jill Hamburg Coplan While more currency—or foreign exchange, forex, FX—changes hands daily than any other financial asset (about $4 trillion on average worldwide), it doesnʼt happen on a specific market or through a clearinghouse. Instead, thereʼs a decentralized “over-the-counter” forex market where buyers find sellers and vice versa. Individuals and small- to medium-size firms turn to brokers to represent them. (Giant multinational banks that need very large “lots” of foreign currency have their own buyer-seller matching system.) Transactions can theoretically happen anytime, any day, since currency trades around the clock, thanks to the major dealers, banks, and brokers concentrated in London, New York and Tokyo,

who open shop as their counterparts in other time zones are shutting down. “Fundamentals”—real events in politics and economics (shifts in a nationʼs interest rate, trade balance, or inflation, for example) make currencies fluctuate relative to each other. A natural disaster can also hurt a currency as holders sell, fearing the worst. When business owners, treasurers, or CFOs want to lock in stability and eliminate currency fluctuation to keep expenses predictable, theyʼre looking for more than just a purchase: They want to hedge risk. They have recourse to two main instruments: spot transactions, which allow them to purchase forex for delivery within a matter of days, and forward contracts, which involve purchase of forex at a particular time in the future, which may be a number of months away. These deals arenʼt standardized, but custom tailored, as needed. Forex is highly liquid, which means any size transaction is always available. Liquidity, plus high-tech telecommunications, keep pricing efficient as data blinks around the globe almost instantaneously. So even absent a centralized market, brokersʼ or dealersʼ quoted prices (called “bid/ask” rather than “buy/sell”) are competitively close, often with razor-thin differences between bid and ask. Confusion sometimes arises because this over-the-counter currency market—yen, euros, dollars, or yuan—is distinct from the market in currency-related futures and options. Futures and options are financial instruments based on currencies. These trade in standard lots, on major exchanges, like the Chicago Mercantile Exchange or the NYMEX in New York. While professional traders track the news and financial press for every word about the euro or dollar, most people just feel the upshot: changing prices and profit margins. Currencies are fluctuating widely today, with growing cross-border trade, economic distress, and split-second pricing. Itʼs striking that forward contracts, a solution created centuries ago so farmers could get paid, are as important to businesses as ever. Jill Hamburg Coplan, an adjunct professor at New York Universityʼs Arthur Carter Journalism Institute, has written about markets, finance, business and economics for Bloomberg News, BusinessWeek, Newsday, and Barronʼs, and served as an economics editor for think tanks and the United Nations....

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