Trading in the Currency Spot Market

Trading in the currency spot market is the most basic form of currency trading and consists of two counterparties agreeing to complete a currency exchange deal. In this agreement, one party commits to the delivery of a specified amount of one currency in exchange for a specified amount of a different currency in what is referred to as a currency pair. The rate that the two currencies are exchanged is set using a spot rate – this is the exchange rate in effect at the time that the deal is made.

Once details are agreed upon, most transactions must then be completed within two business days – this is referred to as the settlement date. Note that the exchange rate for the deal does not change when the transaction settles even if the exchange rate at settlement is different from the deal date.

The two business day requirement – sometimes referred to as “T + 2” where “T” represents the trade day and “+2” the addition of two business days to settle – is a carry-over from the days when currency deals were made over the telephone – or before that –in an outcry market place. Before electronic funds transfers, it would take one to two days to transfer funds between the counterparties and to verify that the money is in each account.

Currency trades involving Canadian (CAD) and U.S. (USD) dollars are a noted exception and are expected to settle within a single business day. This is because of the close proximities of the two countries and the fact that the major business centers share the same time zones. Canada and the U.S. also have a long history of cross-border trading which has led to a very efficient funds-transfer system and usually allows for faster settlement than would be the case for some other currency pairs.

The other common exception to the T+2 rule comes in the form of a cash transaction. A cash transaction is a specific trade that requires an immediate transfer of funds and generally takes place between counterparties that have an extensive business relationship.

In 1973, Reuters began to offer currency traders access to computer terminals linked together in a network known as the Dealing System, and by 1989, it was estimated that 30 to 40% of all forex trades were transacted over the Reuters network.^[1] While this made forex trading more efficient, this system – and competing networks such as the Telerate system offered several years later – were reserved for traders at the commercial banks and large brokerage houses.

Growth of the Retail Segment

It wasn’t until independent dealer / market makers began offering web-based or API trading platforms combined with market-making services, that forex trading was finally made available directly to retail clients and individual investors. Dealers can make a market by offering both a bid (the price you receive) and an offer (the price you pay) for a given currency pair with the difference between the two being the “spread”. While independent dealers can provide a market in this manner, dealers must still channel trades through a bank or broker.

Market Participants

Despite the increase in retail forex trading, commercial banks are still the driving force in the market with much of this activity related to interbank lending. Banks often require short-term loans to cover end-of-day transaction processing and a very efficient system has been established to provide a market for the banks. London, hosts the world’s largest bank lending market and the LIBOR (London Interbank Offered Rate) rate is used as a benchmark for the setting of commercial interest rates.

In addition to financial institutions, large corporations with global operations also require currency trading services. A U.S.-based company with an overseas production plant for instance, must pay workers in their own currency – local invoices must also be paid in the native currency and this requires the conversion of USD to the currency of the country in which the company is conducting business. In addition, companies with contracts in other jurisdictions may turn to the currency markets as a way to lock-in exchange rates as a hedge against an unfavorable change in interest rates.

While financial institutions and large corporations account for most of the trading volume in the forex markets, retail trading continues to grow. Supported by a host of service providers that can process smaller trades more efficiently than the large banks, individual investors can now access the forex market and compete for the best exchange rates for their trades.

Related Links

Currency Market Overview

Understanding Margin-Based Trading

Calculating Trade Profit

References

1. ↑ Global Information Infrastructure - Andrzej Targowski - published 1996