How Does the Currency Exchange Market Work?

The Foreign Exchange or Forex, as it is traditionally referred to, is the international financial market where people and institutions are trading money. This might seem a little bit odd for some of you and in order to understand better, let’s go back a few decades ago when the monetary system was different.

A brief history of money
After the Second World War, the United States emerged as the biggest economic power and thus the Bretton Woods system had been put into place. It pegged the value of the US dollar to the price of gold (an ounce of gold was 35$) and all the other currencies had their exchange rates set according to the US dollar, with a fluctuation bandwidth of several percentage points.

Since 1971, a floating exchange rate system (also known as fiat system) had started and there was no link to gold or another commodity anymore. The price of money is set by supply and demand fluctuations and each currency is valued against other currencies.

Forex infrastructure
Due to the current floating exchange rate system, each of us is able to exchange local currency for a foreign one, either for personal purposes or as a day-to-day activity. That’s possible thanks to a vast physical and electronic network that connects banks, brokerage companies and other financial institutions.

Probably the most important players from the field are the “market makers”. The term refers generally to investment banks or some large banks from the main financial centers of the world (New York, London, Tokyo, Sydney, Hong Kong, etc.) that gather liquidity.

Market makers collect all currency exchange transactions that are being done and using complex algorithms, they constantly set the exchange rate for any particular currency. Retail traders don’t deal with investment banks, but they have access to the forex market thanks to the “middle man”.

In this case, the middle man is represented by brokerage companies, which generally use Electronic Communication Networks or other methods, to help people exchange currencies online, without having to go to a different country. Each broker, no matter where it is based, is working with a market maker. If you want to read more on the subject, you’ll find plenty of information online.

To conclude, the foreign exchange is the result of the technological development combined with the financial developments that have emerged over the course of the last few decades.